# Tag Archive for 'Salmon'

### Double-yolk eggs, clustering and the financial crisis

I happened to be listening when Radio 4’s “Today Show” had a little debate about the probability of getting a pack of six double-yolk eggs.  Tim Harford, who they called to help them sort it out, relates the story here.

So there are two thinking styles here. One is to solve the probability problem as posed. The other is to apply some common sense to figure out whether the probability problem makes any sense. We need both. Common sense can be misleading, but so can precise-sounding misspecifications of real world problems.

There are lessons here for the credit crunch. When the quants calculate that Goldman Sachs had seen 25 standard deviation events, several days in a row, we must conclude not that Goldman Sachs was unlucky, but that the models weren’t accurate depictions of reality.

One listener later solved the two-yolk problem. Apparently workers in egg-packing plants sort out twin-yolk eggs for themselves. If there are too many, they pack the leftovers into cartons. In other words, twin-yolk eggs cluster together. No wonder so many Today listeners have experienced bountiful cartons.

Mortgage backed securities experienced clustered losses in much the same unexpected way. If only more bankers had pondered the fable of the eggs.

The link Tim gives in the middle of my quote is to this piece, also by Tim, at the FT.  Here’s the bit that Tim is referring to (emphasis at the end is mine):

What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. [Snip some examples]

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” … In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

That’s pretty hard-core.  Imagine if under your maintained hypothesis, what just happened was a 25-standard deviation event.  That’s a “holy fuck” moment.  David Viniar, the GS CFO, then suggests that they occurred for several days in a row.  A variety of people (for example, Brad DeLong, Felix Salmon and Chris Dillow) have pointed out that a 25-standard deviation event is so staggeringly unlikely that the universe isn’t old enough for us to seriously believe that one has ever occurred.  It is therefore absurd to propose that even a single such event occurred.   The idea that several of them happened in the space of a few days is beyond imagining.

Which is why Tim Harford pointed out that even after the first day where, according to their models, it appeared as though a 25-standard deviation event had just occurred, it should have been obvious to anyone with the slightest understanding of probability and statistics that they were staring at a structural break.

In particular, as we now know, asset returns have thicker tails than previously thought and, possibly more importantly, the correlation of asset returns varies with the magnitude of that return.  For exceptionally bad outcomes, asset returns are significantly correlated.

### The US bank tax

Via Felix Salmon, I see the basic idea for the US bank tax has emerged:

The official declined to name the firms that would be subject to the tax aside from A.I.G. But the 50-odd firms, which include 10 to 15 American subsidiaries of foreign institutions, would include Goldman Sachs, JPMorgan Chase, General Electric’s GE Capital unit, HSBC, Deutsche Bank, Morgan Stanley, Citigroup and Bank of America.

The tax, which would be collected by the Internal Revenue Service, would amount to about \$1.5 million for every \$1 billion in bank assets subject to the fee.

According to the official, the taxable assets would exclude what is known as a bank’s tier one capital — its core finances, which include common and preferred stock, disclosed reserves and retained earnings. The tax also would not apply to a bank’s insured deposits from savers, for which banks already pay a fee to the Federal Deposit Insurance Corporation.

i.e. 0.15%.  It’s certainly simple and that counts for a lot.  It’s difficult to argue against something like this.

I would still have liked to see it as a convex function so that, for example, it might be 0.1% for the first 50 billion of qualifying assets, 0.2% for the next 50 billion and 0.3% thereafter.

Better yet, pick a size that represents too big to fail (yes, it would be somewhat arbitrary), then set it at 0% below, and increasing convexly above, that limit.

### Gray markets, PPP and the iPhone in China

Via Felix Salmon, I found this fantastic piece by “Bento” on the take-up of the iPhone in China.

Some background:  When Apple launched the iPhone in China, early sales numbers were disappointing.

Some background to the background:  Under Chinese law, WIFI-enabled phones are illegal, so Apple has to cripple the iPhones they sell in China.

From Bento:

The Chinese have long had access to iPhones. They are for sale at stalls in every cybermall and market in every Chinese city, and come in two varieties: The most expensive ones (at around 6000 RMB in Shanghai for a 16GB 3GS, or 880 USD, depending on your haggling skills) come directly from Hong Kong, where the factory-unlocked model is available from the Apple store for around 4800 RMB. That’s a nice arbitrage play by the stall owner, and everyone is happy. The cheaper model, at around 5000 RMB for a 16GB 3GS, was originally bought locked in the US or Europe, and has been unlocked by the stall owner’s hacker-genius cousin using 3rd-party software. This kind of iPhone is cheaper, because you are on your own when it comes to upgrades and iTunes compatibility.

