I'm not going to post about the continuing equity slump - well, not directly. Instead, there's a rather worrying problem that the slump exposed:

"Good God! The Dow just dropped by 200 points," said Jason Schenker, an economist at Wachovia in Charlotte, who was speaking to a reporter as he watched his ticker screen and saw what looked like a sudden market collapse.

Of course, it hadn't really happened - the software that calculates the DJIA had become overwhelmed by the trading volume, and a backup system kicked in with the correct value, creating the illusion of a sudden drop when it should have been showing a steady decline.
Naturally, neither Dow Jones nor the NYSE felt they had to inform anyone of this little hiccup.

Brad DeLong is somewhat annoyed:

The news is not that the DJIA instantaneously dropped 200 points. The news is that Dow Jones, Inc., has not invested enough in infrastructure to be able to produce a reliable real-time index.

Lars Toomre points out: "This great expansion in transaction volume (as opposed to number of shares traded) has been in large part been a result of algorithmic trading programs taking an institutional order for say 10,000 shares and breaking it down" - but doesn't go on to make the next obvious step, which is that the rise of algorithmic trading makes reliable infrastructure far more important. A glitch of less than a second could conceivably cause immense disruption to algo trading.

The Tokyo bourse has been rightly pilloried for its repeated infrastructure problems, but have other exchanges taken the hint? Or, with their focus now on demutualising and takeovers, have they taken their eye off their core business - providing a stable trading environment? We'll find out next time the volumes get heavy.

The SEC has charged 14 defendants at UBS, Morgan Stanley, a handful of hedge funds and elsewhere with insider dealing. The details of the story make fascinating reading - it can be only a matter of time before this story of amateurish tradecraft and escalating greed shows up on TV.
This story has wider significance because of two things.
First of all, it's probably the earliest fruit of the massive data-trawling exercise the SEC embarked on last month. The Boston Herald quotes SEC enforcement chief Linda Thomsen:

"Some defendants may have thought they were flying ’under the radar’ by making modest profits on individual transactions, secure in the knowledge that, over hundreds of tips, they would reap millions of dollars in illicit trading profits,” she said. ”And yet, despite their best efforts to avoid detection, we caught them.”

Lars Toomre predicts that future actions will look at the credit derivatives market - "CDS spreads have been moving too much ahead of unusual corporate events". Gareth Gore covered the issue of insider trading at hedge funds in our December 2006 issue.

An interesting piece of research this morning (via Alea) - on the use of blood pressure as a measure of happiness. The use of happiness as a goal of public policy is becoming popular, with economists such as Lord Layard getting increasing amounts of attention. The problem is that happiness, unlike GDP, is not easily measured, especially not between countries where translation issues get in the way. Fortunately, according to David Blanchflower and Andrew Oswald's paper, it turns out that national blood pressure - or at least incidence of hypertension - is linked fairly closely to national happiness, whether you call it "Glucklichkeit" or "bonheur". (Generally happy nations, such as Denmark, have low rates of hypertension; unhappy nations like Italy have high rates.) So international comparisons of happiness are sound; and, in addition, we have a new and easier way of measuring it.

Meanwhile, in a move likely to reduce the cardiovascular happiness of a lot of investors, Moody's has decided to change its rating methodology in order to upgrade anything up to 200 banks to Aaa status. The reactions from analysts have been, well, hostile. New York-based Creditsights has already stopped using Moody's, for reasons it explains in the headline of its report "Moody's Makes Aaas of Itself".

Food for thought from a book review in the New York Times:

JOHN MAYNARD KEYNES was a day trader. [OTC: actually they mean an investment manager] Besides his own fortune, he invested the money of his employer, King’s College of Cambridge University. From 1928 to 1945, when British equities shrank 0.5 percent a year on average, Keynes earned the college an annualized return of 13.2 percent, wagering on stocks and bonds, but also currencies and commodities, using insight into global events.

That's an impressive rate of return - the Credit Suisse/Tremont hedge fund index only managed 10.97% annualised over the last 14 years. Moreover, that's identical to the S&P 500, which also rose 10.97% a year over the same period. Keynes, on the other hand, outperformed by 13.7% compared to the UK equity index. Not bad - though it would be unkind to make the comparison with a more recent attempt by Nobel Laureates to get into the investment business...

