"Due to its simplicity and familiarity, the Gaussian copula is popular in calculating risk in collaterized debt obligations, but it imposes asymptotic independence such that extreme events appear to be unrelated. This restriction might be innocuous in normal times, but during extreme events, such as the housing crisis, the Gaussian copula might be inappropriate. This paper explores various copula specifications and finds that the degree to which housing prices are related based on the Gaussian copula is too small compared with real housing price data."

"When the Financial Times's Martin Wolf asked former U.S. Treasury Secretary Lawrence Summers what in economics had proved useful in understanding the financial crisis and the recession, Summers answered: “There is a lot about the recent financial crisis in Bagehot...”. “Bagehot” here is Walter Bagehot’s 1873 book, Lombard Street. How is it that a book written 150 years ago is still state-of-the- art in economists’ analysis of episodes like the one that we hope is just about to end? There are three reasons. The first is that modern academic economics has long possessed drives toward analyzing empirical issues that can be successfully treated statistically and theoretical issues that can be successfully modeled on the foundation of individual rationality. But those drives are disabilities in analyzing episodes like major financial crises that come too rarely for statistical tools to have much bite, and for which a major ex post question asked of wealth holders and their portfolios is: “just what were they thinking?”. The second is that even though the causes of financial collapses like the one we saw in 2007-9 are diverse, the transmission mechanism in the form of the flight to liquidity and/or safety in asset holdings and the consequences for the real economy in the freezing-up of the spending flow and its implications have always been very similar since at least the first proper industrial business cycle in 1825. Thus a nineteenth-century author like Walter Bagehot is in no wise at a disadvantage in analyzing the downward financial spiral. The third is that the proposed cures for current financial crises still bear a remarkable family resemblance to those proposed by Walter Bagehot. And so he is remarkably close to the best we can do, even today."

"This article analyzes the role in the credit crisis of the processes by which market participants produce knowledge about financial in- struments. Employing documentary sources and 87 predominantly oral history interviews, the article presents a historical sociology of the clusters of evaluation practices surrounding ABSs (asset-backed securities, most importantly mortgage-backed securities) and CDOs (collateralized debt obligations). Despite the close structural simi- larity between ABSs and CDOs, these practices came to differ sub- stantially and became the province (e.g., in the rating agencies) of organizationally separate groups. In consequence, when ABS CDOs (CDOs in which the underlying assets are ABSs) emerged, they were evaluated in two separate stages. This created a fatally attractive arbitrage opportunity, large-scale exploitation of which sidelined previously important gatekeepers (risk-sensitive investors in the lower tranches of mortgage-backed securities) and eventually mag- nified and concentrated the banking system’s calamitous mortgage- related losses."

"We here report for the first time, to the best of our knowledge, rat motor cortex neurons predicting the behavior of the American stock market. We implanted the motor cortex of the brains of rats with silicon electrodes. Using the correlation technique, we monitored the activity of neurons in our rats while simultaneously tracking the activity of stocks in the U.S. stock market."

Based on his previous (pre-crash) _New Financial Order_, this will be Utopian in the worst sense.

"Financial econometrics has become an increasingly popular research field. In this paper we review a few parametric and nonparametric models and methods used in this area. After introducing several widely used continuous-time and discrete-time models, we study in detail dependence structures of discrete samples, including Markovian property, hidden Markovian structure, contaminated observations, and random samples. We then discuss several popular parametric and nonparametric estimation methods. To avoid model mis-specification, model validation plays a key role in financial modeling. We discuss several model validation techniques, including pseudo-likelihood ratio test, nonparametric curve regression based test, residuals based test, generalized likelihood ratio test, simultaneous confidence band construction, and density based test. Finally, we briefly touch on tools for studying large sample properties."

"The augmented GARCH model is a unification of numerous extensions of the popular and widely used ARCH process. It was introduced by Duan and besides ordinary (linear) GARCH processes, it contains exponential GARCH, power GARCH, threshold GARCH, asymmetric GARCH, etc. In this paper, we study the probabilistic structure of augmented $mathrm {GARCH}(1,1)$ sequences and the asymptotic distribution of various functionals of the process occurring in problems of statistical inference. Instead of using the Markov structure of the model and implied mixing properties, we utilize independence properties of perturbed GARCH sequences to directly reduce their asymptotic behavior to the case of independent random variables. This method applies for a very large class of functionals and eliminates the fairly restrictive moment and smoothness conditions assumed in the earlier theory. In particular, we derive functional CLTs for powers of the augmented GARCH variables, derive the error rate in the CLT and obtain asymptotic results for their empirical processes under nearly optimal conditions."

"As I've written before, the function of the stock market in modern capitalism is to get money out of corporations, not put money into them. The social problem they are solving is not society's need to allocate scarce savings to the most promising investments, but wealth-owners desire to free their fortunes from particular firm or industry and keep them as claims on the social product as a whole."

I'm reading his book, and finding it surprisingly agreeable.

