Stan Liebowitz concludes that the chief culprit in today’s mortgage-market meltdown is government. Here’s a key paragraph from the Executive Summary:
This report concludes that, in an attempt to increase home ownership,
particularly by minorities and the less affluent, virtually every
branch of the government undertook an attack on underwriting standards
starting in the early 1990s. Regulators, academic specialists, GSEs,
and housing activists universally praised the decline in
mortgage-underwriting standards as an “innovation” in mortgage lending.
This weakening of underwriting standards succeeded in increasing home
ownership and also the price of housing, helping to lead to a housing
price bubble. The price bubble, along with relaxed lending standards,
allowed speculators to purchase homes without putting their own money
at risk.
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{ 49 comments }
Although Mr. Liebowitz' comments are subdued and largely non-inflammatory, I have seldom been more angry with our government. Too bad no one in government is likely to pay any attention to what he says.
This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing
Correction: it succeeded in increasing the number of mortgages issued. The homes are not owned by the borrower until the lender is paid. It's a mistake to call borrowers "homeowners" when they have no equity in the home at all.
I'd dearly love to blame the whole thing on government home "ownership" mandates. However, lenders were only too happy to lower risk premiums across the board. Perhaps that too had something to do with implicit government guarantees (Fred & Fran) and reduced competition resulting from barriers to entry raised by regulation of lenders, but I don't know exactly how much that contributed. What I do know is that many investment banks kept some of the tranches of mortgages they were securitizing. For example, Stan O'Neal at Merrill Lynch was well known for overriding any objections to keeping the worst tranches at Merrill to get the deals done. It seemed that the perception was that risk was no longer risky.
Maybe, the perception was that Stan got a bonus at the end of the year based on the value of promises he made to buyers of his "securities", regardless of the truth of these promises.
So is Stan really so different from your garden variety politician?
Martin – but it's important to identify how those perceptions were created, I mean WHO created them?
Look who the plutocrats support.
Top 10 Corporate PAC Contributors:
Obama:
Goldman Sachs $739,521
UBS AG $419,550
Lehman Brothers $391,774
Citigroup Inc $492,548
Morgan Stanley $341,380
Latham & Watkins $328,879
Google Inc $487,355
JPMorgan Chase & Co $475,112
Sidley Austin LLP $370,916
Skadden, Arps et al $360,409
McCain:
Merrill Lynch $349,170
Citigroup Inc $287,801
Morgan Stanley $249,377
Wachovia Corp $147,456
Goldman Sachs $220,045
Lehman Brothers $115,707
Bear Stearns $108,000
JPMorgan Chase & Co $206,392
Bank of America $133,975
Credit Suisse Group $175,503
Stan's board members created them, I suppose. At least, Stan submitted a proposal to the board, and the board voted to accept it.
If I were a plutocrat, I'd be betting on Obama too.
"Perhaps that too had something to do with implicit government guarantees (Fred & Fran) and reduced competition resulting from barriers to entry raised by regulation of lenders, but I don't know exactly how much that contributed."
If you create a buyer for a product (in this case Fannie and Freddie for subprime loans) nobody should be surprised when sellers eventually appear (in this case the mortgage bankers and brokers).
Basically, Fannie and Freddie encouraged them to abandon proven underwriting standards.
Martin,
It wasn't that simple. The buyers of these ABSs were not retail investors but institutions like hedge funds and foreign governments. These institutions were filled to the gills with Ph.D.'s in finance, economics, math & physics. They were perfectly capable of deciphering risk on their own, without Merrill's promises. Plus, at some point (and Stan O'Neal was well beyond that point), the incremental million means less to you than your legacy. I don't think the bigger bonus for O'Neal explains his behaviour. There was a belief in a paradigm shift, though. There was a lot of research coming out of Investment Banks at the time concluding a paradigm shift in risk premiums. for a variety of reasons – including the ability to hedge risk with OTC derivatives – people thought there was solid justification for such low risk premiums. Some of the justification was the ability to hedge (but never perfectly without hedging away all positive edge – as per my earlier post) and some was the diversification offered by packaging mortgages from across the country. The problem is that the hedges were subject to counterparty risk and that severe dislocations tend to correlate uncorrelated markets. For example, emerging markets and developed markets tend to be pretty uncorrelated when volatility is relatively low and diversifying across them works. However, during severe shocks, they tend to become extremely correlated. So a portfolio you thought was well diversified suddenly isn't. I learned that the hard way early in my career.
