This page has been archived and commenting is disabled.
Princeton Economist and Computer Scientists Show that Derivatives Are Inherently Vulnerable to Fraud
As I have previously noted, credit default swaps are destabilizing for the economy. See this. And the models used to evaluate financial instruments - such as the Gaussian copula formula for CDOs - are inherently flawed.
Now, Princeton University economists and computer scientists have demonstrated that financial derivatives are also inherently vulnerable to fraudulent pricing.
PhysOrg summarizes Princeton's findings:
In
a result that may have implications for financial regulation,
researchers from computer science and economics have revealed
potentially impenetrable problems with the pricing of financial
derivatives. They show that sellers of these investments could
purposefully include pieces of bad risk that no buyer could detect even
with the most powerful computers.The research focused on
collateralized debt obligations, or CDOs, an investment tool that
combines many mortgages with the promise of spreading out and lowering
the risk of default. The team examined what would happen if a seller
knew that some mortgages were "lemons" and structured a package of CDOs
to benefit himself. They found that the manipulation may be impossible
for buyers to detect either at time of sale or later when the
derivative loses money.The team consists of Sanjeev Arora,
director of Princeton's Center for Computational Intractability, his
colleague Boaz Barak, economics professor Markus Brunnermeier, and
computer science graduate student Rong Ge.It is now standard
wisdom that a major culprit in the 2008 financial meltdown was use of
simplistic mathematical models of risk at financial firms. This paper,
released as a working draft Oct. 15, suggests that the problems may go
deeper."We are cautioning that even if you have the right model
it's not easy to price derivatives," Arora said. "Making the models
more complicated will not make these effects go away, even for
computationally sophisticated."Arora noted that the problem
arises from asymmetric information between buyers and sellers, and goes
against conventional wisdom in economic theory, which holds that
derivatives reduce the negative effects of such unequal information."Standard
economics emphasizes that securitization can mitigate the cost of
asymmetric information," Brunnermeier said. "We stress that certain
derivative securities introduce additional complexity and thus a new
layer of asymmetric information that can be so severe it overturns the
initial advantage."Brunnermeier noted that the finding came
from combining computer science and finance, which has not been done
before but has the potential for further insights. “I anticipate that
both fields can enrich each other,” he said.
- advertisements -
Brunnermeier noted that the finding came from combining computer science and finance, which has not been done before but has the potential for further insights. “I anticipate that both fields can enrich each other,” he said
Is he kidding
asymmetric information in action:
1. buy pool of securitized mortgages full of lemons
2. write CDS on #1 to N times face (N >> 2)
3. buy individual mortages in bundle at less than face
4. pay off mortgages (to securized pool, ie: to self)
5. profit, (written CDS are worthless, sorry..)
Volcker wasn't kidding when he said the ATM was the only beneficial innovation in the last few decades. I was told straight up that subprime risk was modeled based on a paper from the Boston Fed which downplayed negative factors. Jim Sinclair recently linked a HuffPo article that forcefully denied any link to the CRA in the flow chart of this mortgage bubbacle. I respectfully disagree. Almost all Government clusterfarks germinate within well meaning interventions. Stupidity and vicious Wall St. greed are merely steroids to enhance the malformed growth.
You seem to regard Government and Wall Street as distinct and separate entities.
Question is, to me, which is the head and which the tail?
Nice to see that "computationally sophisticated" analysts are laboring to reveal the truth about asymmetrical information that even pre-schoolers already understand (consider the current series of television commercials featuring kids being "sold" on inadequate information.) Shit, without the asymmetry that violates the basic assumption of most "economic theories," imagine how much trading would actually take place, in any financial products. Asymmetry is necessary for the game part of "the game" to work.
As Benoit Mandelbrot proved in the 1960's much of current financial theories and modelling are humbug. They are inherently flawed becasue they are based are Gaussian distributions (aka the Bell Curve). Events in the real world are not necessarily random. The blowup of LTCM is just peanuts to what will be happening now.
Derivatives are like used cars. Information is asymmetrical in a used car purchase also. The seller knows the flaws and attempts to camouflage them. A smart buyer would have money set aside for the eventual repairs.
At the very top there is fraud. It is called the Federal Reserve Note... nicknamed the United States Dollar. It is not true wealth, it is debt you hold until you pass it off the the Next Bigger Fool. This is why the truly wealthy families that make Bill Gates seem like a pauper (Rothschilds, Rockefellers, Warburgs, etc) hold gold as a store of wealth while they also own very rare/important paintings, RE/CRE, etc. These wealthy families know the truth about FIAT currency and until the central banksters are eliminated there will be no justice, no true market and no chance for an honest system... or something that at least more closely resembles one.
Wake up from your deep sleep ZeroHedgers, the foundation of the monetary system your eyes have been forced to see is a fraud.
