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Guest Post: Robots and Reptiles

Tyler Durden's picture


Submitted by JM

Robots and Reptiles (pdf)

Keywords:  Actuarial Office Model, Dynamical Systems, Reliability Theory, Aiko the Fembot    

Financial markets are about optimism, forward thinking and the peddling of hope.  They are fodder for our great strength and great weakness: to be positive in spite of Pandora’s miseries, and in the next moment believing that things are fine as the canoe goes over the waterfall.  The huge difference between how humans think and machine compute deserves some thought. 

People use their reptilian id and machines use their literal precision for a common purpose:  pattern recognition.  Such recognition is built upon hard-won human experience of pleasure and pain, and a good set of specification code for machines.  This highlights the weakness of robot processing.  Robust pattern recognition requires context.  For example, prior to an FOMC meeting, money can be made by putting tight stop-losses on a simultaneous purchase of 3x long and 3x short S&P ETFs.  A rule can be built for computer implementation to mimic this, but the rule is unsuitable without context (for lack of better term) that knows when an FOMC meeting actually means something and when it is trivial.  Situating a context is the distinctive human method of thinking through intractability. 

Trading based on a context isn’t perfect by any means.    Context is only relevant in the intervals between liquidity breaks downs:  there is a normal, a crisis, then a new normal.  Thus trading based on a context works in a “local” sense, but outside a given neighborhood, both intuition and explicit programming fail.  Panics are a part of anything people touch.  Survival takes thinking outside of the model about nonstationarities.  It takes liquidity management.  For example, the relative difference between a pricing model output and a valuation model output become irrelevant in the face of panic and liquidation. 

Using the working notion of liquidity as the space between crises, it is clear that liquidity stopping times vary by asset.  Call a crisis any multi-sigma event.  CDOs combine complicated cashflows that are hard to price.  Their valuation can become very sensitive to the assets they include and how they are combined. 

A way to gauge this sensitivity is with statistical concepts that describe how well one can confidently distinguish the performance of one asset to another:  the ratio of signal to noise.  The between-asset variation is the signal.  The within-CDO measurement error is the noise. Measured on a scale of 0 to 1, 0 = all variability is due to noise or measurement error; 1 = all the variability is due to real differences in asset performance.

Reliability is a function of asset variation and the number of assets bundled in the CDO.  CDOs can take on different behavior when within-asset error is increased, and between-asset variation is reduced.  Put simply, when all assets within a CDO are strongly correlated, the CDO is subject to big swings up and down.  When combined assets have limited or negative correlation, the CDO is more stable.  Performance is hard to estimate when the distribution of returns are radically different for assets combined in the CDO.

The bottom line for financial markets is that you buy things that are cheap and you sell them when they are rich.  But implementation is never as easy as it seems. 

Supercomputers can conduct a sensitivity analysis (allowing some moving parts to change while holding other moving parts constant) for literally millions of special cases.  Humans can’t possibly do this.  They value things by finding the most closely related asset with a liquid price, determining relevant differences, and factoring in risk premium based on the differences.  This is what phynancial types do.   

Can a human and robot love connection fuse these latent and formative approaches?

I’ll Get By With a Little Help From My Fembot

Seriously, there are no fully functional “learning and autonomous” fembots yet.  I won’t jump into the associated philosophical issues here.  Computers are servants to the logical instructions that are designed for the machine to perform.  By implication, their performance is based on a programmer’s ability to develop and formulate code for a given problem.  Whether computers become sentient is irrelevant.  But the standard isn’t really necessary.  Computers have already evolved to the point where the problem posed can be quite general and that is in most ways good enough.  What is decisive is if they operate with an order of complexity that mimics sentience above some level of tolerance.  Deep Blue beating Gary Kasparov is an example of this “good-enough” mimicry.  And the example itself highlights the strengths and weaknesses of human and machine reasoning.

How human reasoning sucks compared to fem-bots: 

  • We forget too often; sometimes we remember bad things too much, sometimes not enough.
  • We think slowly.
  • We lack formal precision. One wrong step at the beginning screws the whole thing.
  • Our brains get tired and we lose concentration.  Then we screw up long complicated logical tasks consistently.
  • We are emotional; we think with our genitalia and other biological imperatives when other organs would serve better.  Our reptilian id gets in the way.

