I’m Long for a “Big Short” Oscar

Big Short

[This post was originally published in Risk.net’s Hedge Funds Review]

How would you have reacted if I told you, several years ago, that a Hollywood studio was making a movie about the role hedge funds played in the global financial crisis? That it portrayed hedge funds as the heroes? That within the first few minutes every moviegoer would be paying close attention to a detailed explanation of short-selling? What would an option to invest in such a film have been worth? Simply put: not enough. Today, The Big Short is up for five Academy Awards including best picture, best director and best supporting actor. It does an incredible job of taking a rather dry subject and turning it into an engaging story about a few eclectic characters that millions of people continue to pay good money to see. The two best reasons to encourage others to see The Big Short are straightforward: it entertainingly educates about the complexities of the financial system and, more importantly, it accurately portrays the positive role that hedge funds can play.

The Big Short gets the high-level story right and uses accurate details to support its tale. Hedge funds – indeed all successful investment managers – profit from access to scarcely known information. The Big Short tells the story of a number of persistent investors who didn’t accept the party-line explanation of inconsistencies in the mortgage markets. They dug deeper, asked uncomfortable questions and found opportunity. This is not just the story of a handful of investors who profited from the collapse of the housing market – this is the epic story of how to be successful in life: be different, be bold, find a niche, stick to your convictions and see the job through. Each of the subplots in this movie follow that inspiring David vs Goliath storyline.

Christian Bale’s character, Michael Burry, goes through a meticulous analysis of underlying home loans before deciding to bet against the mortgage-backed securities (MBS) in which they’re collateralised. The movie shows him struggling with his preliminary findings, gathering more data, performing more analysis and finally deciding to bet heavily against the US housing market. Day after day as he waits for the collapse, Blurry records his mounting loses by writing his fund’s negative returns in big numerals on a massive white board for all his employees to see. Chutzpah, writ large. His obsessive-like behaviour endears him to the audience. His lack of experience with MBSs strains his credibility with his mentor and investors. We love an underdog and this part of the story delivers.

Meanwhile, Mark Baum, played by a convincing Steve Carell, discovers the hollowness of the same market as he tours empty Florida housing developments and interviews mortgage brokers who brag about putting modest-income earners into palaces through interest-only loans. Following the very skeptical Baum as he pieces together the underlying fragility in the housing market, you can’t help but root for him. This is great acting and great direction coupled with great writing. It’s one thing to hear Steve Carell’s dripping sarcasm when he repeats what he just learned about “CDO”s but to hear him snide as he slowly pronounces “synthetic…” CDO is what makes movie going worthwhile.

The moral aspect of the entire topic is all too briefly – but quite neatly – addressed by Brad Pitt’s character, reclusive Ben Rickert, who left Wall Street to the comfort of his Rocky Mountain sanctuary. Brought back into investing to help two naïve hedge fund entrepreneurs, he admonishes them, “You just bet against the American economy. And if you win, hardworking people will suffer, so try not to celebrate.” Wall Street could use more conversations like that.

The use of cameos to explain complex financial concepts works rather well. The dialogue between Selena Gomez and Nobel Prize-winning behavioural economist Richard Thaler at a Las Vegas blackjack table is inspired, as is celebrity chef’s Anthony Bourdain’s explanation that subprime mortgages can be made to look appealing through collateralisation, just like last week’s fish can be made into seafood stew. Director and screenplay adaptor/writer Adam McKay makes it clear that these topics deserve to be understood and helps the audience by making the lectures entertaining. He seems to tell us “no shortcuts here – I’m going to force you to pay attention to otherwise boring but important stuff by having celebrities teach you. So there!”

To be sure, The Big Short won’t make everyone in the alternatives industry happy, nor will it change the perceptions of those who believe the solution is a radical reform of Wall Street. But it will explain some of the intricacies of the investment management world and how it operates. And it will allow more people to have an informed dialogue about the proper roles of regulation, free markets, finance and opportunity. And whatever side of the debate you’re on, that’s a good thing.

All in all, this is a movie worth seeing. This is a story worth telling. For those of us in the financial investment industry, this is a movie worth encouraging others to see. It’s entertaining, informative and provocative, just like a good movie should be.

