Notes

Anomaly - THE REAL Architects of the Economic Crisis?
Those of you who followed Nouriel Roubini through the Asian Currency crisis over a decade ago* should have already recognized the similarity between that crisis and this one. Roubini was recently interviewed and gave his opinion: "The U.S. has been surviving in a situation of excesses for too much time. Consumers were out spending a lot more than their income and the united states was spending a lot more than its income, running up large current-account deficits. Now we have to tighten our belts and save more. The difficulty is that higher savings in the medium term are positive, but in the short run a consumer cutback on consumption makes the economic contraction more serious."

That's the paradox of thrift. But we must save more as a country, and we must channel more resources to elements of the economy that are more productive. So when Lead Singer Disease have way too many financial engineers rather than as much computer engineers, you've got a problem......I believe this country needs more individuals who are likely to be entrepreneurs, more people in manufacturing, more folks going into sectors that are going to result in long-run economic growth. When the best minds of the united states are all likely to Wall Street, there exists a distortion in the allocation of human capital to some activities that become excessive and eventually inefficient." However, Nobel laureate Robert Merton of the Harvard Business School has a different perspective:

we need more financial engineers, not fewer risk and innovation, including derivatives, are not going away, and we are in need of senior managements, boards, and regulators of financial institutions who understand them." That are the Financial Engineers? And What the Hell Are They Talking About? I received my Master of Science in Financial Engineering degree back 2002 and still to this day no one knows what the hell which means. Ok, Financial Engineers are often "rocket scientists" (literally) that are hired by large banks and multinational corporations to create sophisticated mathematical models with the intention to predict the probability of risky events, to provide valuations for instruments which are traditionally hard to price, also to create synthetic securities for the hedging risk (and sometimes for speculating).

"As LBO specialist Ted Stolberg once told Inc. Magazine, 'Financial engineering is like building a bridge. It is possible to build it anyway you prefer as long as it doesn't collapse when heavy trucks run over it and you will add additional lanes when you want more traffic to go over it. And when it's all done, it ought to be a thing of beauty, just like the Golden Gate'" (Warsh, 1993, p. 296). These "quants", as they are lovingly called, tend to be lured from poor paying academic jobs by Wall Street to high paying jobs in London, New York, Chicago, or California. The organization executives that hire these Quants often like to remind their investors that everything will be alright due to brilliant minds they will have on the payroll. Unfortunately, you can find two large problems in financial engineering that have emerged in hindsight. First, finance is ultimately about humans and their relationships to one another.

Real finance bears little resemblance to the logical order of math and physics. Most models in finance begin with the basic assumption of "Homo Economus", the assumption that man is really a rational being. This has largely been proven to become a faulty assumption because of the recent research of cognitive neuroscience. Second, the output from the financial models is misinterpreted by your choice makers in senior level management. As Alfred Korzybski said, "The map is not the territory". Much too much decision making has been based on these models, providing them with much too much weight. Senior executives seem all to wanting to confirm their successes and deny their failures, it is human nature in the end. Financial Models: CURRENCY MARKETS Rationality or Irrationality? "It is more than a metaphor to describe the purchase price system as a kind of machinery, or perhaps a system of telecommunications which enables individual producers to watch merely the movement of several pointers, as an engineer might watch the hands of several dials, so that you can adjust their activities to changes of which they may never know more than is reflected in the purchase price movement." - F.A. Hayek The efficient market hypothesis is fairly appealing conceptually and empirically, which accounts for its enduring popularity.

In a nutshell, efficient stock markets are generally regarded as equilibrium markets in which security prices fully reflect all relevant information that's available concerning the "fundamental" value of the securities (Tangentially, Benjamin Graham, well-known for co-authoring the fundamentalist treatise Security Analysis with David L. Dodd, was quoted as saying shortly before his death, "I'm no more an advocate of elaborate techniques of security analysis in order to find superior value opportunities... I doubt whether such extensive efforts will generate sufficiently superior selections to justify their costs... I'm privately of the 'efficient market' school of thought..." [Malkiel, 1996, p. 191]). Despite its popularity, efficient capital markets theory has weathered some very appropriate criticisms. Since a theory is really a model of reality rather than "reality" itself, anomalies arise where theory does not mirror reality and the idea of efficient capital markets is not any exception.