I don't know exactly how to accurately allocate the blame for this. I do know that I was by far not the only one who was puzzled by all this when it was going on, so other people clearly understood that there was too much risk and too much leverage at the time this was happening. It wasn't just Wall Street folk who thought there was too much froth but people who were not in the financial field who puzzled at the wisdom of taking out home equity loans on zero down mortgages.
Basically, Fannie and Freddie encouraged them to abandon proven underwriting standards.
Chris, that's true. I can't disagree with you. However, lending standards were loosened for mortgages that Fan & Fred couldn't buy even after the conforming loan limits were expanded. There seemed to be an exuberance that reached beyond that which can be explained by Fan & Fred alone.
Formal theories of finance, or anything else, are like computer programs. In fact, they are computer programs. Garbage in. Garbage out.
Understanding some theoretical framework of "risk" and "widgets" doesn't tell you that I'll pay my mortgage. Einstein couldn't tell you what all of this paper is worth, even if he did his due diligence slavishly, because it's not possible. If it were possible, I'd be a socialist.
Diversification is the unicorn of finance. A fat tailed yield distribution can't be diversified. If the underlying distribution is Cauchy's rather than Gauss', diversification is utterly futile, and there's nothing very unusual about a fat tailed distribution. The Normal distribution is not normal.
I love EconTalk for introducing me to Nissam Taleb. I already knew the math, but Taleb places it in the economics context wonderfully.
Fat Tails
Martin, I have to disagree with you there. If you're buying zero-down terms and no check on income, as a financial professional you should know that this is a higher risk loan than a 20% down, 30 year fixed with all the due dilly and you should (at the very least) demand a much higher credit spread. That wasn't happening. Einstein couldn't tell if you as an individual will pay your mortgage but he could asses the probability of repayment and calculate an appropriate risk premium. And financial theory is no more "garbage" than economic theory. If this is what you understand from Nassim Taleb, then you misunderstand him.
I happen to know quite a lot about fat tails since I specialize in relatively illiquid assets which tend to have fat tails. Unlike Taleb, I've figured out how to be long teeny options without bleeding to death which is why I'm still in business.
…and Taleb had to close his hedge fund.
So what is the explanation that it took so long to burst? My first guess is that the Internet bubble might have proved a delaying factor.
Martin's last post (10:19) was spot on. Economics is a behavioral science, not a spreadsheet. Spreadsheets give you a false confidence.
And I echo the praise of EconTalk.
My criticism of this Liebowitz study is one Martin has made of my thinking: Why did home prices stop increasing? The study ignores this. It claims loose underwriting led to higher prices (plausible) which led to a bubble (not explained). Then, once home prices merely stopped increasing, foreclosures ruled the day because of speculators.
Apparently, 22-28% of US home buyers created a global meltdown. Very disappointing given the detailed research on other aspects of the paper.
"This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. "
Mr Liebowitz would do good to go back and read history on the front pages of the NY Times or Wall Street Journal all available on-line. The weakening of standards was pushed for by Wall Street and its bankers. These guys use their money and power to get everything they want from politicians. They corrupt the democratic and legislative processes. I'm getting to believe people like him, front-men of "think" tanks, pushing an elitist agenda are basically co-conspirators and now apologist of the greatest bank heist in the history of bank heist.