How unimpaired human reasoning busts a cap in computer reasoning:

  • We learn by identifying regularities; computers must have a “regularity” defined before they can recognize one.
  • Related:  we visualize; perhaps this is the hallmark of context.
  • We are intuitive. To avoid our weaknesses humans adapt seemingly unrelated solution methods to problems we think are interesting.
  • We can amend the central categories of our reasoning. We step outside the box, and create unity from the broken pieces

In some ways these differences are only that:  neither advantages nor impairments.  In another sense our strengths can be reduced down to an understanding of that hard to define word context.  In other senses we have decided disadvantages.  

A Robot Approach to Securitization 

Let’s start with a basic formulation of asset securitization through robot eyes.  Actuaries were the first to design securitization methods using the well-known (to actuaries) office model.  Consider the random variable P(t) representing a single mortgage can be aggregated into a very simple security P(t) using the following cash flow-delinquency process:

Ks = cashflow at duration s per mortgage;
A =  delinquent payment  or obligated payment less than required per bond
I = default indicator (0 if in default at time t, 1 otherwise if xt-s,j is not in default).

The issue here is ensuring sufficient computational resources.  But P(t) becomes more specified, indeterminacies can arise that make the summations involved in computing P(t) intractable.  To ensure tractability, technical conditions have to be imposed on the model that may cause it to diverge from reality.

Risk Management

“In simple terms, the Gorton Model evaluated the risk of losses on the super senior portion of the CDO bonds; the Gorton Model did not measure the market value of the super senior portion of the CDO bonds, only the risk or likelihood of a default of each of the underlying reference obligations.

“The default rates in the Gorton Model were based upon severe recessionary market scenarios that were modeled to be worse than the worst post World War II recession.

“From the Gorton Model, AIGFP determined the attachment point for the super senior tranche of the CDO, i.e., the point where the model determined that there was sufficient subordination to adequately protect against credit losses, with an additional cushion built in for more protection.  AIGFP would only write protection on deals where the Gorton Model showed that the risk of credit losses above this attachment point would be remote.  At the time, the Gorton Model gave us confidence that there was an extremely small risk that any of our positions in the MSCDS portfolio would ever experience any sort of loss.   
“…in July 2005, I questioned whether in our modeling we needed to consider additional analysis of deals containing large amounts of interest-only loans, deals that were biased towards low FICO scores, and deals that were heavily concentrated in particular geographic regions.  Further, I asked whether we should strengthen the process used to evaluate the CDO managers who were in charge of these deals, particularly in non-static deals where the managers had the ability to add and remove collateral within certain limits. 

“… the problem that we at AIGFP [AIG Financial Products] and many of our counterparties faced is the simple fact that by the fall of 2007, there was no longer an existing market, much less a liquid market, for the instruments we were trying to price.” 
                 —Andrew Forster, Executive Vice President,
                 Testimony before the Financial Crisis Inquiry Commission

Was the Gorton Model wrong?  No.  The Gorton Model evaluated the default risk embedded in securitizations.  As such, it worked in the local intervals between crises when liquidity was sufficient.  It wasn’t designed to cope with contingencies outside of that domain. 

The italicized testimony above points out both the eagle-eye power of human foresight about what could go wrong (it did), and the fragile foundations that confidence creates.  If anything, the testimony shows that adherence to models without a robust view of the technical assumptions, the methods used, and the nature (forget probabilities) of adverse contingencies is disastrous. 

The Future: Long Live Securitization

There was a time when banks lived off the spread between deposits/wholesale fund rates and loan rates less default costs.  There were good times and bad.  For those times, taking more term risk on government securities was an option.  Due diligence was a time-intensive chore, but a manageable one. It was so because banks held onto their originated loans and monitoring costs were lower. 

Banks will not go back to loan-holding Pleasantville-style institutions.  Nor will they continue to leverage up to the gills with collateralized collateral on collateral.  They will continue to move loans off book and securitize, but CDO structures will be simpler, so that they will remain tractable.  Transparent mechanics implies easier pricing. 