Ray Ball's article THE IDEA of Stock Market Efficiency: Accomplishments and Limitations (Ball, 1994, p. 40) presents a mostly balanced perspective and illuminates some interesting anomalies: 1) A study by French and Roll shows that prices overreact to new information which is then accompanied by a correction, allowing contrarian investors to take profits. 2) Excess volatility of prices because of the "extraordinary delusions and madness of crowds". 3) Prices underreact to quarterly earnings reports, which alone seems an anomaly in the tendency of prices to overreact to new information. 4) A recent study by Fama and French provides evidence that there surely is no relationship between historical betas and historical returns which includes lead many to trust the equilibrium-based CAPM, developed greatly as a result of enormous quantity of empirical data on efficiency, has failed. (Not included in Ball's article, but told in Malkiel's A Random Walk Down Wall Street may be the story of how Fama and French also determined that investing in a stock which has performed poorly for the past two years will often give you above average returns during the next two years (Malkiel, p. 198), thereby allowing contrarians to take a profit once again.) 5) You can find seasonal patterns found in the data on stock returns or small firms, like the "January effect", where stock prices are unusually higher through the first few days of January or the "weekend effect" where average stock returns negatively correlated from closing on Friday to closing on Monday.

Anomalies missing from Ball's article include: 1. the data that firms with low price-earnings ratios outperform people that have higher P/E ratios. 2. the data that stocks that sell with low book-value ratios have a tendency to provide higher returns. 3. the evidence that stocks with high initial dividends tend to provide higher returns (Malkiel, pp. 204 -207). Where Ball's article differentiates itself from almost every other summaries of the trials and tribulations of the idea of efficient capital markets is in a section titled "Defects in 'Efficiency' as a Model of Stock Markets" (Ball, p. 41 - 46) where he discusses the general neglect within the theoretical and empirical research on currency markets efficiency of the processing and acquisition costs of information. This neglect could be the reason behind the anomalies, like the "small firm effect", the tendency of small cap stocks to provide higher returns. He also criticizes the assumption in the efficient markets hypothesis of investor "homogeneity" and suggests the necessity for a new research program. Ball also considers the role of both transactions costs in the efficient markets theory literature "largely unresolved" and the result of the specific market mechanism on transacted prices, also referred to as "market microstructure effects".

He defends efficient markets theory from Robert Shiller's argument (that the historical variance of stock prices has been a lot more volatile than can be justified by historical variance in actual dividends) by challenging Shiller's usage of a constant market expected return in nominal terms. Since CAPM assumes a constant risk free rate of return and a continuing market risk premium it really is impossible to determine a "correct" amount of variance in the market index. Ball also defends market efficiency from Shiller and other behavioralists in maintaining that the mean-reversion in stock returns will not necessarily imply market irrationality. CAPM will not claim to dismiss the trend for periods of relatively high returns to be accompanied by periods of relatively low returns. Actually, such cyclical patterns may be the consequence of rational responses by investors to political/economic conditions and corporations to changes in investor demand for stocks.

Ball then grants more space to Shiller and the behavioralists by ending his piece with the rhetorical question "Is 'behavioral' finance the answer?" He rapidly answers, "I don't believe so" (Ball, p. 47). I'd rephrase the question so that it reads "Does 'behavioral' finance yield useful answers?" and my answer will be "yes." Whether investors behave rationally, that's, whether investors accurately maximize expected utility is an important assumption of the efficient market hypothesis and if it is not true, it may explain why the anomalies exist. Work in prospect theory by Allias, Kahneman and Tversky provides important evidence that the standard assumption of expected utility maximization assumed by most financial economists might not furnish accurate representations of human behavior (prospect theory states that folks are better represented as maximizing a weighted amount of "utilities," determined by a function of true probabilities which gives zero weight to extremely low probabilities and a weight of one to extremely high probabilities). While such evidence isn't damning, it is troubling to say minimal (Shiller, 1997).

Interestingly enough, Ball's article omits the common practice of financial economists to categorize the idea of the stock market efficiency into three types which, from least to many orthodox, are the following: 1. The weak form states that the history of stock price movements contains no useful information enabling investors to consistently outperform a buy-and-hold portfolio management theory. 2. The semi-strong form maintains that no available published information can help security analysts select "undervalued" securities. 3. The strong Form holds that everything known and even knowable in regards to a company is reflected in the price of the stock. Statistical evidence lends credibility to the weak and semi-strong forms, and discounts the strong form revealing that corporate insiders have earned excess profits trading on inside information. To get the weak and semi-strong forms, the results of Ball and Brown's mid-1960's study (Ball, p. 35) of how the stock market actually responds to announcements of annual earnings shows that the market anticipates approximately 80% of the brand new information within annual earnings before the earnings were actually announced.