I'm dubious. When I deposit my money in the bank, I (in effect) take a very small position in every loan it makes. _I_ lack the time and resources to evaluate investment opportunities, and the transaction costs of diversification are prohibitive for me, but not for the bank. Similarly in normal times the bank really doesn't have to turn over the cash to all but a very small fraction of deposits. This is not fraud; it is averaging.
Of course this sort of averaging is not that complicated and so lots of firms can do it, which drives down the profits, so banks have a huge incentive to come up with complicated things that no one else can do, which probably does contribute to fraud. But I don't think the _whole_ of finance is based on fraud.

Errr, rather obvious, yes?

For the PCA problem set.

Query: to what extent has the shift to defined-contribution retirement plans, especially 401(k)s, contributed to financial-sector profits?  (Via (1) a continuing supply of dumb money/noise traders, and (2) guaranteed or at least strongly subsidized demand for financial sector services.)

I find this rather plausible: "rapid economic growth in China is creating the largest pool of suckers the world has ever seen. Real world individuals exhibit bounded rationality, and lots of Chinese people who may have been extremely smart at getting rich in China’s industrial revolution may be quite foolish about their decisionmaking regarding complicated western financial products. American rich people are much better-positioned than Chinese rich people to avoid getting ripped off, and yet a large number of people were taken in by Bernie Madoff’s rather crude fraud. China is a treasure trove of potential marks and Pharo is getting in on the game."  (It also echoes some of the opening remarks in Maurer's _The Big Con_ on where the golden age of American con artists came from.  [Everyone should read _The Big Con_.])

This sounds remarkably like that Heinz Pagels book chapter from the early 1990s...

"traces the longer-term historical evolution that made the rise of finance possible, arguing that this development rested on a broader transformation of the U.S. economy than is suggested by the current preoccupation with financial speculation.
Krippner argues that state policies that created conditions conducive to financialization allowed the state to avoid a series of economic, social, and political dilemmas that confronted policymakers as postwar prosperity stalled beginning in the late 1960s and 1970s. In this regard, the financialization of the economy was not a deliberate outcome sought by policymakers, but rather an inadvertent result of the state’s attempts to solve other problems. The book focuses on deregulation of financial markets during the 1970s and 1980s, encouragement of foreign capital into the U.S. economy in the context of large fiscal imbalances in the early 1980s, and changes in monetary policy following the shift to high interest rates in 1979."

"We show that it is very difficult to devise performance-based compensation contracts that reward portfolio managers who generate excess returns while screening out managers who cannot generate such returns. Theoretical bounds are derived on the amount of fee manipulation that is possible under various performance contracts. We show that recent proposals to reform compensation practices, such as postponing bonuses and instituting clawback provisions, will not eliminate opportunities to game the system unless accompanied by transparency in managers' positions and strategies. Indeed, there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories."

I really need to write up those notes on realism & social construction

" one way to perhaps summarize the issue with the performativity argument is that it suffers from a serious endogeneity problem. Namely, the performativity approach selects a particular model (theory, device, etc) and traces it’s “effect” (diffusion, use) through history, post hoc, without looking at the set of possible models (or devices) that might have been chosen or created. In fact, performativity assumes that models, a priori, are “arbitrary” and thus ignores (even rejects) the underlying “reasons” for why the particular model (or device etc) has an effect or perhaps is better than feasible alternatives. " --- The sampling-on-the-dependent-variable argument is strong, but (to repeat myself) you could have a "performative' theory which was an evolutionarily stable strategy (or more exactly lead to practices which were an ESS). Need to dust off those old notes about a realist theory of social construction.

It is good to hang a banker from the lamp-posts in lower Manhattan from time to time, to encourage the others.

When the IMF (the IMF!) calls for a tax specifically targeted at the financial sector, you know it's too big.

As every school-child knows, firms in a competitive market earn no profit over their cost of capital (and paying for their employees' time, including the entrepreneurs' if any). Deregulation of banking and finance had many effects, but creating a competitive environment was very evidently not one of them.

"My new goal is to have a financial engineering [Monte Carlo simulation] blow up so bad modeling CDS portfolios that Jessica Alba needs to rush into the office in some sort of superheroine costume to save me."

"So there are a lot of people out there who think that we need to kill the moral hazard of having your savings account insured. Grandma has $12,000 in her savings account, and doesn’t worry about whether or not the bank is solvent – so let’s force her to worry by removing the FDIC protection. This worrying will result in her providing discipline to her bank on their risk. ... How will grandma know what to do? ... I know the simple way you do it, some techniques that I’ve had some training in: You place out the payment structures using monte-carlo simulations with lognormal random walks; you take a metric of correlation in the market, perhaps in a gaussian copula structure and use that to run correlations at each step between the instruments; you take the distribution you generate and apply a “value-at-risk” logic to it, looking at some piece of the tail distribution.
... a 16-year old who wants to open a savings account for his part-time job will need to know these techniques..."