Neo : Morpheus?
Morpheus : Yes...I've been looking for you, Neo. I don't know if you're ready to see what I want to show you, but unfortunately you and I have run out of time. They're coming for you, Neo, and I don't know what they're going to do.
Neo : Who's coming for me?
Morpheus : Stand up and see for yourself.
Neo : What, now?...............
Trinity : Get in.
Neo gets into the car, as the driver, a blond woman named Switch, turns around in her seat and points a gun at him.
Neo : What the hell is this?
Trinity : It's necessary, Neo. For our protection.
Neo : From what?
Trinity : From you...
Switch : Take off your shirt.
Neo : What?....
Neo starts to get out of the car....Trinity stops him
Trinity : Please Neo, you have to trust me.
Neo: Why?
Trinity : Because you have been down there, Neo. You know that road. You know exactly where it ends. And I know that's not where you want to be............
Morpheus : Do you believe in fate, Neo?
Neo : No.
Morpheus : Why?
Neo : Because I don't like the idea that I'm not in control of my own life.
Morpheus : I know exactly what you mean. Let me tell you why you're here. You're here because you know something. What you know, you can't explain. But you feel it. You've felt it your entire life. That there's something wrong with the world. You don't know what it is, but it's there... like a splinter in you're mind, driving you mad. It is this feeling that has brought you to me. Do you know what I'm talking about?
Neo : The Matrix?
Morpheus : Do you want to know what it is?
Neo nods
Morpheus : The Matrix is everywhere. It's all around us, even in this very room. You can see it when you look out your window or when you turn on your television. You can feel it when you go to work, when you go to work, when you pay your taxes. The US Dollar/Euro Matrix is the world that has been pulled over your eyes, to blind you from the truth.
Neo : What truth?
Morpheus : That you are a slave, Neo. Like everyone else, you were born into bondage, born into a prison that you cannot smell or taste or touch. A prison... for your mind.... Unfortunately, no one can be told what the Matrix is...you have to see it for yourself....................
Buy Gold, silver, rare important historic things and other like-items as a store of wealth.
Morpheus : Welcome to the real world....
No, they are saying the complexity is just a way to obscure and confuse people?
I thought the people who invented derivatives were geniuses and thats why it was so legalistic and too complex for any human to understand...
I am sorry, but this is pseudo-scientific crap. Models? Rules? Fair pricing? Regulation? Reason? It is like trying to measure hot air and smoke with a slide-rule. In the Wonderful World of Fiction you pays your money and takes your chances. Dont wanna be a sucker? Either take remedial classes in horse sense, or get yourself a goat and start organic gardening. Really. Anything divided by zero (sense) is infinite (magic).
Wow a Princeton economist actually figured out that if you want to defraud someone and put some effort into it it's very hard to detect. Brilliant.
I was thinking this as well. Don't want to be a killjoy on the quants, but isn't this pretty easy to figure out over a few beers? This whole world needs a lot more of the "Keep It Short and Simple" principle.
IMO it's even more simple. The old rule your dad taught you still holds: if it seems to good to be true, it is. Derivatives enabled fantastic leverage; in other words, the enable printing money. Printing money is fraud. So of course they lied about ratings in order to sell the crap. The increased leverage enabled the welfare/warfare state to go on for a few more years, so it was embraced as the miracle of Wall Street financial engineering. People who complained about loss of productive jobs were laughed at with "yea, but we're making lots of money!"
Merry Christmas to all, and God Bless Tiny Tim.
George you always have some great stuff to report on, over my head but great stuff, which is what I've gotten used to here at ZH, but as a layperson it would seem probable when dealing with liars and cheaters that your probability of risk goes up tremendously and I love that phrase "asymmetric information that can be so severe it overturns the initial advantage" now that's a very scientific way of saying these sellers were a lying sack of shit. If I knew, they knew it. It literally made me sick to see that 1% loan sign flashing on C's website every morning. If I ever needed their product I'd give it to AMNET 1st then they can sell it to whoever they wanted. You science guys I think will help greatly into the forensics but as far as THIS BULLSHIT ABOUT FHA PUSHING ARMS IS RIDICULOUS, WHY AREN'T THEY OUTLAWED OR SHELFED RIGHT NOW!? AND STOP THE BULLSHIT ACCOUNTING ALREADY! NUMBERS ARE SUPPOSE TO MEAN SOMETHING! (I would like to hear Janet's thoughts on the subject, personally.)
Washington, We Are Watching You
Merry Christmas George, Keep Up The Good Work!
Princeton economists? What's that, Bernanke-lite? I'm a little worried about any economist coming from Princeton.
Nah, just kidding.
All Princeton economists are all Kool-Aid drinking bitches! The only exception is in Federal prison. And I'm NOT kidding!