Put simply, investors were mostly deprived of future opportunities to profit from the brand new information since stock prices had already processed the information released in the annual earnings reports. It appears to me investors and "Quants" alike would do well never to to swallow anybody approach whole, warts and all, but to carefully weigh the data of all different approaches. In scientific experimentation, where Quants feel at home, there are no success and failures, only outcomes or results. All that emerge are data points that let you know in the event that you hypothesis is correct or not. Unfortunately, in capital markets, if an "experiment" is leveraged enough, you can bankrupt entire countries, and now, perhaps even the planet. In capital markets, the real risk of experimentation like this can lead to people not eating. What is Risk and Where Does Financial Engineering Come In? Well, we are able to intuitively say there seems to be a confident relationship between risk and uncertainty. The more certain we can be of a specific outcome, the less risky it is. However, in a dynamic world such as ours where we are able to barely (and usually inaccurately) predict the elements five days from now, how can a financial manager, farmer, or any interested party expect to predict, say, the price of tea in China weeks, months, as well as years from now?

This is where the stunning asymmetric nature of a financial instrument named an "option" will come in: "A call option may be the right to purchase a specified quantity of some underlying asset by paying a specified exercise price, on or before an expiration date. A put option is the right to sell a specified quantity of some underlying asset for a specified exercise price, on or before an expiration date" (Figlewski and Silber, 1990, p. 4). An investor's potential loss is bound to the premium, as the potential profit is unlimited. So although it could be impossible to predict the near future price of tea in China, it is possible to set a floor for the quantity of loss permitted to occur without setting a ceiling on the gains reaped. Options belong to a class of financial instruments called derivatives, aptly named since they derive their value from another thing. Options, for example, derive their value from an underlying asset. Other derivatives include interest and exchange rate futures and swaps, whose values depend on interest and exchange rate levels (some parties exchange cash payment obligations since they may prefer someone else's payment stream), commodity futures, whose value depend on commodity prices, and forward contracts, which act like future contracts except that the commodity under contract is actually delivered upon a specified future date. But how can we use these instruments to minimize our exposure to risk?

"Financial engineering is the use of financial instruments to restructure an existing financial profile into one having more desirable properties" (Galitz, 1995, p. 5). In other words, it's the province of the financial engineer to create "synthetic" securities to accomplish desired risk-return results. You take combinations of option, futures, swaps, etc. and create new securities to mitigate unforeseen risks. Assuming that the cash flows between the straight security and the synthetic portfolio are equivalent, then any difference in the present market values of both can be an arbitrage opportunity. An arbitrage is trade where one buys something at one price and simultaneously sells basically the same thing at an increased price, in order to make a riskless profit (Within an efficient market such opportunities should be rare, and when the wily investor took advantage of it the very process should drive the price of what they're buying up and the price tag on what they are selling down).

A Simple Example of How Financial Engineering REALLY WORKS In his article, The Arithmetic of Financial Engineering (Smith, 1999, p. 534) Donald J. Smith uses simple arithmetic and algebra to illustrate the relationships of a number of different security combinations (synthetic securities) used by financial engineers to generate these unique risk-return trade-offs. His basic explanatory formula looks like this; A + B = C where, A + B comprise the synthetic portfolio C may be the straight security + sign denotes an extended position, or a lending posture - sign denotes a brief position, or perhaps a borrowing posture Utilizing the arithmetic outlined above, Smith can illustrate the relational structure of such synthetic securities as; Interest rate swaps + INTEREST Swap = + Unrestricted Fixed Rate Note - Floating Rate Note The coupon for some bonds is fixed in advance, hence the name fixed-income securities, but many issues have coupons that are reset on a regular basis and therefore float, they are called floating rate notes.

