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No more black swans

Posted in Finance by Pankaj Gudimella on April 8, 2009

Here are the ten principles for a black swan proof world from Nassim Taleb in FT.

1. What is fragile should break early while it is still small.
2. No socialisation of losses and privatisation of gains.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
5. Counter-balance complexity with simplicity.
6. Do not give children sticks of dynamite, even if they come with a warning.
7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.
8. Do not give an addict more drugs if he has withdrawl pains.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
10. Make an omlette with the broken eggs.

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The financial oligarchs

Posted in Finance by Pankaj Gudimella on March 27, 2009

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

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The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

Excellent piece from The Atlantic. More here.

State of the economy

Posted in Finance by Pankaj Gudimella on March 27, 2009

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Nice interactive updated 15th of every month from Russell

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Geither Plan Explained

Posted in Finance, NYTimes by Pankaj Gudimella on March 27, 2009

Leave on one side the question of whether the Geither plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases.

Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.

But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?

The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.

Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy.

And in this example it’s a large subsidy — 30 percent.

The only way to argue that the subsidy is small is to claim that there’s very little chance that assets purchased under the scheme will lose as much as 15 percent of their purchase price. Given what’s happened over the past 2 years, is that a reasonable assertion?

Source:NYTimes

FT has a 3 min video explaining the plan.

Systemic Failure

Posted in Finance by Pankaj Gudimella on March 14, 2009

Barry Ritholtz on factors which led to systemic failure

The perfect-storm metaphor is imperfect; rather, what led to the current situation were numerous legislative, ideological, and business decisions that worked together to create a systemic failure. Consider each of the following:

* The Commodities Futures Modernization Act (2000) allowed unregulated derivatives to run wild.
* The repeal of Glass-Steagall (1999) allowed depository banks to become far more intertwined with Wall Street.
* From 2001-03, Fed Chair Alan Greenspan took rates down to unprecedented levels, causing 1) a mad scramble for yield and 2) an enormous housing boom.
* In 2004 the SEC allowed the five big investment banks to leverage up from 12-to-1 to 35-to-1 or more.

Reverse each of the above and the total systemic damage is far, far less. There were several other factors—the changing business model of the ratings agencies from customer-financed research to a form of payola and the misaligned compensation system on Wall Street that pays people for short-term gains despite ongoing long-term risks. There’s a lot more, but I cannot forget the misguided deification of markets—a false belief system that led to a radical deregulatory philosophy that ignored the abdication of lending standards (“Innovative,” said Greenspan) among the subprime lenders.

Source:Slate

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The Gaussian Copula and VAR

Posted in Finance, Risk Management by Pankaj Gudimella on March 3, 2009

Risk management is very important for any firm, especially in the financial sector. Risk and return are inherently related to each other, there is a tradeoff associated with them. There certainly are times where more risk means more return and there are also times where more risk means no return. Many individuals and firms have come up with various models/formula to assess this risk-return phenomena.

The most successful formula of them all has been the VAR – Value at Risk. Almost all the firms use it today and have used it for the last couple of decades to understand not only a portfolio’s risk but the overall firm’s risk. But there is one serious detractor to VAR and that is Nassim Taleb. He says “VAR is like an airbag that works all the time except when you have a car accident”. Here is a good article from NYTimes on the heavy reliance of the Wall Street on VAR and how it affected their Bottomline.

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Another formula that Wall Street fell in love was what is called “The Gaussian Coupla” devised by David Li. You can read more here about how this formula was used and how it destroyed many firms on the street.

I think the lesson learnt from these stories is to avoid heavy reliance on one single metric/formula/model to run a business. The reason being none of them would be able to account for the Black Swan. And it is also true that the metrics created with the Black Swan scenarios in perspective wouldnt take into consideration the regular scenarios. There is no hard and fast rule here. Use the metrics/formulas/models with caution, understand the limitations that come with them, understand the upside and the downside, and hey use your gut feel and intuition!