Lenders Try to Fend Off Laws on Subprime Loans
By RICHARD A. OPPEL JR. AND PATRICK MCGEEHAN
Published: April 4, 2001
The latest battle is in Philadelphia, where Citigroup, Household International and other lenders are seeking to derail a measure scheduled for a vote tomorrow in the City Council.
A Hands-Off Policy on Mortgage Loans
But many state regulators want to go further than the federal government. State banking regulators are locked in a long-running power struggle with Washington over so-called predatory lending: deceptive mortgage loans that have extremely high fees and are usually offered to people with poor credit.
Anyone attempting to blame this mess solely on government or even placing most of the blame on government is guilty of perpetrating a fraud on the American people. SHAME!
"These institutions were filled to the gills with Ph.D.'s in finance, economics, math & physics. They were perfectly capable of deciphering risk on their own, without Merrill's promises."
Funny… people are worried about the economic consequences of reacting to questionable complex models on climate change and yet these Wall Street wizards were allowed to test their models directly on the real economy. I bet that was probably pretty fun for them having the world economy as a laboratory with no restrictions. Well I guess it's back to the drawing board…. assuming government keeps its nose out of their private experiment.
Why did home prices stop increasing?
Russ, higher home prices encouraged more home building, more home building saturated the market, once the market was saturated and there was an oversupply of homes, prices began to decline.
Apparently, 22-28% of US home buyers created a global meltdown
That's the effect of leverage. Leverage amplifies everything. Suppose you have a portfolio leveraged 30x. Suppose the value of the assets in your portfolio decline a mere 3%. The value of your portfolio declines 90%. A 4% decline in the value of the assets results in a 120% in the value of the portfolio.
Since many new mortgages required very little down, the leverage on house purchases were far greater than 30x – often 90x, 100x or even infinity (zerod down). Thus, practically any decline in the price of the house means the mortgage is underwater and, with no skin in the game, there is huge incentive to default.
Even the best theory is not an oracle of truth either. If you feed garbage into it, you get garbage out of it. The problem is what you don't know (and can't know) about the specific assets you're trading, not the theoretical analysis of this information.
What I understand is linked above. He'll tell you it's correct.
I wish you the best.
An asset doesn't have a tail in this sense. A distribution of yields, describing many assets, has a tail. The "tail" is the sequence of decreasing frequencies in the example linked. A tail is "fat" if its expectation doesn't approach zero, so no matter how far out in the tail you go, rare events out there can significantly affect your average.
Sampling a fat tailed yield distribution doesn't mean that you'll inevitably fail to profit. It only means that a larger portfolio combining more yields can be as risky as a smaller portfolio combining fewer yields.
If a reliable counter party will accept your risk, by selling you options or whatever, that's fine, but the options are risky assets too, of course, and if the covered assets have a fat tailed yield distribution, I suppose the options do too. AIG was a big player in default swaps, emphasis on "was".
If Taleb had to close a hedge fund, that's not surprising. Understanding Black Swans doesn't entitle him to find any beautiful ones or to avoid any ugly ones.
LOL. Yeah it is okay for them to use the real economy as a laboratory as long as we watch them very closely. LOL.
Even the best theory is not an oracle of truth either.
Nor is it garbage.
An asset doesn't have a tail in this sense.
I was talking about the standard deviation of price distribution.
Sampling a fat tailed yield distribution doesn't mean that you'll inevitably fail to profit. It only means that a larger portfolio combining more yields can be as risky as a smaller portfolio combining fewer yields.
A point often missed and worth making repeatedly (only for it to be ignored, apparently).
You don't need to accept counterparty risk to trade derivatives. Counterparty risk only exists for OTC derivatives. Generally, derivatives are risky only in the hands of people who don't understand them or are careless about risk management. Plenty of people trade derivatives very successfully without blowing up because they understand risk and how to control it.