Collars + Collar = + Cap - Floor "Caps" and "Floors" are option contracts that guarantee the utmost [cap] and minimum [floor] rate which might be reached. Caps and floors are essentially interest insurance contracts that insure against losses from the interest rates rising above or falling below determined levels. Mini-Max Floater + Mini-Max Floating Rate Note = + Typical Floating Rate Note - Cap Inverse Floaters - Inverse Floater = - Two Fixed Rate Notes + Unrestricted Floating Rate Note -Cap Inverse floaters interest those investors that are bullish on bond prices and expect interest levels to drop. This can be a synthetic security that Robert Citron used wrongly and ended up bankrupting Orange County, California when the Federal Reserve sharply raised interest levels in 1994. This folly finished up costing Orange County $1.7 billion in 1994 dollars! Participation Agreements + Participation Agreement = + Cap - Floor This simple arithmetic formula wields great explanatory power for many who seek to a straightforward understanding of the complexities of financial engineering.

However, the financial engineer must be cautious with the double edged sword of derivative instruments. When used to hedge, derivatives can be invaluable guards against risk, however if used to take a position, they can invite unnecessary risks. Also, hubris can be devastating as sometimes the payoffs could be too complex to totally understand. Unintended consequences can be quite a bitch (see credit default swaps) AMERICA Government = The Paleo-Financial Engineers "Blessed are the young, for they shall inherit the national debt" -Herbert Hoover Let's look at one of the complicated financial engineering schemes ever, the relationship between the United States Treasury and the Federal Reserve system. The Federal Reserve is a privately owned corporation. In other words because the popular phrase goes, "The Federal Reserve is as 'federal' as Federal Express". The biggest stock holders of the Federal Reserve bank are the 17 largest banks on the planet. As a matter of record, for america the final century has been among deficits and debt.

To put it simply, a deficit occurs whenever you save money than you have. Each time the government spends a lot more than it has it must issue a debt instrument or I.O.U., usually a U.S. Treasury bond, to cover the expenses. The Federal Reserve banking cartel buy these bonds (with paper currency literally created out of thin-air) on the promise that the federal government can pay the Federal Reserve back both principal and a set rate of interest. In trade for this interest payment, the Federal Reserve literally creates money (mostly electronically and completely out of thin air) through manipulated ledger accounts. What most people fail to recognize is that the main way Treasury generates the revenue to pay off it's debt to the Federal Reserve is through taxation. To put it simply, our taxes goes directly to bankers. A far more sobering simple truth is this, to get a concept of how much the U.S. owes to bondholders (i.e., the Federal Reserve banking cartel) just take a glance at the National Debt. It towers at over $11 trillion (remember a trillion is really a thousand billion, and a billion is really a thousand million, and million is a thousand thousand.

With an estimated population of america of 305,367,770, which means that each USA citizen's share of the outstanding public debt 's almost $40K as of this writing. The tricky part is this, if the growth of your debt is constant and higher than the rate of growth of average real income, then what should we expect the federal government to accomplish when tax revenues are no more sufficient to cover the interest on your debt? Then once the money (again, which was created out of thin-air) trickles down back to the economy because the government spends it, and finds its way back in to the private banks. Once there, the real inflation begins through the magic of fractional reserve banking. This is all documented in the Federal Reserves' own manual entitled "Modern Money Mechanics". The bottom line is, given that they only maintain a fraction of the specific reserves on-hand (while their ledgers falsely say they will have the complete amount) the currency is inflated and the risk of bank runs are ever present.

There are only three basic courses of action the government may take; repudiate, hyperinflate, or liquidate. I favor the liquidation of governmental assets (non-essential governmental properties just like the FDA, FCC, or the IRS) over repudiation or hyperinflation simply because liquidation of governmental assets is the surest way to end big government once we know it. Repudiation would shock the economy, interest levels would skyrocket, and bond prices would plummet; an excessive amount of risk involved. Hyperinflation would only devalue the currency and impoverish everyone concerned. TO CONCLUDE All this brings me back back to where it started to Nouriel Roubini's quote again: "The U.S. has been living in a situation of excesses for too much time. Consumers were out spending more than their income and the country was spending more than its income, running up large current-account deficits. Now we have to tighten our belts and save more. The trouble is that higher savings in the medium term are positive, however in the short run a consumer cutback on consumption makes the economic contraction more serious.

That is the paradox of thrift. But we must save more as a country, and we have to channel more resources to elements of the economy which are more productive. And when you have way too many financial engineers rather than as much computer engineers, you have a problem......I think this country needs more those who are likely to be entrepreneurs, more people in manufacturing, more people going into sectors that are going to result in long-run economic growth. When the best minds of the country are all likely to Wall Street, there is a distortion in the allocation of human capital to some activities that become excessive and finally inefficient." I wholeheartedly concur that the solution lies in entrepreneurship. However, the quote is bookended by the idea of "excess" and associates it with our economic crisis. This begs the question though, that are the true architects of the excess, the Financial Engineers alone or are the Federal Reserve and the U.S. Treasury complicit aswell?