Yes. This has been another edition of easy answers to simple questions.

Annals of financial innovation, 1920s American real-estate edition. (Note to self: Was this a direct precursor of the gov't-established secondary mortgage market? Should re-read Carruthers & Stinchcombe.) Also: more support for Galbraith's contention that there is really hard anything new in any bubble.

17th century Netherlands edition.

While I have no doubt that the financial adviser being attacked is, in general, a quack (because they almost all are), Frank has a hidden premise here which is completely false, namely that if you pay down your credit card, you'll have the line of credit available to you in the future. This may once have been roughly true, but it's sure as hell not true now. And if you are credit-constrained, cash in the bank for emergencies has considerable value.

"The French government currently honors a very unusual debt contract: an annuity that was issued in 1738 and currently yields E1,20 per year. I tell the story of this unique debt, which serves as an anecdotal but symbolic summary of French public finances since the 18th century." Or: That is not dead which can eternal lie, and with strange aeons even the dead can collect interest.

This is cute, but I don't think it's anything more than that. This sort of securitization has problem enough even when pooling is done honestly. Still, I like the idea of derivatives being produced by the Adversary,

Review of Tett's _Fool's Gold_. But this scene is NOT in my copy - what gives? "Fool’s Gold begins in a conference room in Nice in spring 2005. Tett admits that at that point she was baffled by the technical language – ‘Gaussian copula’, ‘attachment point’, ‘delta hedging’ – used by the participants. However, before joining the FT she had conducted fieldwork in Soviet Tajikistan for a PhD in social anthropology, and the ethnographer in her was now reawakened. The conference reminded her of a Tajik wedding. Those attending it were forging social links and celebrating a tacit world-view – in this case, one in which ‘it was perfectly valid to discuss money in abstract, mathematical, ultra-complex terms, without any reference to tangible human beings.’"

Need to see if they mention Ilinksi...

Hear, hear.

Tett on how the idea of free and competitive markets was used as ideological cover for rent-seeking. (I do not think that phrasing this in terms of "silences" and Bourdieu was helpful.) The bit at the end about need to actually pay attention to power structures is, however, absolutely right on.

Color me skeptical about the recommendations (as reported in the blurb).

"Informationally efficient" prices are neither necessary nor sufficient for actually allocating capital efficiently.

Despite the niceness of Steve's review, I wrote my own: http://bactra.org/reviews/fox-rational-market/

I had never heard of these instruments before, and, reading this, I find myself thinking "the idea that buying these is a good idea for anyone is one of the most ridiculous things I've ever heard." ("Rortybomb" is very good on all the reasons why.) The problem with reading a lot about finance is that I have this reaction about once a week.

Ummm... maybe my memory is playing tricks with me, but this really sounds like the Brock & Hommes models from the mid-1990s...

"We propose a flexible generalized auto-regressive conditional heteroscedasticity type of model for the prediction of volatility in financial time series. The approach relies on the idea of using multivariate B-splines of lagged observations and volatilities. Estimation of such a B-spline basis expansion is constructed within the likelihood framework for non-Gaussian observations. As the dimension of the B-spline basis is large, i.e. many parameters, we use regularized and sparse model fitting with a boosting algorithm"

This will be an... interesting experiment. (For instance, can they really turn MBAs into math teachers in 3 months?)

"He reaches these conclusions by confusing causation with correlation, deducing something about the location of an unobserved variable from a correlation, assuming that 19th and 20th century financial markets must have been efficient and reaching a conclusion by not considering any alternative. Altogether a methodologically interesting article."

Attempting to figure out how much of the profits of US non-financial firms was down to "financial relations" ("payment of interest, financial incomes and capital gains, depreciation of the debt by inflation, the consideration of net worth instead
of tangible assets as a measure of capital"), plus a profit rate estimate for the financial sector ("It declined up to the early 1980s, and then sharply recovered").

For tomorrow's exam. (Of course it won't help people at all to know where the data came from.)

"Remember that the gilded Wall Street of 2007 was a fairly new phenomenon. From the 1930s until around 1980 banking was a staid, rather boring business that paid no better, on average, than other industries, yet kept the economy’s wheels turning. So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes. Consider a recent speech by Ben Bernanke, the Federal Reserve chairman, in which he tried to defend financial innovation. His examples of “good” financial innovations were (1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks?"

all of this has happened before...

Shorter Crotty: there was no good reason to expect a minimally regulated financial sector to stably and efficiently allocate risk and capital, and it didn't.

Shorter (really, paraphrased) Steve: Shiller's heart is in the right place, but his brain is somewhere in the gamma quadrant. In a vat. Talking to swamp things.

Someone from the Mercatus Center argues against regulation. In other news, cooks prepare food.

There is a serious selection bias issue here (disproportionately looking at the badly-performing loans), but wow does everyone come out of this looking like a dangerous idiot. (Use this as a negative example in the next incarnation of the data-mining class?)