You're too hung up on entitlement. Taleb wasn't taken out by a black swan event. He closed his fund because it bled to death. His strategy was to buy teeny options and wait for the tail event to occur and then make a lot of money. The problem is that you can blow through all your capital paying premiums for teeny options before the tail event occurs. That's what happened to him. It's sort of the opposite of making $1K every day for 29 and losing $31K on the 30'th day. Figuring out how to be long tail risk without bleeding to death in the process is hard.
I bet that was probably pretty fun for them having the world economy as a laboratory with no restrictions. Well I guess it's back to the drawing board…. assuming government keeps its nose out of their private experiment
About as much fun as your unrestricted use of real children as lab rats for your experimental foray into playing "doctor". Soon, it'll be back to the drawing board for you – assuming the government stays out of your private experiment. Whatever that means.
"Funny… people are worried about the economic consequences of reacting to questionable complex models on climate change and yet these Wall Street wizards were allowed to test their models directly on the real economy."
Funny…will you finally realize the danger of the hysteria about the environment and "climate change", will you be against allowing prophet Al Gore and its acolytes to test their policies directly on the real economy (all their fantasies about alternative energy, green jobs, et cetera).
Without the Fed easy money policy, the government push for home ownership and the "too big to fail" mantra they couldn't have gone as far with their failed financial risk models.
Free markets cannot eliminate human folly, hubris and the herd mentality but left to its own devices the punishment comes fast and swift and so the recovery.
Free markets cannot eliminate human folly, hubris and the herd mentality
Free markets aren't meant to be or do anything.
It must be driving muirgeo crazy when we say things like that. He is unable to get it.
"Damn it sir, there must be A PLAN."
What ever happened to a belief in creative destruction — and why do we accept the fiction that there is no market for these residential mortgage backed securities. I'll bid on them — somebody point me to the market where I can make my bid. Link please.
This is the biggest lie in this whole mess. We know whose fault it is — it's the same people who keep perpetuating the myth that a market doesn't exist.
If I have my house on the market for $300k — lower it to $250k — lower it again to $225k — then reject an offer for $200k — am I being fair to hold my price at $225k and claim that no market exists for my house? Of course not! The market exists, I just don't like it.
Government intervention at this time would be idiotic unless their intent was to artificially support a market level that their previous intervention created. If they weren't going to overbid the market that does exist — why intervene?
I'm all for creative destruction. I'm a big fan of piling on. I say, kick a guy when he's down (this is doubly true for bankers). Let's clean this mess up quickly and get back to free markets run by a bunch of guys who've had the crap kicked out of them and will approach their next job with the caution they should have learned in their last job.
"Damn it sir, there must be A PLAN."
Posted by: Sam Grove
Right Sam there is no plan and that's why there is a shadow market "worth" nearly $60 trillion dollars of unregulated complex securities that hid the risks until it was too late to do anything about them.
It will cost me and you and society dearly and will be a drag on the economy for years to come.
You chose faith and ideology over a plan only to find out when you die there is no heaven or hell. You choose a lie over a plan and then think you're smart and I'm funny because I want a plan. That makes you look not so smart like a creationist. You think you're smart because you chose faith over planning. That's not smart. That's stupid and irrational. We are rational beings Sam… that's our advantage and you don't want to use rational thought…. you chose superstition. Instead of a cross on the wall over your bed is there an invisible hand? That's kinda weird Sam.
Sheetnotsowise,
There's no guys to kick "when their down". They're not down. They're in Tahiti driving their yacht, they're riding horses on their 100,000 acre ranch in Colarado. They are gambling in Macau …gambling huge amounts. They are counting their gold bullion. What you thought they didn't know what they are doing? Eee gad!! But they appreciate ones like you willing to back up their next "free-market" adventure.
George, "creationism" is an irrational belief that everything has to – must – be planned. That you would accuse advocates of spontaneous order to be likened to creationists is just another careless emotional reaction, albeit an ironic one. Two random thinks you've arbitrarily decided you don't like, you figure, must be comparable. No need to think about what the things are, just go with how you feel about them.
