Guest Post: Princeton Economist and Computer Scientists Show that Derivatives Are Inherently Vulnerable to Fraud

By Washington’s Blog.

As I have previously noted, credit default swaps are destabilizing for the economy. See this. And the models used to evaluate financial instruments – such as the Gaussian copula formula for CDOs – are inherently flawed.

Now, Princeton University economists and computer scientists have demonstrated that financial derivatives are also inherently vulnerable to fraudulent pricing.

PhysOrg summarizes Princeton’s findings:

In a result that may have implications for financial regulation, researchers from computer science and economics have revealed potentially impenetrable problems with the pricing of financial derivatives. They show that sellers of these investments could purposefully include pieces of bad risk that no buyer could detect even with the most powerful computers.

The research focused on collateralized debt obligations, or CDOs, an investment tool that combines many mortgages with the promise of spreading out and lowering the risk of default. The team examined what would happen if a seller knew that some mortgages were “lemons” and structured a package of CDOs to benefit himself. They found that the manipulation may be impossible for buyers to detect either at time of sale or later when the derivative loses money.

The team consists of Sanjeev Arora, director of Princeton’s Center for Computational Intractability, his colleague Boaz Barak, economics professor Markus Brunnermeier, and computer science graduate student Rong Ge.

It is now standard wisdom that a major culprit in the 2008 financial meltdown was use of simplistic mathematical models of risk at financial firms. This paper, released as a working draft Oct. 15, suggests that the problems may go deeper.

“We are cautioning that even if you have the right model it’s not easy to price derivatives,” Arora said. “Making the models more complicated will not make these effects go away, even for computationally sophisticated.”

Arora noted that the problem arises from asymmetric information between buyers and sellers, and goes against conventional wisdom in economic theory, which holds that derivatives reduce the negative effects of such unequal information.

“Standard economics emphasizes that securitization can mitigate the cost of asymmetric information,” Brunnermeier said. “We stress that certain derivative securities introduce additional complexity and thus a new layer of asymmetric information that can be so severe it overturns the initial advantage.”

Brunnermeier noted that the finding came from combining computer science and finance, which has not been done before but has the potential for further insights. “I anticipate that both fields can enrich each other,” he said.

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21 comments

  1. Dave Raithel

    Could be my mistake, but I thought the results showed not just that fraud can infiltrate the product; even when no fraud’s been done, the computational problems are intractable. It’s not just that complexity makes dishonesty a bit easier, but that honesty cannot be proven…

  2. Independent Accountant

    To their credit, Anne Rutledge and Sylvan Raynes of R&R Consulting in New York has said this for years. I call this “cherry picking”, i.e., selecting paper from the “left side” of the distribution for inclusion in CDOs.

  3. BS

    “Princeton Economist and Computer Scientists Show that Derivatives Are Inherently Vulnerable to Fraud”

    Geez, does that cover stock options too? Or just some derivatives…?

    1. Philico

      Can you believe they make a career out of it? Instead of focusing their minds to solving problems beneficial to mankind, they fraudulently think of how to scam the unsuspecting.

  4. David Merkel

    The Gaussian Copula was not the main model for credit default swaps, it was the main model for Collateralized Debt Obligations. Please slow down and get your facts right. You write a lot, but you owe it to readers to get it right.

  5. Don the libertarian Democrat

    “The results of this paper show how the usual methods of CDO design are susceptible ( NB Not Inevitable- Don ) to manipulation by sellers who have hidden information. This raises the question whether some other way of CDO
    design is less susceptible ( NB No one is claiming impervious- Don ) to this manipulation. This section contains a positive result, showing more exotic derivatives that are not susceptible ( NB Don ) to the same kind of manipulation. Note that this positive result is in the simpli ed setup used in the rest of the paper and it remains to be seen how to adapt these ideas to more realistic scenarios with more complicated input correlations, timing assumptions, etc.”

    I don’t see that this paper has settled the question about the usefulness of some CDOs.

    1. Dave Raithel

      This is the language that caught my eye: “One of our main results suggests that it may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields. (Note that since this is a hardness result, if it holds in simpler models it also extends for any more model that contains the simpler model as a subcase.) This result immediately posts a red flag about asymmetric information, since it implies
      that derivative contracts could contain information that is in plain view yet cannot be understood with any foreseeable amount of computational effort. This can be viewed as an extreme case of bounded rationality [GSe02] whereby even the most sophisticated investment banks such as Goldman Sachs cannot be fully rational since they do not have unbounded computational power.”

      That language immediately precedes the text most others seem drawn to: “We show that designers of financial products can rely on computational intractability to disguise their information via suitable ‘cherry picking.’ They can generate extra profits from this hidden information, far beyond what would be possible in a fully rational setting. This suggests a revision of the accepted view about the power of derivatives to ameliorate the effects of information asymmetry” (page 1)

      Then on page 3 we get: “Would a lemons law for derivatives (or an equivalent in terms of a standard clauses in CDO
      contracts) remove the problems identified in this paper? The paper suggests (see Section F.4 in the appendix) a surprising answer: in many models, even the problem of detecting the tampering ex post may be intractable. The paper also contains some results at the end (see Section 5) that suggest that the problems identified in this paper could be mitigated to a great extent by using certain exotic derivatives whose design (and pricing) is influenced by computer science ideas. Though these are provably tamper proof in our simpler model, it remains to be seen if they can find economic utility in more realistic settings.”

