Images of the Crisis

The Freakonomics Blog at NY Times had a post about magazine covers illustrating current crisis.
Here are some more images I found on the covers of magazines:

Cover of the Ukrainian "Contracts" magazine depicting banker and homeowner fighting for mortgage money.
Another Ukrainian magazine called "Money". Looks like this rope is about to brake.

Anatomy of the bubble

Today I found a nice illustration of a buble dynamics. What we see here is a land price index in Japan over time annotated with public sentiment about future direction of prices. As you can see buble has been correctly predicted approximately half way through to the top. However by the time prices peaked out most people tired of waiting for decline and accepted that new level of prices is absolutely justified. Similarily first stages of decline we accompanied by optimism. And only when prices reached bottom people capitulated and proclaimed that land ownership is inferior to just renting.

Similar sentiment dynamics has been observed in other financial bubbles as illustraded in Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay.

Planes, trains, and financial market.

I've never been late to a plain, train or any other mode of transportation with a set schedule. I guess I got it from my father. He always left in advance, was constantly in a hurry, and always had 2 hours before departure to spare when he arrived to an airport or a train station. I did the same. I left early, calculating every possible delay into my schedule. And even with traffic jams, long lines to check-in, and even longer line at TSA gate I always had at least an hour to kill at the gate. An hour to kill not counting any delays. So I've never been late to my flight.. That is I've never been late till today. Today I missed it by 2 minutes. But 2 minutes don't count when the plane is in the sky and you are on the ground looking at it's shiny tail waiving good-bye.

What happened to me today is very similar to a recent situation in financial markets. I used to be risk averse. And it never paid. In fact it was not very pleasant to kill all these extra hours at the gate not unlike it was painful for risk-averse money managers to see how guys next door make more money. In addition I used to fly from airports with relatively fast security line. On one occasion it took me mere 20 minutes from the door of my apartment to the gate. And in numerous other cases I had very predictable experience door-to-door. So I wrongfully assumed that "normal" familiar pattern that repeated so many times. In fact I counted on it to repeat. Similarly, calm and ever-growing financial markets of the past 4-5 years before the crash lead many people to believe, at least subconsciously, that same pattern will persist forever and ever .

And then all went wrong. I left to the airport 8 minutes later than I planned thinking that surely 8 minutes won't affect my plan that much. Then, I accidentally took the wrong turn and had to walk across the airport to the next terminal. Next there was a security line that was 4 times longer I normally see and it was moving 10times slower (I kid you not. It virtually felt like the line was not moving at all). Then, there were travelers with strollers, babies, and ticket problems in my line; there was an elderly gentlemen with extreme patience and deteriorated motor skills (3 minutes to untie shoes); there was a poor choice in picking which phalanx of line to pick (picked the longest one). And finally running with untied shoes to the farthest gate from checkpoint. And I was just 10 minutes late. Maybe none of these events in isolation would've caused me to miss my flight. But all together they were catastrophic (of course if you consider being late for your flight a catastrophe which I don't)

Of course you all know what happened in financial markets, or at least know as well as I do (if not, I can write about it in my next article). It was a perfect storm of sort. Many events unforeseen by most caused excessive strain on the system.

Unlike my obstacles, many obstacles that brought asset prices down were not uncorrelated (If you are a nitpicker, you might argue that my problems weren't uncorrelated too. When flying on Saturday from Orlando one might expect long lines to security, strollers, elderly gentlemen, and long distances all together).

So what is the lesson here? The lesson for me is that I need to allocate more time for all airport procedures when traveling next time. Instead of relying on averages and recently observed variances I should estimate reasonably bad cases and build time buffers for those. Similarly, when managing risks of a financial portfolio recent variance and expectations of analysts don't do you much good. (Like my reckless travel planning it works most of times until once it doesn't). Instead one should really think hard and estimate reasonable bad cases one wishes to avoid. Of course it is more art than science unlike math of variance and value at risk. And secondly, one must try really hard to avoid trap of proximity bias. Neuroscientists say that brain infers general pattern from only 3 observations. After seeing 3 white swans we assume all swans are white. Of course not many people consciously think that market will go up forever after 3 years of bull market (at least reasonable people). But subconsciously they might still believe, deep down inside, that the good times will roll.

Checking out ping.fm

Magazine covers, expectations, and housing crisis

Bernie Schaeffer, the father of the expectation analysis and mastermind behind Schaeffer's Researchhas a theory, that when magazine covers predicts doom and gloom things might actually turn for the better and, vise versa, when magazine covers are overly optimistic it might be time to sell your stock and stock up on ammo and canned food. And this applies even to serious publications. It must be said that quality of analysis and level of insight under the cover of above mentioned serious magazines might be very high. But it is the cover that sells and therefore the cover reflect sentiment of a potential reader much more than actuall analysis that goes under the cover.

Recent cover of the Business week magazine made me wonder if current real estate situation is really that bad. Everyone seem to have accepted by now that it is terrible and everyone is scared of it from investors on wall street to homeowners on main street. However, given that cover doesn’t look too pessimistic it might be some time till recovery actually starts. But it might be time to start buying.

One should be mindful though, that this is not the first time business week ran a cover story on housing crisis. So far they were right on the money. So much for contrarian indicator.

MSFHOO

Yahoo finance posted a poll asking what people think the fair price would be for Yahoo acquisition. Opinions differ on this one. It is not surprising that Yahoo users value Yahoo higher than Microsoft did. What is surprising that many people vote for lower price and very few actually see offer price as "fair". It seems to me that people have strange concept of fairness. After all it's a free market and "fair price" should be synonimous to "current price"

Here is the snapshot of results:

What do you believe would be a fair price for Microsoft to acquire Yahoo?

$40 or higher	25%
$35 to $40	21%
$31 to $35	19%
$31 per share	9%
Under $31	26%

77885 Votes to date

Knowlege, Crisis and Risk Management

-What do you call a medical school graduate with 2.5 GPA?
-Doctor

Everybody writes about recent mortgage market slash credit meltdown. And everyone has his or her own favorite explanation how we ended up in a situation like this. Some say it was the lack of adequate quantitative models led to mispricing of mortgage-backed assets and derivatives. Others say it was poor back-office operations that led to double-booking of same collateral. I used to say it was greed and proximity bias that let people to down play the risk every month the market didn't break down. Every month until it finally did. Some blame over-reliance on VAR and poor risk management in general.

I am sure all these are good reasons and there is truth behind every single one of them. It wouldn't be wise to try and pinpoint singe main reason and I am not trying to do it here. My post is more humorous than a serious one.

No to get to the point. Two weeks ago I came to think that the main reason is that people simply don't know what they are doing and do not understand markets and risk well enough. Here is why. Last November I took a test in Financial Risk Management. This is a standard certification by GARP (Global Association of Risk Management) which is designed to show that holders of this certificate are knowledgeable enough to manage financial risks. It is not required to be certified in order to work in a field. I don't do risk management myself at my job, I just interact with risk managers a lot so I decided to take a test to be able to understand what they do and what they think. I didn't study well enough for this test and was worried I might not pass. Surprisingly when results came not only had I passed but I had also gotten top quartile scores in every category (they don't tell you exact score, just the quartile). So essentially I know risk management theory better than 75% of people. Most of these people work in banks. And many of them are involved in risk management. Of course they have some practical skills that I don't have. But never the less level of knowledge that people in this business have is very discouraging.