Alarming news from a team of economists at the Stern School of Business in New York: the Institutional Broker Estimate System, the database run by Thomson Financial that stores equity analyst recommendations for the last 20 years, appears to have been compromised.
In brief: in 2002, Alexander Ljungqvist and Christopher Molloy took a large dataset - 280,463 recommendations covering the 1993-2002 period - from the database for a paper they were working on. Two years later, they pulled the same dataset again and compared them.

Ideally, the two datasets should have been identical. Realistically, one would expect a few changes as Thomson corrected initial errors. In fact, they found that 54,729 of the entries - 19.5% - had been rewritten. Worse still, their analysis showed that the changes were overwhelmingly in one direction - rewriting history to make the analysts look better, for example by changing "buy" to more conservative "hold" or "sell" recommendations.

Thomson argues that the authors simply misunderstood the data - and many of the apparent changes are the result of “contributor rating
scale changes, contributor code mergers, and the removal of Rankings Only contributors.”

"These factors do not appear to fully explain the
patterns we see," the authors respond.

"It is difficult to overstate the significance of the changes to the I/B/E/S historical
recommendations database outlined in the previous section." No kidding. Via Slate, which comments at greater length on the consequences; as does Barron's (subscribers only).

Nick Sawyer writes:

Risk magazine celebrates its 20-year anniversary this year. To mark its two decades in the business, Risk will publish a special anniversary issue in July 2007 to coincide with a 20-year party celebration at the Royal Courts of Justice in London on July 10.

The anniversary edition will look back at some of the seminal moments in the derivatives and risk management industries over the past two decades. We’ll reveal the most influential Risk technical papers ever, we’ll talk to the biggest names in the industry, and we’ll name those institutions we think have made the biggest contribution to the development of the derivatives and risk management businesses over the past 20 years.

But we’ll also look forward. What challenges will the coming years bring for the industry? Who’s best placed to ride the wave of the next generation of products? Many of the derivatives traders of the 1980s have gone on to lead the world’s largest investment banks – who are the rising stars of the current generation?

And this is where I need your help. Who do you think are the rising stars in the current generation of derivatives and risk management practitioners? I’m looking for nominations from people in the industry – anyone you think could be the next Dow Kim, Bill Winters, Anshu Jain, Jerry del Missier or Brady Dougan. Feel free to email your suggestions straight through to me at nick.sawyer@incisivemedia.com.

I’m also keen to get some thoughts and reminiscences from people in the industry, which I’ll include in the magazine. What are your favourite memories from the last 20 years? What do you think have been the most important developments in the derivatives market?

I’m hoping that the 20-year anniversary party will be an opportunity for everyone in the industry to come together, share a few glasses of wine and reminisce over how the market has developed over the past two decades. If you want to be involved in the event or want to know more about commercial opportunities, please contact Nat Knight at 020 7484 9795 or nat.knight@incisivemedia.com. For a full rundown of the editorial content, please contact me.

As always, I’m always pleased to hear any feedback you may have about the magazine. Please don’t hesitate to contact me if you have any comments.

Kind regards,

Nick Sawyer
Editor, Risk magazine

For anyone forced to make a speech about the risk management industry, this quote might come in handy:

It is often supposed that the costs of production are threefold, corresponding to the rewards of labour, enterprise and accumulation.[In other words: salaries, shareholders' dividends, and debt costs - OTC.] But there is a fourth cost, namely risk; and the reward of risk-bearing is one of the heaviest, and perhaps the most avoidable, burden on production. This element of risk is greatly aggravated by the instability of the standard of value. Currency reforms, which led to the adoption by this country and the world at large of sound monetary principles, would diminish the wastes of Risk, which consume at present too much of our estate.

Keynes was talking about inflation risk. Given the time he wrote it, that's understandable; as Brad DeLong explains, his concern was to argue against a return to the gold standard, abandoned during the fiscal stresses of the First World War (and reintroduced, tragically, the next year by then-chancellor Winston Churchill), and in favour of a strong inflation-targetting central bank. But, of course, the point holds for any sort of risk; the reason we are willing to pay so much to get rid of risk is that the shadow of an uncertain future has a terribly chilling effect on any sort of enterprise.

From the FT today, the latest structured product worry: snowball notes. Highly leveraged and attractively cheap, they have a nasty tendency to turn against the issuer if volatility goes up. According to the report, a number of European companies have been issuing rather too many of these over the last few years and are now about to reap the whirlwind.

Is there anything to this? Hard to tell; the report acknowledges that the deals are very private and difficult to judge, so at present it's just market rumour. Any thoughts?

