frankly speaking

The Formula that Killed Wall Street

There’s an interesting article in Wired about David Li, a quant who derived the Gaussian copula function, was touted as a lock for the Nobel Prize in Economics, and recently fell from grace due to the roll his function had in the current economic meltdown.

The Gaussian copula function models risks in a different manner, supposedly with greater accuracy. It was quickly adopted by ratings agencies, regulators and the greater financial community. In particular, it was instrumental in the securitization of assets like sub-prime mortgages. More specifically, Li’s function estimates the correlation of defaults in specific tranches, by looking at the movement of credit default swaps in the past. It allowed ratings agencies to assign Triple-A ratings to the “safest” tranches, which have since been found to be overrated. These unrealistic ratings led to lower financing costs (since lower risk or higher safety means lower required compensation for risk and thus lower financing costs) which quickly caught on and helped drive significant economic growth.

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don’t want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn’t have any risk at all, when in fact they just didn’t have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

Fast forward a few years, and the limitations of the Gaussian copula function become more obvious as correlations between defaults skyrockets and bankers, ratings agencies and regulators continued to ignore the effects of the assumptions they have made in using Li’s formula and fail to adjust these assumptions to reflect the new economic reality. Li himself warned of the way his model was being used, though these warnings fell on deaf ears. Perhaps if the model’s creator had been listened to, some of the current mess could have been avoided. Anyways, it is a good article that I’d recommend. Enjoy.

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The Day Wall Street Exploded

You’ve heard of 9/11, but what about 9/16? I hadn’t either, but September 16, 1920 was the deadliest attack on US soil until the Oklahoma City bombing, and most people have never heard of it.

More surprising was that this terrorist attack, like the first World Trade Centre attack and the attack on 9/11, was also aimed at Wall Street.

A Yale Professor is now arguing (in her book, The Day Wall Street Exploded: A Story of America in its First Age of Terror) that 9/16 is relevant today given the parallels between that attack and 9/11.

The NY Times has a book review here. I’ve got this on my reading list and will post my own review once I get a chance to read it.

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Long Delay & Quick Update

After a long delay in posts, I thought I would offer a quick update and note that I am going to work toward more frequent posts.

I’m currently on international exchange to the University of Auckland in New Zealand, finishing my last semester of the combined LLB/MBA (side note, I should start using JD/MBA, since my law school recently decided to make the switch). In December, I wrote and passed the CFA Level I examination, and now I’m studying for the Level II exam this June.

Enough about me – I’ll get some new content up shortly

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Barbarians at the Gate: The Fall of RJR Nabisco

I recently finished Barbarians at the Gate: The Fall of RJR Nabisco, by Bryan Burrough and John Helyar, about the 1988 leveraged buyout of RJR Nabisco. Although it is an older book dealing with an event that occurred twenty years ago, it is still called one of the best business books ever written, and has been on my “To Read” list for a long time. Having finished it, I am satisfied that it is one of the better business books that I have read, and would recommend it to others interested in leveraged buyouts and tales of Wall Street mega deals.

One of the best features of Barbarians at the Gate is that the authors did an excellent job discussing the backgrounds of the key players and how each party got to a position where they were bidding upwards of $20 billion (in the late 80s!). What’s more, many of the players are still relevant today (Kohlberg Kravis Roberts, to name just one which is often in the media).

The story begins with Ross Johnson who, through a series of cunning moves, became the head of RJR Nabisco. Early in the story, Johnson, fed up with the low valuations the market is assigning his company (due to the market’s distaste for tobacco-derived revenues), decides to launch a management-led leveraged buyout (LBO) to purchase the public shares of RJR Nabisco and take the company private. Such deals were exceedingly popular in the 80s. Critics argued that LBOs saddle good American companies with debt in order to finance the purchase and then leave the company unable to compete effectively against overseas counterparts. Proponents responded by saying LBOs force companies to become lean in order to pay off the high levels of debt, which makes the companies more competitive.

After Johnson launches the bid (with the help of Salomon Bros and Shearson Lehman Hutton), Kohlberg Kravis Roberts (KKR) makes a bid (with the help of Drexel Burnham Lambert’s junk bonds), which prompts Ted Forstmann’s Forstmann Little & Co to enter the fray (due to Forstmann’s hatred of Henry Kravis of KKR and the junk bonds it employs).

CONTINUE READING THE REST OF THIS ENTRY »

Tags: Book Review, Finance, Leveraged Buyouts, Takeovers

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It’s Your Ship: Management Techniques from the Best Damn Ship in the Navy

During an MBA course on leadership, I was given an article to read called It’s Your Ship, by Captain D. Michael Abrashoff. I recently found out that the article became the basis for a book entitled It’s Your Ship: Management Techniques from the Best Damn Ship in the Navy about Captain Abrashoff’s leadership education as commanding officer of the USS Benfold.

Abrashoff took over the Benfold at a time when the military was having problems attracting and retaining strong candidates and disillusionment ran high. The Benfold had a “sullen crew that resented being there and wanted to go home.” Abrashoff was able to turn the ship around to be “the best damn ship in the navy” by all accounts. As the junior ship in its area, the Benfold became the leader in all of the navy’s metrics, winning commendations and setting the standard for other ships to meet. Even more impressive is the fact that Abrashoff accomplished this without having to fire or replace a single crewmember – instead, he found the potential that had not been recognized to that point. It’s Your Ship is about how Abrashoff was able to accomplish this turnaround.

When reading the book, I was struck by the simplicity of Abrashoff’s actions. No act was complex or difficult, but the sum total was nothing short of remarkable. Abrashoff freed his subordinates (something counterintuitive in the armed forces) to solve problems creatively without fear of reprimand, and by doing so he created a team of problem solvers who didn’t need to turn to him for directions.

Abrashoff recognized that most obstacles that limit an organization’s potential are set in motion by that organization’s leadership, which often fails because of their own shortcomings. It is very rare that an organization fails because of the collective inadequacy of the workforce – too often the workforce is hampered by leadership. Abrashoff recognized that the more control he gave up, the better his team performed.

Abrashoff arrived at several leadership lessons that we can all learn from:

Tags: Book Review, Leadership

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The Black Swan – Part 4

This is the fifth of a five-part series reviewing Nassim Nicholas Taleb’s The Black Swan: The Impact of the Highly Improbable. You will find the review navigation at the bottom of this post.

Part 4: The End

What can we do about the Black Swan?

The Black Swan occurs relative to expectations. Expectations are derived from past experience, which as we have seen is fallacious (since a single disconfirming Black Swan is sufficient to destroy the soundness of our conclusions). Thus, if have undue confidence in your expectations, you will be open to the effects of Black Swans. On the other hand, if you keep an open mind about expectations, then you will be more likely to not let yourself fall prey to the Black Swan.

Recognize that we live in Extremistan and that a single event is enough to have an enormous impact. By recognizing this, you will be less likely to leave yourself vulnerable even to a single negative event. Hedge and be careful.

The Great Asymmetry
You should try to put yourself in situations where favorable consequences are much larger than unfavorable ones. This is known as the Great Asymmetry. Taleb gives some tips for how to do this:

Tags: Book Review, Logic, Nassim Nicholas Taleb, Prediction, Probability

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