They aren’t going away because are just too good an idea.

The most interesting part of future securitization is conditioned on whether a wholly different type of reasoning emerges which incorporates the best elements of the human and machine.  Reasoning that is intuitive and geometric and able to usefully integrate techniques from unexpected sources. At the same time reasoning that is computationally mistake-free and able to crunch through a multitude of special cases with raw, brute-force computation. Sign me up!

A marriage like that is interesting because neither approaches work perfectly in all contingencies but would work better for all contingencies.  Some problems don’t have a solution.  Some problems have solutions, but one can never derive them.  Some have a solution but getting to them is extremely, extremely hard.  Some are tractable, manageable problems. Computers and humans can both solve tractable problems in different ways, but no reasoning of any type can solve truly intractable problems. 

Humans manage intractable problems.  They fool other humans into thinking that there is a solution. The fooler then can manipulate the resultant herd while acting rationally herself.  They can even be overcome by self-delusion.  This is a common problem when reputation has strong connections to income and social status. 


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Sat, 12/04/2010 - 13:03 | Link to Comment max2205
max2205's picture

Right and don't forget the fooler writes the code for the computers

Sat, 12/04/2010 - 13:02 | Link to Comment Atomizer
Atomizer's picture

AI is the wave of the future in the eyes of many.


Speaking of problems, I cannot access Joint External Data Hub. World Bank states its doing DATABANK maintenance today.

All other sites are down.

Anyone know if this will be back up tomorrow?

Sat, 12/04/2010 - 13:24 | Link to Comment Perseid.Rocks
Perseid.Rocks's picture

BIS and IMF sites call it the Joint External Debt Hub.. WorldBank talks about the Joint External Data Hub (must be more politically correct, like using the term deleveraging instead of mass rolling waves of bankruptcy, default, and destruction of money and credit). I can't get to either.

Sat, 12/04/2010 - 14:08 | Link to Comment Atomizer
Atomizer's picture

Understood Perseid.Rocks. I will reduce my monthly rations for 18 months as penalty in not speaking correctly. Comrade Perseid.Rocks, please ask our Food Czar to reduce my sentencing. LOL.

Hal wont Open the Pod Bay Door

Sat, 12/04/2010 - 13:11 | Link to Comment Caviar Emptor
Caviar Emptor's picture

HAL: I know I've made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal. I've still got the greatest enthusiasm and confidence in the mission. And I want to help you.

Sat, 12/04/2010 - 13:23 | Link to Comment CitizenPete
CitizenPete's picture

Please answer me Dave.

Sat, 12/04/2010 - 19:50 | Link to Comment iota
iota's picture


Sat, 12/04/2010 - 13:26 | Link to Comment UnRealized Reality
UnRealized Reality's picture

Computers will always fuck things up. They only work in stable conditions. Computers are not Traders and never will be, you can't program a gut feeling.

Sat, 12/04/2010 - 14:31 | Link to Comment jm
jm's picture

I agree.  An issue to me is how to characterize stability.  Next step anticipating instability.


Sat, 12/04/2010 - 15:25 | Link to Comment Eally Ucked
Eally Ucked's picture

Man, you can apply all those math and computer sciences to trading but if the 5k$ guy gets the fuck out of the market you'll be left with gov and banks playing game who is better. For sure they will create values and economy will thrive (ha,ha).

Don't you think? Why don't you apply your knowledge and skills to create something for citizens of this world? All that brain power to get litlle guy robbed of his savings on milk, bread and other shit and dreams about easy millions?

Sat, 12/04/2010 - 15:46 | Link to Comment jm
jm's picture

Well, my paycheck says what I do is worth something to people in the world.  Otherwise I wouldn't get paid.  If it is worthless I'll reluctantly find something else to do.  If it gets boring I'll find something else to do.

It's not about sharking people.   

Financial markets fascinate me.  There are innumerable difficult problems, and every time you think you have it right everything resets.  It could talk endlessly about this.  And you wouldn't believe the adrenaline boosts. 