David Rowe at Sungard (who writes the monthly "Risk Analysis" column for Risk) has launched his own risk management blog, "David Rowe's Risk Management Blog". He opens the bowling with a fascinating piece on the availability of alpha.

...hedge funds have grown dramatically over the past decade. This raises the question of whether the market imperfections that create alpha opportunities in the first place are being squeezed out of the system...

My old friend Barry Schachter argues against the view of declining alpha on two grounds... One is that the total amount of available alpha is unknown and new entrants to the hedge fund industry may be effective in discovering previously unexploited sources of such opportunities. The second is that the presence of less skilled managers among the proliferation of new hedge funds may promote herding behavior, with resulting market overshooting that creates alpha opportunities for other managers.

My own view is less optimistic. While total exploitable alpha may well be increasing, the essential question is whether such an increase is slower than the rate of growth of funds seeking to exploit it. That this is so, I suspect, is a good part of why hedge fund returns have been less impressive in recent years than had been the case five to ten years ago...

I confess that I am slightly more on Schacter's side than on Rowe's.

The idea of a 'gold rush' implies that there is a limited supply of the resource, and it gets used up in direct proportion to the number of people working it. I suspect this is an oversimplification (as, I gather, do both Schacter and Rowe).

Leaving aside Schacter's point that a thundering herd of mediocre hedge funds charging about the place may in fact create more market inefficiencies than it removes (a very appeallingly cynical idea), the important question seems to be this:

Market inefficiencies - opportunities for alpha to be reaped - arise due to exogenous factors. At some point after they arise, they may get noticed by a smart hedge fund, that exploits them. Some time later, one of several things can happen: a) the inefficiency vanishes of its own accord as the exogenous factors change; b) the original hedge fund slowly smoothes away the inefficiency; or c) the aforementioned Thundering Herd arrives and flattens it rather more quickly.

Now, Rowe's concern is that, now we have a very large Thundering Herd, it will smooth away any inequality terribly quickly and no one will be able to make any alpha. I suspect matters may be a little more hopeful.
First of all, presumably, the initial rate of exogenous inefficiency formation hasn't changed - in fact, if Schacter is right, the Herd may have increased it. Good.
Second, presumably, because there are more eyes watching for inefficiencies, the average time between formation and discovery is now shorter. (Although it's possible that all eyes are not equal - that the number of smart fund managers, capable of spotting new alpha hasn't changed. 80% of hedge funds underperform the index, after all.) This, however, doesn't affect the supply of alpha even if it is true.
Third, from the point of view of a discovering hedge fund, the alpha source lasts until either it goes away of its own accord or the Herd arrives.
Now, here's the question: is it true to say that most hedge fund alpha sources disappear because of the Herd, or because of other exogenous factors? If the latter, then the existence of the Herd is having only a minor effect. And furthermore, if the Herd generally arrives only shortly before the alpha would have disappeared anyway... then really they have little effect on its supply from the point of view of the smart minority. As well, it's not sure (see remarks about not all eyes being equal) whether a bigger Herd will necessarily be quicker at spotting and following a smart investor than a smaller one.

Any thoughts?

The CME/CBOT merger could be running into problems, with the US Department of Justice reportedly seeking evidence from brokers and competitors on potential problems with the deal, chiefly its effect on competition. (The Futures Industry Association went public with its disapproval last month, along the same lines.)

Chicago Business writes:

Department investigators have asked customers and competitors of the exchanges for signed statements describing their objections to the deal, according to three who received the requests…investigators only embark on such evidence gathering if they think they might need it in court, antitrust lawyers say.

But the Justice Department has a hard job ahead of it; it can't compel people to point out problems, and they may keep quiet despite their misgivings if they think they'll profit personally from the merger - or simply to avoid antagonising the CME.

The merger's set for the middle of the year, but the DoJ has until mid-April to decide whether to challenge the deal. It hasn't sued to block a merger since 2004 - the article points out that the Bush administration has been a lot more merger-friendly than its predecessor - but that doesn't mean the CME/CBOT merger will be nodded through.

"They are obviously investigating this seriously, and are at least wanting to make sure that they have things lined up properly in the event they ultimately decide to challenge the merger," says Paul Stancil, a former antitrust lawyer who now teaches the subject at the University of Illinois at Urbana-Champaign.