The distribution model is extensive and robust, and in fact most Chinese buy their mobile phones from stalls like this. There are no iPhone shortages, as prices fluctuate to meet demand. The received wisdom is that around 2 million iPhones are in the Chinese wild; I’ve personally seen a good many of them here in Shanghai, where they are much in evidence among the eliterati. Still, this is a minuscule portion of the 700 million odd phones in use in China, of which a small but growing portion is smartphones.

What can Apple do to grow the number of iPhones on mainland China? Short of lowering prices in Hong Kong (not going to happen) it can do two things: Increase awareness of the iPhone via advertising, and bring the benefits of a Chinese-language App Store to Chinese iPhone owners.

To do either of these, you sort of need to sell the product locally first, though. Apple can’t really go round putting up banners in Chinese tier-3 cities urging consumers to head for the local iPhone aftermarket.
[…]
Apple … is not revenue-sharing with China Unicom, the local vendor, but selling the iPhones outright to them. It is up to China Unicom to flog them in China.

And that’s what China Unicom is trying to do. China Unicom stores all have iPhone banners up; I’ve passed several China Unicom road shows stopping by Shanghai extolling the iPhone. The iPhone is being talked about widely. But so is the fact that the China Unicom iPhone is crippled — the Chinese are sophisticated consumers; forget this at your own peril.

The upshot: anecdotal reports tell of aftermarket prices increasing for Hong Kong iPhones these past few weeks, as demand increased. Clearly, the advertising is working, even if China Unicom’s sales of wifiless iPhones are anaemic.

Arbitrage is clearly still happening — buy for 4800 RMB in Hong Kong, sell for 6000 RMB in Shanghai; that’s a 25% markup and well above any reasonable estimate of transportation costs — so Purchasing Power Parity (PPP) doesn’t even hold within the “one” country, but this is a great example of gray market imports.

### Ecuador defaults. Wait, no. Yes. Maybe?

Felix Salmon points out the absurdity of the situation:

A couple of major developments on the Ecuador front: yesterday, finance minister Elsa Viteri came out with the rather stunning decision that the country would make the coupon payments on its 2015 global bonds — despite deciding to default on the 2012s and the 2030s. And today, the Ecuador CDS auction closed at 31.375%, meaning that anybody holding an Ecuador CDS will receive 68.625 cents on the dollar.

Viteri’s decision opens up a major legal battle: there’s no doubt that Ecuador’s legions of creditors will attempt to attach those coupon payments the minute they arrive in the US. And I, for one, can’t imagine for a second that holders of the 2012s and the 2030s will take Ecuador up on any forthcoming offer to buy their bonds back at 30 cents on the dollar when the country is happily paying the 2015s in full.

This is not the first time Ecuador has tried to pay some foreign creditors without paying others who are pari passu. Ten years ago it tried a very similar trick with its Brady bonds — with disastrous results. But I don’t think that Ecuador has any grand strategy here; instead, the most likely hypothesis is that a well-connected financier has greased enough palms to make sure that he gets paid out on both his 2015s and his credit default swaps.

What all this means in practice is that Ecuador is now behaving so erratically that there’s no point even attempting to deal or negotiate with the present administration in anything like good faith. Instead, the holders of the 2015s will thank their lucky stars and hope that they actually receive their money; the professional vultures will be spending a lot of time in federal court in lower Manhattan; and most of the rest of the holders of the 2012s and the 2030s will simply wait for the next Ecuadorean president to come along. Because this one just isn’t acting logically.

*sigh*

### The (latest) bailout of Bank of America

Bank of America is being handed a butt-load of cash:

Bank of America will on Friday receive \$20bn in fresh capital from the US government and a guarantee on most of a further \$118bn of potential losses on toxic assets.

The emergency bail-out will help to cushion the blow from a deteriorating balance sheet at Merrill Lynch, the brokerage BoA acquired earlier this month.
[…]
The package is on top of the \$25bn BoA received from Tarp funds last October, and underscores the depth of the financial difficulties affecting the world’s leading banks.

At this point, BofA has received US\$45 billion in hard cash and – more importantly, to my mind – a guarantee against US\$118 billion of CDOs and related assets that they hold, many of them from their takeover of Merrill Lynch.