Why this acquisition was the best decision

The three reasons Investor Analytics was purchased by StatPro


Lots of contemplation, emotion and cold hard logic go into the decision to have your company acquired by another firm. While even my own 13-year old daughter made the canonical “but it’s your baby” argument in trying to convince me not to, it’s never been about that for me. Investor Analytics has not been the goal but rather the means. IA has always been a vehicle to promote what I fundamentally know to be true: that we can all make better decisions by understanding and using analytics and methodologies that have passed rigorous testing. For me, Investor Analytics has been an expression of the tremendous benefits of the scientific method, as applied to financial markets. It matters because real people’s livelihoods depend on financial decisions. Good financial risk management can mean the difference between retiring early and working until old age, or between living month-to-month and investing for your future. With a nod to Simon Sinek, that is my Why. Analytics improve decision making and improve human lives. I’ve spent my career applying it to financial markets so people can make better investment and risk decisions and avoid catastrophic financial mistakes.

You can read the rest of the post here.


5 Financial Risks to Keep an Eye On This Summer

oil_rigs (2)This summer is no time to take your eye off the risk management ball as the uncertainty and volatility in financial markets won’t take much of a holiday.

There are five financial risk focus areas we suggest you continue to monitor through the dog days of summer: Oil, China, Rate Hike, Liquidity and Loans. Although Greece seems to have settled down – for now – and the EuroZone has avoided its most recent crisis, it’s likely to come back at some point since the solution kicks the can without really addressing the underlying differences in the EU’s constituent economies and cultures. For now, there are bigger market risks to watch for.

To read about these top 5 sources of risk, click here to see the whole text in LinkedIn.

The Beta/Correlation Language Barrier

This post originally appeared in my column in Risk Magazine in October, 2014.

Institutional investors tend to use a different vocabulary when speaking about risk than hedge fund managers. Institutional investors often talk about beta and benchmarks. Hedge funds talk about correlations and absolute returns. Betas and correlations are closely related to each other, but not the way most people think.

Institutional investors as a group first learned about quantifying risk when they were introduced to the concept of beta, probably by a long-only equity manager. The conventional interpretation, they were told a long time ago, is that beta measures the relative risk of their portfolio to their benchmark: if beta is greater than 1, the fund has more volatility than the benchmark. If it’s less than one, the fund has less volatility than the benchmark. This simplification has merit for many long-only funds, but it has led to misinterpretations and a false sense of security when alternatives are included. The issue is compounded by the introduction of a related measure – correlation – from hedge funds’ ubiquitous claims of “uncorrelated returns.” The relationship between beta and correlation is not well understood by many managers and, when misinterpreted, can lead to poor investment decisions.

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The Pre-Mortem: sidestepping disasters before they happen.

Projects fail for many reasons, even after enormous effect and planning.

Projects fail for many reasons, even after enormous effort and planning. Pre-mortems can help avoid disaster.

Let’s suppose your team needs to decide whether to pursue a project (investment related or not), and it’s time to discuss the risks. What’s the best way to do it? Gary Klein, a research psychologist and currently Senior Scientist at MacroCognition, found that ‘prospective hindsight‘ — imagining that an event has already occurred — increased the chances of identifying the reasons for failure by 30%! In any risk management context, that’s worth learning more about.

Enter the Pre-Mortem.

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Be Prepared

The scout motto tells us to be prepared. My children’s schools practice fire drills and intruder drills as often as monthly. And first responders practice the “be prepared” philosophy as well. At least Boston’s clearly does. I just read an inspirational article in the Wall Street Journal about the preparedness of their emergency medical teams and the speed with which they were able to save people’s lives. “The efficiency of the rescue reflected careful planning, heroic execution and elements of good fortune.” The article went on to state that “Rescuer reaction was so instantaneous that it appeared to be rehearsed.” It appeared that way because in fact, it was. I know of no better way to be prepared than to rehearse. Thespians do it before the curtain rises, politicians do it before a debate and athletes do it before a game. So why don’t more portfolio and risk managers do it before a market crash?

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Doctor, Heal Thyself!

A client recently emailed me this link to an article about JP Morgan having discovered an error in their firm-wide calculation of Value-at-Risk, the industry standard measurement used to quantify risk.  His email concluded with:

“They are using a spreadsheet!!!”

You read that correctly.  JP Morgan – the firm that famously invented Value-at-Risk in the 1990’s – is apparently using a spreadsheet for this calculation.  This revelation is simply astounding.  If true, it would mean they really are sitting on a house of cards.  The article quotes the JP Morgan Task Force on VaR: “the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a  factor of two and of lowering the VaR…. It also remains unclear when this error was introduced in the calculation.”