We are rational beings Sam.
Yes, we are rational beings, George, but you are not.
You keep blaming this mess on what I believe when obviously what I believe is not what we have. We have had over 70 years of progressive government. A government that has involved itself in the economy in many ways for even longer.
There has been no free market here from my libertarian perspective, there has been no laissez faire.
We have a government that has been intertwined with the bankers almost from day one. You should read that Hamilton link, it's quite illuminating.
You want to keep business out of government, I keep telling you, there is only one way to accomplish that.
You try to have it both ways, you assert that there is no free market, there has never been a free market, and then you insist that this mess is a result of free markets. That you do not see the contradiction in your mutually exclusive claims is not indicative of a rational mind.
A rational mind does not accept such a contradiction. A sensible mind would not claim such a contradictory position.
I've tried very hard to avoid dis-respecting you the way others here have done, but your intellectual dishonesty does you no honor.
Your unwillingness or inability to indicate that you have gained even the slightest comprehension of our multiple and extensive attempts at explaining the reasons behind our advocacy of markets freed from the (wealth influenced) guns of government leaves me wondering how someone can be so inverted as to completely negate their good intentions.
Hans Luftner,
"No need to think about what the things are, just go with how you feel about them."
I read something along that lines the other day in a book called "Plato and a Platypus Walk Into a Bar" (great little book for a plane ride). The idea was that statments like, "I think there is a god", should be interpreted as, "I get a warm fuzzy feeling when I think about god". That is, though presented in a psuedo-rational form, the statement is actually emotive. It occurs to me that most of Muirgeo's statements, and a great many of mine as well, fall into this category. So what does this mean? Not sure yet, but I think it means that most of what we argue about isn't worth the argument. Not quite ready to accept that though – I do love a good argument…
Sam,
Muirgeo simply doesn't want to accept what he's being told because it scares him. His mind creates a wall around the fear, and he dissociates from the reality of it. He's not dishonest or stupid, he's delusional. This psychosis allows his mind to create any manner of contradictions which he feels keep him safe.
Fear is a powerful emotion.
I'm not demeaning the financiers and economists here. Astrophysicists make the same mistake. I've seen it happen. A famous test for the spatial homogeneity of stars based on their apparent brightness, called the V/Vmax test, is also flawed for this reason.
The test might be valid, but it assumes a thin-tailed distribution of intrinsic brightness, so it really doesn't tell us anything about the spatial homogeneity of stars unless this assumption is true, and we know the distribution of intrinsic brightness only theoretically.
In other words, theoretical astrophysics is a lot like politics. People bicker a lot over vague assertions about stuff they don't understand.
A fat tailed distribution doesn't have a standard deviation, because it doesn't have a mean. Remember that the standard deviation is defined in terms of the mean. If you try to compute the mean for the distribution, the series doesn't converge.
Try to compute the mean of the fat tailed distribution I discuss at the link. The sequence of frequencies is a proper frequency distribution, i.e. the numbers add up to one. But if you try to compute the mean of this distribution, you find that it isn't well defined.
In elementary statistics, we're always assuming that the mean of a distribution is well defined, but this abstraction (the mean of the distribution) is only a simplifying assumption. Real distributions often don't have well defined mean values. To understand why this is true, look at the specific example at the link.
I'd like to hear him discuss this strategy, but we can't simply assume that a distribution is fat tailed either. A distribution can be either fat tailed or thin tailed. We typically don't know this characteristic of the particular distribution we're sampling, and we actually discover Black Swans all the time, i.e. we discover that assumptions we're making are not true.
I don't understand this statement. I thought that "counterparty risk" in this context is the risk that whoever sells you the option to buy an asset at a fixed price, for example, ultimately doesn't honor the contract, because he sold it naked for example. Are you saying that naked options are illegal except over the counter? Who polices this regulation?