REFERENCES
Hayek, F. A. (September, 1948). The utilization of Knowledge in Society.
The American Economic Review, XXXV, No. 4. Malkiel, B. G. (1996).
A random walk down wall street. NY, N.Y. Ball, R. (1994).
The theory of currency markets efficiency: accomplishments and limitations. In D. H. Chew, Jr. (Ed.),
The brand new corporate finance; where theory meets practice (pp. 35 - 48). Boston, MA. Shiller, R. J. (1997). Human Behavior and the Efficiency of the ECONOMIC CLIMATE. [online]. Available: [http://www.econ.yale.edu/~shiller/handbook.html].
Warsh, D. (January 17, 1988). After the Crash (financial engineering). economic principals.
NY, N. Y. Figlewski, S. and Silber, W. L. (1990).
financial options: from theory to practice. NY, N. Y. Galitz, L.C. (1995).
financial engineering: tools and ways to manage financial risk. Burr Ridge, Illinois. Smith, D. J. (1999). The Arithmetic of Financial Engineering. In D. H. Chew, Jr. (Ed.), The new corporate finance; where theory meets practice (pp. 535 - 543). Boston, MA. (June 20, 1999).

*The Lessons of the Yen (I wrote this back in 1998 for the Golden Gate University student newspaper, in the event that you substitute "Japan" for "America" it could be true today) As little as ten years ago it was thought that America's unemployment and growth rates could not be more appealing than those of Japan's. Such thinking has proven wrong, and the sting has been felt around the world. What effect, if any, do problems in a single part of the world have on the others? Well, the sinking Japanese economy, the most recent of the Asian Tigers to be struck by the Asian currency crisis iceberg is cause for concern for a few Golden Gate University students in San Francisco. International students receiving funds from Japan are the most immediately affected. Erina Ishikawa (MBA, entrepreneurship) and Dongil Yun (masters, computer information systems), have both felt the consequences of an unfavorable exchange rate because the decline of the Yen.

"When I came (to America) ten years ago, things were much cheaper for all of us in Japan, now the opposite is true," said Yun. Anticipating economic problems in Japan and noticing higher interest levels in america, Misa Aoki (MA, Public Relations) changed her Yen savings to dollars over this past year. While not influenced by the risk of waning purchasing power due to her foresight, she still worries about finding a job after graduating and returning to Japan. Such fears aren't unfounded. The rising unemployment rate of 4.1% may be the highest in Japan since World War II. Fortunately, none of these interviewed knew of anyone who has had to drop out of school and go back to Japan because of the crisis. They all said that they were concerned for future years of Japan's economy, but that they ultimately do not believe that the existing crisis is that big of a deal. Jiro Ushio, chairman of the powerful Japan Association of Corporate Executives echoes the same sentiment, "[t]he realities of Japan's economy aren't as bad because the world thinks." The president of the American Chamber of Commerce in Japan, Glenn S. Fukushima, said, "[f]undamentally it boils down to the truth that people in Japan generally don't believe that things are so bad that they have to have fundamental change." Even some in Japan believe that the US expects its own bubble economy to pop soon and is only looking for a scapegoat.

Obviously, there were problems enough for Secretary of the Treasury, Robert Rubin, to intervene to prop up the falling Yen in mid-June. His multi-billion dollar gamble paid off in the short run, reversing the Yen's slide by 8% within one day. Critics of Japan's government maintain that the under guidance by the Ministry of Finance, Japanese banks made bad loans to weak companies rather than letting the market work. The bad loans account for a lot more than $600 billion, a quantity larger than the complete economy of China, the world's most populated country. Surprisingly however, the Japanese people overwhelmingly re-elected the current government. Prescriptions for recovery are everywhere, MIT's Paul Krugman suggests that Japan's central bank should inflate the money supply and lower interest rates to stimulate domestic demand, while some say that Japan's April deregulatory "Big Bang" liberalization program will ultimately pay off in the long run. Whether the "big bang" or perhaps a more Schumpeterian "evolutionary" course is taken, with last week's resignation of Prime Minister Hashimoto, the future is uncertain.

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