The markets like the sound of ICE's bid for the Chicago Board of Trade - and the CME, which was due to close its merger before ICE came on the scene, has taken a fall as a result.
Points worth pondering: the CBOT has a clearing agreement with the CME that will last until January '09; is this enough to tip the balance? Is the CME going to raise its bid? Almost certainly; but might ICE not simply follow suit? In an all-share deal, where it has already surrendered control (the merger would give CBOT shareholders 51% of the company), there isn't really a good reason not to.
And the big question: are the authorities going to get involved? The US government has been fairly hands-off on mergers recently, but this week we heard that the Justice Department was looking into CME/CBOT in a highly menacing way.
CME must be hoping that it won't get any more bad news before April...

Don't get your hopes up, the San Francisco Fed advises in this brief letter: Chinese companies are likely to stick to bank loans in the near future, because the banking industry is still too opaque and politicised to make a corporate bond market efficient. (Via Mark Thoma at Economist's View.) Our colleagues at Asia Risk looked at the Chinese banking market in November last year: here.

Another piece of news: now up on the Risk.net website, our global business school directory.

Yes, says economist Kash Mansori (via Calculated Risk) who quotes the latest Federal Reserve figures on bank exposure to the real estate market.
"First of all, banks have direct exposure to residential real estate loans of close to $2 trillion, plus another $1 trillion in indirect exposure through their holdings of mortgage-backed securities (MBSs). That's not a trivial amount.
Secondly, banks continued to expand their residential real estate lending at an extremely fast pace during 2006, despite the rapidly cooling housing market."

Or, possibly, not, says the Cleveland Fed's associate director of research David Altig. After an impressive list of links to commentary on the US residential market (almost all negative), he cautions:
"Adjustments of this sort are never easy, there will be some pain, and probably a disruption in the pace of economic expansion as things sort themselves out. The punch line is always something like, "but things do sort themselves out, and there is no reason to expect that the economy will fail to return to a normal pace of growth after a sluggish quarter or two."

Too confident? Or is the wave of negative forecasts as much a result of herding behaviour as any bubble?

Not a good month for the ratings agencies. There's been the fuss over Moody's decision (which it is now rapidly backing away from) to change its bank rating methodology. And now Bethany McLean of Fortune, who made her name when she suggested that Enron might be unsound, writes that the agencies - all of them - may be partly to blame for the continuing collapse of the US subprime mortgage business, by rating CDOs based on mortgage debt far too highly.

Janet Tavakoli, who runs Tavakoli Structured Finance, points out that AA-rated tranches of CDOs backed by subprime mortgage paper now yield far more than AA-rated debt backed by other assets - a sign that the market doesn't trust the ratings.

Back in February I looked at the suggestion that hedge funds have been deliberately exposing themselves to tail risk - ignoring the low-probability events at the tail of the bell curve in order to make above-average profits most of the time.
In this long and detailed analysis, James Hamilton looks at another class of investor which may have been following the same strategy - public-sector pension funds. He looks in detail at the San Diego City Employees' Retirement System, which seems to have been suffering from short-term politically-driven managers and incompetence; a nasty combination that has left it several billion dollars in the red.
The problem, briefly, was that the administrators thought: "Our investment policy assumes average return of 8%. Therefore, every year over 8%, we are actually getting free money, which we can spend on more generous benefits". This, of course, went horribly wrong.
San Diego isn't alone - he gives a few other examples.

Because of different political systems, this isn't a problem that's come up in the UK, but it could well be widespread in the US - there's even a link to the subprime mortgage collapse, which took $65 million from the New York teachers' pension fund with it when New Century hit trouble.
How many other funds have been making similar bets? I suppose we'll find out in the months to come.

And: to blame for the mortgage problem today - the regulators. At least according to the WSJ (via Mark Thoma).

...standards still declined and the volume of loans surged in the past two years.

One reason: Changes ... have moved large swaths of subprime lending from traditional banks to companies outside the jurisdiction of federal banking regulators...

Yet even where federal regulators have jurisdiction, they sometimes have been slow to grapple with the explosive growth in especially risky practices and quick to shield federally regulated banks... The underlying belief, shared by the Bush Administration, is that too much regulation would stifle credit for low-income families, and that capital markets and well-educated consumers are the best way to curb unscrupulous lending.

A highly entertaining report from the Commodity Futures Trading Commission, which is taking court action against people who, it says, set up entirely fictitious energy brokerages, which traded on entirely ficititious exchanges, with (the killer line) an entirely fictitious government regulator overseeing them.
Presumably, customers who asked "so, is this brokerage, you know, kosher?" were told "Of course it is! We're regulated by the American Futures and Options Trading Commission!"