You don't "figure" it. That's the point. Figuring averages doesn't work as you expect when you're dealing with a fat tailed distribution, and we typically don't know characteristics of the distributions we're sampling at all. We're only guessing. Maybe a distribution is thin tailed. Maybe it's not. This characteristic of the distribution might be variable. The distribution might be thin tailed today and fat tailed tomorrow. So you aren't figuring. You're guessing.
Guess is absolutely necessary in a capital market. If it were all about figuring, I'd be a socialist. The problem with "scientific socialism" is the "science" rather than the "socialism". I want everyone to be warm, cozy and secure too.
Taleb's point is that we often assume a lot more than we know. Often, we simply deny what's staring us in the face. That the baby boom is retiring and that this year is particularly noteworthy is no mystery. We simply choose not to acknowledge the event, because we want to discuss "problems" with the rent payers rather than discussing the fact that we've reached too far into the risk distribution, because we've run out of less risky rents.
If that's not true, explain a rising ten year Treasury yield even while the real yield is already deeply in the red.
Correction: … a rising ten year Treasury price. The yield is falling incredibly.
I don't understand this statement.
Martin, I explained this to you in an earlier post in response to your question about the existence of hedging options for debt instruments.
OTC derivatives have counterparty risk because they are structured products with no existing market. Since fixed income products are largely not standardized, it's more difficult to standardize derivatives to hedge risk and one must be careful of the soundness of the counterparty. Exchange traded derivatives are standardized and cleared, thus the clearing agent stands between the counterparties. Taleb was buying way out of the money exchange traded options ("teeny" options).
You don't "figure" it. That's thepoint.
Martin, I appreciate your zeal for Nassim Taleb and learning in general. However, I think you're in over your head here. What you're doing is akin to me, who understands some concepts in Quantum Mechanics and has read Dancing Wu Li Masters commenting on a particular physicist's particular experiment. I'm just not knowledgeable enough and I couldn't be made knowledgeable enough on a blog. When I say "I'm long gamma", do you know what I'm talking about?
You chose faith and ideology over a plan only to find out when you die there is no heaven or hell.
A schizophrenic mind or mangled Pink Floyd lyrics? You decide.
Sam,
Muirgeo simply doesn't want to accept what he's being told because it scares him. His mind creates a wall around the fear, and he dissociates from the reality of it.
Posted by: Adam
Adam,
It works both ways. My ideas scare you as well. But yes the idea of libertarianism scares me. If it didn't then why WOULDN'T I support it.
I simply don't think libertarianism will increase liberty. I actually think it would result in massive accumulations of wealth and all property being held in hands of a minority of wealthy people.
Here is my most selfish aspect of all this. I love to hike and backpack. I love the fact that I can pack my bags and hike The Lost Coast of California or to Azure Lake in the Sierra and no one can tell me I can't.
If Libertarians had their way their would be a NO TRESPASSING sign on all these areas now held in private ownership. There will be no increased liberty for the vast majority of people forced to live on others private lands under their conditions. It's truly the road to serfdom in my opinion.
Created wealth would give way to inherited wealth. The economy and innovation would stagnate. We'd have 2 classes. The small group of well to do Haves and the rest of the people the Have Nots. Corporations would still control the world and politicians and the government. I despise corporate politics. The wickedest people rise to the top.
Aside from my own selfish concerns is my concern for my 2 daughters. I wouldn't want them to grow up in such a world run by greed. It's against everything we teach them and its a brutal cold unfeeling world.
Yes it scares me.
Muirgeo,
Okay, I'll stop criticizing the government if they will;
1. End all payroll taxes and make the programs voluntary. The government can still run the programs for people who want government run programs.
2. Reduce the federal income tax rate to 10%, cross the board, no deductions, no credits, no exception. All other revenue has to be from user fees to allow people the ability to opt out of the so-called "services".
What do you say?
The question that needs to be asked of George is this:
Did the banks want to get in bed with the Government because the government has the power to coerce better outcomes for the banks.