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Occupying Wall Street

Investor Analytics is moving back to the Wall Street area.  We’ve taken the entire 25th floor of 55 Broad Street, just a few doors from the NY Stock Exchange, to serve as our corporate headquarters.  For the past several years, we’ve had an office in New Jersey and a small office near Grand Central, which made for convenient meetings in NYC.  But we’ve expanded a lot in the past year – we’re up to 35 people – and we’ve needed a single space where we can all work together, where we can meet clients and business partners, and where we can continue to attract top talent to join our firm.

Floorplan of the new headquarters (click to enlarge)

When we started looking for space last Spring we focused on midtown Manhattan, especially near Penn Station, and on parts of Jersey City.  But lower Manhattan was just too compelling – Commercial rent near Wall Street is about half of what it is in midtown.  And landlords in the Financial District pay for office build-outs (that means walls, carpets, doors, etc.) and give rent-free periods of several months that midtown and Jersey City landlords just don’t offer.  Besides, there’s a vibe to downtown that we like.  It’s the oldest part of the city and it’s steeped in history going back to 1624 when it was founded as New Amsterdam, and it’s never lost its Dutch roots: commerce and tolerance.

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Biggest Risk

“The biggest risk is hiring the wrong person.”  That was my swift answer when asked to identify the most important risk facing hedge funds.  In that case, I was talking about hiring the wrong Chief Risk Officer — the person who sets the risk policies and monitors and enforces the risk management practices of an asset manager.  Little did I realize how applicable my advice was to my own firm.  At 25 people, it’s safe to argue that my firm is at material risk of hiring ‘the wrong person’ every time we make an offer.  It’s especially true for the person who is our equivalent of a ‘risk manager’ – the person who makes sure bugs don’t make it through the code and errors don’t end up in client’s reports: our head of Quality Assurance.  I can now with personal experience enhance my previous answer: the biggest risk facing any business is hiring the wrong person.

Two weeks ago we suddenly found ourselves needing to hire a new Head of Quality Assurance and my highest priority became writing a new job description.

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The Risk of Success

Switzerland has a problem – they’ve been so incredibly successful at financial risk controls while the rest of Europe falters, that the Swiss Franc now costs too much for most Swiss to afford their own country’s products!  The Swiss Franc is now so expensive compared to the Euro and the US Dollar that Swiss exports are out of reach for foreigners and the Swiss themselves find much better bargains by crossing the border to any one of their Euro-denominated neighbors.  According to this NPR article, Swiss shopping centers are empty and the Swiss now regularly go shopping in foreign countries.

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What are Credit Ratings Good For?

On the front page of today’s Wall Street Journal (well, the on-line version anyway), there’s an article about how the major credit rating agencies ‘failed to see defaults coming.’  You can read some of the article on their public site, but you’ll need an on-line subscription for the entire text.  The point of the article is that a given country’s or company’s official credit rating usually severely underpredicts the real probability of default.  This is not news in the industry.

A few years ago as the credit crunch was getting underway, several of our business partners asked if we could model corporate bond credit risk using the official ‘big three’ credit ratings as inputs.  While this initially sounded pretty straightforward, my crack team of financial engineers showed me why it really doesn’t work.  Basically, there is supposed to be a relationship between the credit rating and the chance of default.  S&P claims that a rating of ‘single B’ means there is a 2% chance of default within 1 year.  But if you look at 100 different companies rated ‘B’, far more than 2 of them defaulted in the coming year.  Given how poorly the ratings predict what they are supposed to, my quants emphatically refused to build a system that used credit ratings as the basis of default.  But at the same time, many of our competitors were selling exactly that type of system – one that estimated how much money a fund could lose based on the credit ratings of their investments.  And these systems were selling very well.  The only problem was that they, just like the big credit ratings, severely underpredicted the real risk.

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Stress Testing the United States

A curious thing happened on the way to August 2… Last week, professional money managers started asking us to perform Stress Tests on the US Government.  Gulp.

My company provides a variety of different risk management services for professional investors.  Among them is a ‘Stress Test’ for Money Market Mutual Funds in which we simulate a number of different simultaneous market downturns to show the fund’s managers what impact these hypothetical events would have on their ability to continue to provide liquidity at $1.00/share.  Typically, we simulate three simultaneously ‘bad’ things happening: interest rates rising (so bonds lose value), credit spreads widening (so bonds lose value) and fund investors increasingly redeeming shares (so the fund has to sell bonds – potentially at a loss – to have the cash to pay back investors, a vicious downward spiral).  For most of our clients, we perform these stresses monthly.