Australian and Singaporean regulators are also involved.

The whole list of non-existent brokers and exchanges sounds almost correct...rather like one of those alternate-universe stories that always involve zeppelins or an averted Russian Revolution.

Customers were duped into believing that: (1) New York Options Exchange (NYOEX), International Energy Exchange (INTENX), New York Petroleum Option Exchange (NYPOE) and American Futures and Options Exchange (AFOEX) are futures exchanges; (2) Tahoe Futures (Tahoe), Vitol Capital Management (Vitol), HPR Commodities (HPR) and Metro Financials (Metro) are their respective brokers; and (3) all these entities are located in the United States. ... In addition, Metro, in order to bolster its credibility, directs customers to American Futures and Options Trading Commission (AFOTC)’s website which purports to be the regulatory body that regulates the commodity futures and option markets in the United States when, in fact, AFOTC is a fictitious entity.

In Risk's April issue, I interview Reuben Jeffery, the chairman of the CFTC (which, unlike the AFOTC, actually exists).
Discussing Amaranth, he told me: "We do not second-guess individual firms’ or traders’ decisions or strategies. We’re not in the business of picking winners or losers, but defining the rules of play… If we have evidence of manipulative or abusive behaviour, we will investigate, but there are a lot of smart people who make bad investment decisions and Amaranth fell into that category.”
Read the full interview when it is published in Risk or online at Risk.net - available from next month.

Appeals to "the wisdom of crowds" have become terribly popular over the last few years. Some with justification - the Iowa Electronic Markets have an enviable record in forecasting (through betting) the results of US elections - some without. Alea reports a fund management experiment that falls into the latter category.
Marketocracy was set up seven years ago and allows anyone to sign up and run a fund with $1 million in play money. In November 2001, the company capitalised on this by launching the Masters 100, a real fund based on the investments the top 100 performers were making.
How's it doing now? Very badly.

Now, here's the question: why? I can think of two possible explanations, and I'd be interested in hearing more.

1. Posit that no one in the original pool knew anything about fund management. Never the less, out of 60,000 people, some are going to make good bets by chance in the course of a year. If you then follow their investments over the next six years, their innate lack of ability will shine through, and your fund will perform as well as any other fund run by randomly picked amateurs, ie not very.

2. Perhaps a lot has changed since 2001. The markets certainly look different; maybe a strategy or a general management approach that did well in 2000-1 was very badly suited to 2001-6. This seems reasonable...

The auto parts manufacturer's bankruptcy made headlines in May 2005 - and prompted a good deal of sweat and tears in the CDS market. Almost two years on, and we may be about to learn more about the reasons behind its filing for Chapter 11.

The SEC has filed against the company's CEO, David Stockman, for accounting fraud. Stockman and other executives are said to have faked supplier documents and misled auditors for four years before the company finally went under. Stockman not only defrauded investors and tried to cover up the company's true state, the SEC says; "during the same period in which we allege Stockman was defrauding investors, he was collecting millions of dollars of the management fees C&A paid to Stockman's private equity fund, Heartland Industrial Partners."

The company's CFO, treasurer, corporate controller, and several others have also been charged; and Stockman and three others are also facing criminal conspiracy charges.

Stockman, incidentally, first made his name as President Reagan's budget director and one of the most energetic supporters of supply-side economics. His Heartland fund was intended to follow a strategy of buying up Midwestern manufacturing companies (like, for example, Collins & Aikman) and turning them around - without cutting thousands of jobs or hammering trade unions.

Brad DeLong makes the comparison here between Stockman's work on the 1981 budget and his alleged misdeeds at Collins & Aikman.

I'll be out of town for the next couple of weeks - in the meantime, here is a list of decent economics and risk management blogs to read.

Our own David Rowe writes his risk management blog, "David Rowe's Risk Management Blog", at the Sungard site. The blog only started earlier this month - so take a look.

Brad DeLong, probably the best-known economics blogger, writes his Semi-Daily Journal here; macroeconomics, economic history, current US politics, journalism and science fiction all make appearances.

Calculated Risk has been covering the US housing market in impressive detail.

Econbrowser is an interesting US-oriented economics site; Economist's View is the same with some politics mixed in.

Roubini Global Economics actually maintains three blogs - macro-oriented, highly readable, and slightly (though not irrationally) bearish in outlook.

Alea posts less frequently, but often has derivatives-related material; as does Risk Markets and Politics. And for a more technical approach, try Coding the Markets, The Park Paradigm or Mostly.