Or
Did the Government happen to fall into bed with the banks because they "have all this money"?
I believe that the former is correct. If that is the case, then the answer to the problem is not to regulate the actions of the government and "the banks" in that bed. Rather the answer to the problem seems to be a dramatic and sudden decrease in the power wielded by the government. If the government cannot be used to force and coerce outcomes for an industry, then what's the point of lobbying?
So many of you neo-socialists don't seem to understand this concept. If the congress and the president actually followed the constitution then much of this crony-capitalism would not have occurred.
But that throws a wrench in your model of perfect government control doesn't it?
If Libertarians had their way their would
be a NO TRESPASSING sign on all these areas now held in private ownership.
I suspect there are more NO TRESPASSING today than in the past. Courts have made lawsuits a lucrative business.
When I was a kid we used to go to a swim hole on somebody's land where we took a path by a bull in the pasture. We had a great time.
I bet there's a NO TRESPASSING sign there now.
George loves his subsidized field trips.
A different manifestation of greed.
Thanks. That's what I asked. So the clearing agent is the policeman and warrants that an option seller can cover his bet?
Not yet, but I do know that you can't figure the standard deviation of a fat tailed distribution, because the distribution doesn't have a standard deviation, by definition. You can always figure the standard deviation of a statistical sample, but that's not the same thing.
I agree that you'd have a hard time developing a strategy to bet on Black Swans with the rational expectation of a yield. You can bet on them, but an expected value is precisely what a fat tailed distribution doesn't have.
If you want tell me what you're talking about when you say "long gamma", I think that's great.
I'll read this page for starters.
"He's not dishonest or stupid, he's delusional." – Adam
Well, you at least got it right in describing what Muirduck IS.
"My ideas scare you as well." – Muirduck
The difference being is that we've seen the results of your ideology. Most spectacularly in the USSR, Nazi Germany, Cuba, Cambodia and North Korea. Everywhere your ideology is tried, it produces human suffering of staggering immensity. You claim your version is different in that you want fifty percent-plus-one to impose your socialism on me. You crave the security of your Master's yoke, but you also know that you won't have to pull as hard if others are forced to into the yoke with you. BTW: You ducked Methinks' point on another thread about elections being held in the USSR.
By your own admission, you've never seen the results of libertarian ideology. You may never see the results because it's unlikely the Political Class will accept that they really shouldn't be so involved in our daily lives.
I actually think it would result in massive accumulations of wealth and all property being held in hands of a minority of wealthy people.
Sorta like we have now after 70 some years of progressive government.
Oh, wait, I can explain it. The libertarians took over the government about 70 years ago, got rid of: central banking, the FED, tariffs, anti-trust law, etc.
No, wait, that doesn't work. OK, the libertarians took over in 1980 and got rid of all of the above PLUS: DOE, EPA, FDA, FCC, a bunch of other government bureaucracies and programs, all business subsidies (which prevented the Chrysler bailout), all foreign aid, withdrew our troops and bases from all around the world, all agricultural subsidies, marketing orders, and so on, AND we eliminated the income tax.
OH wait, that doesn't explain the world at all. We're still stuck in this universe where all those things we want to get rid of still exist and the government and the bankers still run things.
Somebody must have had a plan and implemented it.
I know, George is posting from an alternate reality. I think that's it!
Sam, I was going to suggest that the center of Muirduck's alternate universe is Uranus, but I'm pretty sure it's actually his. :p
So the clearing agent is the policeman and warrants that an option seller can cover his bet?
No. Here's an explanation of clearing and settlement.
given your quantitative background and your interest, you should really check out Natenberg or Hull's derivatives textbooks. I think you would find them interesting.
Gamma is the second derivative of the option price with respect to the price of the underlying. To generalize, a long Gamma position is implicitly long Vega (volatility). So, you benefit when the market goes crazy, as it's doing now. We're in the tails! The trick is not to overpay for it – and that's what Taleb could never be sure of and I'm pretty sure he overpayed. Although, fools tend to blow up very quickly, so I figure most of the options traders willing to sell him the options were making him pay dearly.