      Now this: “In fact, the problem of detecting such a tampering is equivalent to the so-called hidden dense subgraph problem, which computer scientists believe to be intractable (see discussion below in Section 1.2). Moreover, under seemingly reasonable assumptions, there is a way for the seller to “plant” a set S of such over-represented assets in a way that the resulting pooling
      will be computationally indistinguishable from a random pooling.”

      And so this point: “In the above setting however, there seems to be no direct way for seller to prove that the financial product is untampered. (It is believed that there is no simple way to prove the absence of a dense subgraph…)”

      There is no effective procedure to separate the good apples from the bad. No “honest” price is computable – unless the models latter suggested have useful applications.

      My emphasis on this point is that I run somewhat at odds with attributing our problems to only fraud, cooked books, misrepresentation, etc. I don’t dispute that those are causal factors. A question which more draws my attention, however, is more like this: Even if there were only honest players, would finance capital still have run aground? Papers like this – which I confess, give me a headache to follow – provide no reassurance. One may as well assume the game is fixed and nobody can be trusted….

        1. Dave Raithel

          And you and yours may be right. But that would mean the analysis one gets from Keen, built on Minksky, etc., is not salient. Most any analysis that assumed honest “rational” actors got us to here could not be salient. We are here because too many people cheated. That’s a whole different causal account. That matters for policy. Or it should…

          Thanks ….

  6. Rishi

    It’s simple and straight. Anything that is too complex for most people would naturally have even fewer whistle-blowers.

    By the time you understand such complicated financial calculus you already have an incentive not to hurt your bread and butter. Nobody learns financial calculus to critique it in the media articles.

    Besides when something is too complex or firmly established, it takes a hell lot of audacity to criticize it and be the sole person on opposite side of an army of intellectuals. One of the physicists, Boltzmann if I remember correctly was criticized so severely when he presented his work that he committed suicide unable to take the criticism of his work.

    Another physicist Richard P. Feynman once peer reviewed a manuscript meant for a journal publication. The manuscript submitted by two phd students was criticized very severely by respected Feynman in his review back to the authors. But Feynman kept dwelling on their ideas and realized that the students were right. When he wrote back to them, he came to know that subsequent to his scathing review both the phd students had abandoned their phd and one of the students had turned to alternative profession as a cab driver leaving physics altogether.

    The moral of the story is: As long as things are going right it takes nerves of steel to take on intellectuals on established theories/models.

  7. craazyman

    ” . . . the finding came from combining computer science and finance, which has not been done before but has the potential for further insights. “I anticipate that both fields can enrich each other,” he said. ”

    ha ha hahah ahahah!

    Haven’t they already!

    ha hahah ahahahah

    “Not been done before” . . . I mean really Dude! Like Never? I mean how do these hedge fund and proprietary trading desk quants suck the blood from the economy like Dracula year in and year out . . . God-Dang Santa Clause, I can’t stop laughing reading this stuff. It’s better than a Chris Rock video! ha ha hahah ahah!

  8. K Ackermann

    In even bigger news, other scientists are reporting that the fraud and risk tend toward the taxpayer.

    Jack Greene, a run-of-the-mill scientist, had this to say, “Yeah, there seems to be some mysterious attractor centered around the taxpayer. We don’t know what the hell it is yet.”

    1. charcad

      …there seems to be some mysterious attractor centered around the taxpayer. We don’t know what the hell it is yet…

      It’s fleece.

      On an administrative note, please make timely reservations for me to receive my Nobel Prizes in Physics and Chemistry for this discovery in Stockholm on December 10, 2010.

      1. K Ackermann

        Lol!

        I hope you win. I think Hank Paulson’s nomination for his treatment of the taxpayer as a new type of particle called a moron, is bogus.

        1. Dave Raithel

          Remains to be seen. Bogusoty is a function of positive acknowledgement – it is recognizable only when one’s dials are set for opposite polarity….(north is south, and east meets west …)

  9. Paul Tioxon

    It seems that rigorous examination from a scientific standpoint is not producing the wondrous awe that a well engineered bra from Victoria Secrets would in the eyes of the commentators. This is just one paper. It could be added to the preponderance of scientific evidence that would let us draw a conclusion based on more than revenewers and fancy pants Easterners figured out that water runs downhill. Yeah, it does, but do you know why? You business types still don’t get how little esteem you are held in. And it didn’t start with Big Bank Bailouts and galactic executive bonus. In our economically stratified society, those at the bottom know the game is rigged. From the state constitutions at the beginning of our Republic til today, the institutions that have produced a lot of wealth, even for John Q Public, have produced even more for John D Rockefeller. The too big too fail set of corps have de facto state power that supersedes our duly elected government. It is just now being openly discussed that if these organizations grow to a size where if they fail, they could bring down our social order, is a political problem bigger than the issue of property rights in the Constitution. We really are facing a Constitutional crisis, but it is not the one the Republicans are fabricating over Health Care Reform. The issue is the corruption of university mathematics research in the employ of stock market schemes. The use of the whiz kids, the braniacs and Nobel Prize winners always was the patina of respectability imported from outside of Wall Street to attract the investors and separate the rubes from their fortunes. Wall Street by itself commands no respect, the piles of money and what they can buy is what brings the academics into the casino. You get sick and tired of seeing 4th rate pseudo intellectuals get wealthy doing nothing more than a cheap imitation of an ambulant pus on the body politic. Now that serious minded people have taken their attention away from intractable problems of the academic sort, we see a socially useful and politically explosive analysis, lending their own patina of high powered ammunition necessary to take down aging oligarchs. It may be not bringing up anything more than we all already know, but they do it in way that commands respect that can not be easily countered, if at all. There will be more.

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