Last week, we got calls from several clients asking us to run these stresses in the middle of the month because they’re concerned with the US not raising the debt ceiling.  The fact that professional money managers are paying us to perform a stress test on the US Government should ring alarm bells. Let me describe what they’re worried about:

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Learning from Mistakes

The Economist has a nice piece about how European authorities did it right this time with volcano ash.  My previous two posts were about how last year’s closures were done without proper testing and my second post was about an article that seemed to justify those closures because of a detailed study of volcano ash.  I was afraid that it would lead to European authorities taking an even more conservative approach because of this study, overreacting without proper testing.  As I mentioned in the previous posts — I’m not arguing that the airspace shouldn’t be closed.  I’m arguing that it shouldn’t be closed without testing the actual ash – every time.  This new Economist article supports that view and states “The actual eruption of Grimsvotn a little over a month after the April 12 exercise shows that airlines, air traffic controllers, and governments appear to have learned the lessons of 2010’s Eyjafjallajokull-driven chaos.”

Now THIS is risk management.  Appropriate reactions by authorities to this new eruption is much more data-driven than the previous eruption.  An evidence-based approach to risk (heck, to everything) is a much better approach.  Arguably, when the last eruption started there was little evidence to go on.  In my view, that means it became imperative to collect the information as soon as possible.  This time around, it seems things are being done in a proactive way.  If it turns out that the ash really poses a risk, I’ll be the first one to support massive airport closures.  But massive airport closures without simultaneous verification should be criticized loudly.  I for one am glad they’re doing it right this time.


How Do You Know It Works (part 3)?

In this 3rd part of  ‘How Do You Know It Works” I’m going to cover three different popular ways to measure risks and show how to tell if they work or not (I know, I know, that part 2 cartoon is a cheap way of making this a trilogy-post but I’ll take what I can get).

What we’re talking about is much wider than financial risk, but it’s also at the very heard of financial risk management:  How do you know if your risk measure is worth the paper it’s printed on or the computer it runs on?  Here are some things to look for in evaluating a particular forward-looking risk analytic:

  1. It can be calculated from available information and isn’t tied to a proprietary piece of data.
  2. The analytics’s accuracy can be quantitatively determined in some way.
  3. The assumptions going into the analytic can be clearly communicated.
  4. Users of the risk analytic can have an indication of when it is applicable and when it is not.

I’m just going to concentrate on the second feature: evaluating the quantitative accuracy of the analytic.  Let’s consider three different analytics:

Worst Case Loss
Investor Analytics
is sometimes asked to calculate a firm’s proprietary risk model which falls into the category of “worst case loss.”  I’ve heard it described many different ways, using many different formulas / techniques / methodologies, and it usually starts with a set of reasonable inputs but boils down to a series of alchemy-like adjustments that render the thing useless.

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How Do You Know It Works?

I participated in a panel yesterday at a hedge fund conference in NYC.  What made this panel a little different was that I wasn’t the first person to talk about how important it is to know the limitations of risk models.  In fact, I was the THIRD person.  The question was posed “what makes an outstanding risk manager?”  The first person to respond included in his answer something along the lines of “an outstanding risk manager asks the question – how do I know the model works?”  Bingo!

How do you know if any prediction works?  Over the ages, people have tried all sorts of methods.  Let’s take a look a few of them.

Method #1: you believe it if an authority figure tells you it’s true. Like the village elder.  Or the shaman.  Or a celebrity.  Or Congress.  Assessment: inconsistent results at best.  Let’s try something else…

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What Went Right?

Note: This article was originally published in IPE (Investments & Pensions Europe) on 1 October, 2010 under the title “Never mind what went wrong in the financial crisis, what went right?

A lot has been written about all the things that have gone wrong leading up to and during the financial crisis, and for good reason. After all, a lot did go wrong, and we are still reeling from it. Over the same period, though, many things – largely unnoticed – went right. Let’s remember that not everyone who considered Madoff actually invested with him, not every bank or mortgage broker made undocumented loans, and not every fund lost terrible sums of money. It’s worth taking a look at what these people and institutions did to prevent catastrophic loss, especially because their tactics turn out to be both practical and widely applicable.

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