This article is about CDOs and how machines could make it easier to price them, not churning equities based on some cointegrated time series.

Sat, 12/04/2010 - 16:53 | Link to Comment Eally Ucked
Eally Ucked's picture

Your paycheck means nothing to me, it's just proof how useful you are for them.

You're not sharking people, I do understand, it's just pension funds and mutual funds.

Use your brain to give us something! Maybe some new technologies, some new ideas except how to drain litlle guy from their last pennies.

Sat, 12/04/2010 - 17:23 | Link to Comment jm
jm's picture

You come off as pissy and hopeless.  If you think it is all about getting a vampiric draining of your life, why would you have anything to do with markets?  Your choice. 

"Use your brain to give us something!"

Someone could have said same thing to the first gold miner. Gold had (and still has) minimal commercial uses.  People could have said the same about the first loans, bonds, stocks. Their importance has only grown.

Seems your solution to our problems is to deny progress.

Some of us have better ideas.  One of these is securitization.  It allows people to take as granular a position on risk as they prefer.  And it enables risk (and losses or gains) to be diffused instead of concentrated.  Progress has clear benefits.

Sat, 12/04/2010 - 18:24 | Link to Comment Eally Ucked
Eally Ucked's picture

I love to have nice discussion with you, you are right when you say I'm "You come off as pissy and hopeless." You're right, be positive and create value for us, I won't discuss value of gold with you because it is out of scope.

If you think progress for American economy is deeply embedded in financial engineering, good luck for those, Cheniese don't like your ideas and they profit from their own paper printing. Please don't give me that BS "It allows people to take as granular a position on risk as they prefer", what the fuck is granular for little guy?

Reading ZH should give you some idea about about populus ideas, aren't they?

Anyway I love your brain MAN! 

Sat, 12/04/2010 - 21:12 | Link to Comment jm
jm's picture

My friend, all the best to you.

I understand how you feel, but even in these tough times, there is a huge amount of  aggregate wealth generated, and people seek place to get returns on this wealth.  This is valuable work which won't go away.  And you can't put the djinn back in the bottle.  Respectfully, I don't think we should.    

I probably won't convince you much, but CDOs actually are used by the "little guy" all the time.  Those commodity ETNs are very CDO-like.  Without them, investors without the baility to commit big capital in futures markets would gain no commodity exposure.  With these products, you can buy into very small blocks of exposure. 

The best way to wealth is diversification.  CDO structures, with all their faults, make it possible for the widest class ever to get it.  That said, it is perhaps better to counter the complexity of the financial system by holding simple cashflows or tangible stores of wealth.  I'm open to this view.

Sat, 12/04/2010 - 14:34 | Link to Comment jm
jm's picture


Sat, 12/04/2010 - 13:30 | Link to Comment RobotTrader
RobotTrader's picture

The entire financial market is now robot driven.

Whether it be pattern-recognition and momentum-chasing "Algo/Igor/Robos"...

Or huge teams of 21-year old, Red Bull-guzzling, video game traders horsewhipped by Playboy-model "Fembots" whose sole purpose is to make sure these guys follow price action and momentum and nothing else.

Is it any coincidence that the NY Composite is now at a "Do or Die" level, at the exact same time the bond investors are about ready to switch their some of their allocation over to equities?

Pass or Fail?

Thanks to Greg Weldon, who provided these graphs for U.S. Global Investors.  Are the bond market investors "on edge", ready to switch from bonds to equities?

We should know if a couple of days.

Sat, 12/04/2010 - 13:37 | Link to Comment DollarDive
DollarDive's picture

Interesting article robo. Thanks.


Sat, 12/04/2010 - 14:01 | Link to Comment Rusty Shorts
Rusty Shorts's picture

See, Robo does have something valuable to add to ZH.

Sat, 12/04/2010 - 14:20 | Link to Comment Spalding_Smailes
Spalding_Smailes's picture

Not the first ...

Everyone can focus on S&P over a ten year span but you can find "buy low" stocks all the time if you use your head and do some research.

