On August 12, in a post titled, “The Subprime Meltdown Hits Quant Hedge Funds,” DeLong summed up the quant attitude:
“Our strategy is fine. We were just hit by a sixteen-standard-deviation event.” “Then it didn’t happen: the universe isn’t old enough for even one sixteen-standard-deviation event to have ever happened.”
Tails are fat.
From an article in the Financial Times, “Goldman pays the price of being big“:
“We were seeing things that were 25-standard deviation moves, several days in a row,” said David Viniar, Goldman’s chief financial officer. “There have been issues in some of the other quantitative spaces. But nothing like what we saw last week.”
And investors trust these guys with their money….
And Goldman management hired them….
Everything is fine as long as you don’t look behind the curtain!
I’m just an old guy with a public school education, but what financial statistical regularity wouldn’t break down with millions of dollars thrown at it in the blink of an eye? Shouldn’t management supervise the 27 year old wizbangs. Didn’t Mr. Blankfein recently express concern that nothing is certain?
They are also wrong in their assessment of how unlikely the events have been
This one of today’s Le columns at the FT
Published: August 14 2007 09:58 | Last updated: August 14 2007 14:30
To judge by the reactions of some, financial markets have disappeared completely off the radar. Goldman Sachs says its quantitative funds experienced “things that were twenty-five standard deviation events”. Leveraged buy-out deals – from the auction of Cadbury’s drinks unit to the sale of TXU – are said to be endangered. KKR and Blackstone have lowered their expectations for the LBO market. Meanwhile banks have been hoarding cash, prompting the biggest open market intervention in the European Central Bank’s history.
Yet the uncomfortable fact is that, by any historical standard, nothing serious has actually happened. For example, in the last week of July, US junk debt yields did jump by 50 basis points using Lehman’s universal index. But since the end of 1986 a weekly rise or fall of at least 50 basis points has been seen no less than 37 times. The idea that equity volatility has been unprecedented is also dubious. The S&P500 index has fallen by 6 per cent in four weeks. An equivalent move in either direction has been seen 123 times since the end of 1986.
Some of the price moves in specialist areas, like mortgages, have been far more severe. But how could the business models of generalist equity vehicles, banks or buy-out funds be in jeopardy? The answer, of course, is leverage. Before Monday’s bailout, Goldman’s Equity Opportunities Fund had gearing of six times. This year, for European LBOs, gross debt hit 6 times earnings before interest, tax, depreciation and amortisation. Assuming typical capital expenditure levels, that implies cash flow interest cover of 1.3 times. Quoted companies run at 10 times.
This cult of debt has its origin in asymmetric pay structures which overcompensate risk. It has been compounded by the trend of allowing managers, whether of structured debt or private equity funds, to in effect value their own portfolios. The tremors in the financial superstructure show how fine the margins for error now are. It is hard not to wonder what would happen if something genuinely serious – like a downturn in US profits – occurred.
Thanks for the comments, particularly the quote from the Lex column: “Yet the uncomfortable fact is that, by any historical standard, nothing serious has actually happened.”
Although it’s hard for all of us who aren’t on a trading desk to be certain, it appears that at least part of the problem is that a lot of capital has gone into instruments like CDOs that have never been tested in a serious downturn, and that these instruments have a lot of embedded leverage (their price moves disproportionately with changes in the underlying asset). And then investors often leveraged on top of that!
Yves, over at the FT, Dizzard makes the case that these guys do not consider fat tails and non-normal distribution because of their compensation structure.
The normal distribution works well in the short term and they get paid on a short term basis, while nontypical events occur about once a decade, so they need not worry fat tails.
Thanks for the pointer to the Dizard piece. One of the current problems with my posting strategy is that I look at the news and “obvious’ commentary first (editorial page stuff) and if there is a fresh item, I run with it. Which means that good stuff from folks like Dizard gets incorporated later.
I particularly liked his observation:
Everyone has known, or should have known, this for a long time. There are terabytes of professional journal articles on how to measure and deal with tails risk….
All this makes life easy for the financial journalist, since once you’ve been through one cycle, you can just dust off your old commentary.
See the earlier exchange on normal distribution v. Levy distribution – the latter makes these triple digit moves look far common but for reason only gaussian curves seem to be used to describe the financial markets!