I don’t really want to get into whether bailouts in general are worthwhile, or if this one in particular is worthwhile. What I want to rant about is the nature of this bailout and in particular, that guarantee.  It’s been done in a manner highly similar to the one given to Citigroup last year, so my criticism applies to that one as well.

Here is the joint Press Release from the US Federal Reserve, the US Treasury Department and the FDIC.

Here [pdf] is the term sheet for the deal with Bank of America.

The guarantee is against a pool of assets broken down as:

• US\$37 billion worth of cash assets
• US\$81 billion worth of derivatives (i.e. CDOs and other “troubled” assets)

Profits and losses for the pool will be treated as a whole. The fact that one third of the pool is cash (and cash equivalents) will have been insisted upon by the US government because they will almost surely generate at least a minor profit that will offset losses in the derivatives.

In the event of losses on the pool as a whole, BofA will take the first US\$10 billion of losses; the US Government will take the next US\$10 billion of losses; and any losses beyond that will be split 90/10: the US government will take 90% of them. That gives a theoretical maximum that the US government might be liable for as 10 + 90%*(118-20) = US\$98.2 billion.  In all likelihood, though, the cash assets will hold or increase their value, so the maximum that the US government can realistically be imagined to be liable for is 10 + 90%*(81-20) = US\$64.9 billion.

But kicker is this: There was no easy way for them to arrive at that number of \$81 billion. The market for cash is massively liquid (prices are available because trades are occurring), so it is easy to value the cash assets. The market for CDOs, on the other hand, is (at least for the moment and for many of them, forever) gone. Unless I’m mistaken, there are no prices available to use in valuing them. Even if there were still a market, CDOs were always traded over-the- counter, meaning that details of prices and volumes were secret.

Instead, the figure of US\$81 billion is “based on valuations agreed between [BoA] and the US [Government]” (that’s from the term sheet).

I want to see details of how they valued them.

When TARP was first envisaged and it was suggested that a reverse auction might take place, the rationale was for “price discovery” to take place. The idea – which is still a good one, even if reverse auctions are a bad way to achieve it – is that since nobody knows what the CDOs are really worth, confusion and fear reign and the market drys up. Since nobody can properly value banks’ assets, nobody can tell whether those banks are solvent or not.

The generalised inability to value CDOs remains, and will continue to remain, a core issue in the financial crisis.

Suppose that the true value of BoA’s CDOs is US\$51 billion. At some point, we will collectively realise that fact. The market will become (at least semi-)liquid again and the prices will, at least approximately, reflect that value. But since the BoA and US government had agreed that they were worth US\$81 billion, it will technically look like a \$30 billion loss and so will trigger the US government handing \$19 billion (= 10 + 90%*(30-20)) to BoA and unlike the \$45 billion in direct capital injection, the government will get nothing in return for that money.

Therefore, BofA had an enormous incentive to game the US government. No matter what they privately believed that their CDOs were worth, they would want to convince the Treasury that they were actually worth much more.

The US government isn’t entirely stupid, mind you. That’s why the first \$10 billion in losses accrue to BoA. That means that for the money-for-nothing situation to occur, the agreed-upon valuation would need to be out by over \$10 billion. On other hand, that means that instead of telling a little white lie, BoA has an incentive to tell a huge whopper of a bald-faced lie in convincing the Treasury.

That is why I want to see details on how they valued them.

Felix Salmon thinks that both Citigroup and Bank of America should be nationalised:

[N]either institution is capable of surviving in its present form much longer. [Hank Paulson and Tim Geithner] should embrace the inevitable and just nationalize the two banks.

[T]his isn’t a bank run: Citi and BofA aren’t suffering from liquidity problems. They have all the liquidity they need, thanks to the Fed. The problem is one of solvency: the equity markets simply don’t believe that the banks’ assets are worth more than their liabilities.

The problem being, as I explained above, that nobody knows what the assets are really worth and the market is simply assuming the worst as a precautionary measure.

I’m not yet convinced that they should be fully nationalised. I just don’t think that the government should put itself in a situation where it promises to give them money for nothing in the event that their private valuation turns out to be too high (i.e. the market is correct in believing that they’re worth bugger-all).

Barry Ritholtz wants to know why the heads of Citi and BoA are still there:

Like Citi, the B of A monies are a terrible deal for the taxpayer — not a lot of bang for the buck, and leaving the same people who created the mess in charge.

Organ transplant medicine understands certain truths: You do not give a healthy liver to a raging alcoholic, as they will only destroy the organ via their disease/bad judgment/lifestyle.

In this, I agree with him entirely.