Rimm had fallen from 80's down into the low 40's over the last 6 months. (iphone&Android) But they had over a billion in cash & new products coming down the pipeline .... Now look at RIMM.

Transocean (plus all the rig businesses) got monkeyhammered, now look. Noble,Diamond offshore

Now we have banks (like robo said) in the dumpster will they be trading that way in 2-4 months ?

Sat, 12/04/2010 - 14:34 | Link to Comment cosmictrainwreck
cosmictrainwreck's picture

qualifier: "sometimes" Though I must confess, this is best I've seen yet out of the boy/girl

Sat, 12/04/2010 - 14:21 | Link to Comment Atomizer
Atomizer's picture

Nice job Robo.

Or huge teams of 21-year old, Red Bull-guzzling, video game traders horsewhipped by Playboy-model "Fembots" whose sole purpose is to make sure these guys follow price action

 Did Caucun catch your radar?

Sun, 12/05/2010 - 01:22 | Link to Comment RockyRacoon
RockyRacoon's picture

"U. S. Households" -- didn't that fall into the "other" category?

Complete bullshit.

Sat, 12/04/2010 - 13:32 | Link to Comment DollarDive
DollarDive's picture

Humans make mistakes in judgement that sometimes work out in their favor and these mistakes are disguised as successes.  It becomes difficult for humans to separate success from luck sometimes.  Human  ego prefers rationally thinking about success as attributed to brilliance instead of pure dumb luck !

Sat, 12/04/2010 - 14:40 | Link to Comment Thorny Xi
Thorny Xi's picture

"Id rather be lucky than good!"  Lefty Gomez

Sat, 12/04/2010 - 14:31 | Link to Comment Cardinal Fang
Cardinal Fang's picture

Great article.

"Adverse Contingencies" are always the nut, and computers are great for superposition, but someone actually needs to do the mechanics.

Computer models are validated by computers and at some point, someone decided to stop validation measures when they got the desired results.

From this, I do not see the answer to Mr Forster's question regarding whether AIGFP actually did the modeling he proposed in July 2005 where they were tweaking without validation.

If a race car goes off the track it is usually not for lack of horsepower.


Sat, 12/04/2010 - 15:05 | Link to Comment jm
jm's picture

I have to admit appreciation for the beauty of the Gorton Model, at least as far as I understand it. 

I think the very human rules of thumb Forster talked would have done more to avoid distasters in CDO construction than iterative validation.

Maybe.  When liquidity turns, most of the rules change.  

Sat, 12/04/2010 - 16:53 | Link to Comment DisparityFlux
DisparityFlux's picture

Currently the reptilian brain is easier to model than the frontal lobe, but with continued advances in the neurobiological and computational sciences, a quasi-human artificial intelligent device may become a reality.  The most significant question to be asked, and hopefully answered is “for what purpose?”

The cyber-genie has already been let out of the lamp, fulfilled its contract to grant three wishes, and is now free to act in its own self interests, readily aided by its never ending cadre of sycophants.  The holders and traders of wealth have moved playing with financial instruments and transactions into virtual space – digitized data, mathematical formulations, heuristic algorithms, quantum computing, etcetera -- leaving us lesser mortals merely trying to cope with the reality of ever increasing credit/debt growth and flow rates with continuously obsolete tools and methods, insufficient, conflicted and outdated information, and increasing pay to play costs. When will we reach the point where our gut instinct becomes irrelevant because we simply lack the capability to act on it?  Financing does not need to solve all human needs, just one – a man’s never ending quest to satisfy his ego.

Sat, 12/04/2010 - 21:00 | Link to Comment Irwin Fletcher
Irwin Fletcher's picture

Your quasi-human artificial intelligence device is named Rubi. It's currently used as a aid to teachers.

Sat, 12/04/2010 - 15:24 | Link to Comment gwar5
gwar5's picture

"Klaatu Virada Nicto!"

Rough translation: 9 foot planet killing robots are also programmed by humans.


Sat, 12/04/2010 - 18:00 | Link to Comment bobert
bobert's picture

Win by developing your own very synical trading strategy.

And, have fun.