Nassim Taleb's hedge fund strategy was to be long teeny options (deep out of the money options). Teeny options are particularly difficult to price because they are pricing catastrophic or manic events. If a distribution is fat tailed, applying a normal distribution model to it will severely underestimate risk. The Black-Scholes options pricing model uses a normal distribution, so it will always underestimate risk for teeny options, making them much more difficult to price. However, options traders know this. In addition, teeny options are obviously extremely hard to hedge and very few options traders are willing to trade them at all. In such thinly traded options, with so little price competition, it's doubtful that Taleb didn't overpay. But, we can't be sure. Depends on how many fools were willing to write them.
as you say:"You can bet on them, but an expected value is precisely what a fat tailed distribution doesn't have." Since Taleb wrote whole books about this, I'm surprised he thought this was a good strategy. It seems to me that he was hoping to get lucky – which isn't very different from a lot of other hedge funds.
I'm cogitating, Methinks. Watch this space. I'm glad you're taking me deeper.
Let's see if I follow you here. I need to work through a specific example.
I hold a mortgage backed security, and I want to insure myself against a falling price. This insurance is not quite the same as a default swap, because the seller of my bond needn't default for the bond's price to fall. The bond's price can fall if competing bond prices fall for example.
So I buy a put option from you. If my bond currently trades for X dollars, I pay you dX, and you agree to buy the security from me at the current price within six months, at my option.
With the option, I'm invested in this security to the tune of X + dX over the next six months, because instead of selling for X, I held and paid an additional dX.
I could sell the bond to someone else before the put expires, and I could sell the put itself, but I'm ignoring these options for the sake of simplicity.
Specifically, I'm assuming that my bond is highly illiquid, so the offer I purchase with the put is the only attractive offer I can expect.
First Question: This put is "teeny"? Have I captured the definition of a "teeny put" with this example?
I need these sorts of assumptions to model the price of the put. I want to understand the assumptions behind the pricing model we're discussing.
Martin,
As per my previous post on the subject of hedging, fixed income securities are much more difficult to hedge because fixed income securities have several risk factors which may be hedged including, interest rate, default, and credit. In addition, because most fixed income is not standardized, the derivatives products used to for hedging are varied and structured specifically to hedge individual risks for each security. Because it's practically impossible to hedge all the risks and to make a profit due to the size of the market and how the quantitative relationships, most fixed income traders don't hedge each risk.
By contrast, stocks have only one risk – price moves which require hedging. Derivatives for stocks are standardized, trade on exchanges and don't have counterparty risk. Thus, it's easier to examine stock teeny options instead of fixed income.
Everyone uses the Black-Scholes model to price options. "Teeny" options are deep out of the money options and because the probability of the stock reaching that price before expiration is so remote, the premiums were small – 1/16 when trading used to be in fractions (a market maker would quote his market as "a teeny at a quarter" for example). Because "teeny" uses fewer words than "deep out of the money options" and when traders are screaming orders at each other they use as few words as possible, deep out of the money options got the nickname "teeny" options. A teeny option may have a strike of $25 or $75 for a stock currently trading at $50.
Assume that you buy a stock which is trading for $50 and you want to hedge only against a catastrophic event, like a bankruptcy or a market meltdown like the one we're in now. You will buy the teeny put with a strike of $25. If you shorted a stock at $50 (ostensibly because you think it's overvalued at that price), and you want to hedge against only a vicious market mania like we had in the late 90's or the risk that the company might come out with a new product that will make the stock double in price, you'd buy the $75 call.
If all you're doing is betting on black swan events, then your strategy might be to just buy teeny options on individual stocks or indexes. Of couse, the problem is that you might run out of capital buying options before you can capitalize on the black swan event.