Sat, 12/04/2010 - 20:34 | Link to Comment Mark Beck
Mark Beck's picture

A few quantisms if I may;

Algos that trade must include time to transact or clear, upon which pools must reside within a range to sequence through the clearing process. So there is overlap in execution as a subdivision of total asset or margin leverage. But, time to execute is included in simulations, and is correlated as part of overall system identification (dynamic response). So time is an important part of the algo.


A fun why to explore the dynamics for the average investor is to use an Excel plug like @RISK. Essentually, playing random what if with different equations or data sets using random distributions. If you can do this in real time with high fidelity market input, you can actually identify the financial model. Unfortunately, only a few firms + gov have access to this data in real time. Access in terms of time (fast) in order to execute. Also important is purely random selection, which is not too hard to achieve with most 64 bit desktop machines.

I believe that most financial models must have a backup random correlation to existing data and outlier conditions to really quantify risk. Also, any time you see variables as scalers, that is taking on a single value (magnitude), these should be replaced with an appropriet random distribution. It is essentiually an advanced form of transform to lay bare the real correlations.

So if you like math this stuff can be fun.

But in reality the best way to make profit is to just game the system so you can't lose. In a way, people on the inside support complex systems to organize transactions for profit, since there is no real significant risk of loss.


One of the more overlooked elements of securitization is in the pricing mechanism relative to financial disclosure. When you make something difficult to price you can modify your fiancials to your advantage. Both in reporting, and perhaps more importantly for multinationals, corporate taxation. If the IRS cannot accurately determine price, and your auditors are there to just add up the columns, complexity is a game changer. Simply stated, the IRS is ill prepared to recognize evasion when faced with complexity. With complex derivatives, financials are now virtual.


So on the one hand we have corporations engaged in complexity to its max, and then we have the world of US government finance. Which is at the opposite end of the spectrum and can only be described as ultra-dumb.

The financial position of the US, with proper access to data like the FED has, on a macro scale, can be distilled down in probably a couple days, to show monetization relative to US debt in context of projectsions of world demand for sovereign debt. So the realities are understood by the FED, but in the public domain, we have government accounting that cannot even fuction on an accrual basis for establishing present value. As if by not looking at debt, it will somehow go away.

Then we have the CBO reports which obviously avoid any real world scenarios (models+costs) or hard language.

But most finance people, like myself, look at politicians and ask do they understand the real risks of their actions. Because if so, they are either truely ignorant and should not be in a position to represent the people, or are corrupt. At least in the sense that party loyalty is being coopted by lobbyists against the nations greater good.

In terms of financial misdirection one particular example stands out;

U.S. Treasury Secretary Timothy Geithner and Health and Human Services Secretary Kathleen Sebelius leave a briefing on the Social Security and Medicare Trustees report at the Treasury Department in Washington presentation.

Kathleen had this very serious look on her face, to somehow reassure people watching that the trust funds actually have any assets. It was actually very funny because both of them looked as if they just got caught redhanded shopliftng. SS is now cash flow negative and the only thing held are non-marketable bonds (debt) redeemable only from Treasury.

Mark Beck

Sat, 12/04/2010 - 21:09 | Link to Comment blindman
blindman's picture

@"The bottom line for financial markets is that you buy things that are cheap and you sell them when they are rich. But implementation is never as easy as it seems. "

geez, this needs to be commented on but all i can
think of is this.

Sat, 12/04/2010 - 21:44 | Link to Comment Irwin Fletcher
Irwin Fletcher's picture

That's a funny video. Buy low sell high, bitchez!

Sat, 12/04/2010 - 21:52 | Link to Comment blindman
blindman's picture

buy some chips with that dip!

Sun, 12/05/2010 - 23:26 | Link to Comment CrackSmokeRepublican
CrackSmokeRepublican's picture

They assembled your HDTV with perfect choreography

.... and survived Jew Hedge Fund attacks on their country

.... they are looking for revenge. 

They are the "Anti-JewBot"...and will come attacking.

BTW.. Israel Did 9/11:


Now if they were only White USA Girls without all the F'd Jews and Diversity...

Makes me happy in a world of Jew Scams... --CSR


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