Wall Street’s Math Wizards Forgot a Few Variables

September 14, 2009

by Steve Lohr
Monday, September 14, 2009
The New York Times

In the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. They, after all, invented the exotic securities that proved so troublesome.

But the real failure, according to finance experts and economists, was in the quants’ mathematical models of risk that suggested the arcane stuff was safe.

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.

That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.

“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”

In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.

The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.

Much of the early work has been done tracking online behavior. The Web provides researchers with vast data sets for tracking the spread of all manner of things — news stories, ideas, videos, music, slang and popular fads — through social networks. That research has potential applications in politics, public health, online advertising and Internet commerce. And it is being done by academics and researchers at Google, Microsoft, Yahoo and Facebook.

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Investors dump brokers to go it alone online

July 24, 2009

Fri Jul 24, 2009 12:31pm EDT

By Rachel Chang

NEW YORK, July 24 (Reuters) – The collapse of Lehman Brothers (LEH) last September marked the start of a downward spiral for big investment banks. For a smaller fraternity of Internet brokerages, it has set off a dramatic spurt of growth.

Since the start of the financial crisis, $32.2 billion has flowed into the two largest online outfits, TD Ameritrade Holding Corp (AMTD) and Charles Schwab Corp (SCHW), company records show.

By contrast, investors have pulled more than $100 billion from traditional full-service brokerages like Citigroup Inc’s Smith Barney (C) and Bank of America-Merrill Lynch (BAC).

Of course, Americans still keep more of their wealth with established brokerages. According to research firm Gartner, 43 percent of individual investors were with full-service brokers last year, compared with 24 percent with online outfits.

And while figures for 2009 are not yet available, the flow of investors in the past 10 months has clearly been in the direction of the online brokerages, according to analysts both at Gartner and research consultancy Celent.

Joining the exodus is Ben Mallah, who says he lost $3 million in a Smith Barney account in St. Petersburg, Florida, as the markets crashed last year.

“I will never again trust anyone who is commission-driven to manage my portfolio,” said Mallah. “If they’re not making money off you, they have no use for you.”

This trend, a product of both the financial crisis and the emergence of a new generation of tech-savvy, cost-conscious young investors, is positioning online outfits as increasingly important in the wealth management field.

The numbers reflect a loss of faith in professional money managers as small investors dress their wounds from the hammering they took over the last year, the Internet brokerages say.

“There has been an awakening,” said Don Montanaro, chief executive of TradeKing, which reported a post-Lehman spike in new accounts of 121 percent. Investors now realize they alone are responsible for their money, he said.

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How Do I Know You’re Not Bernie Madoff?

June 15, 2009

by Paul Sullivan
The New York Times
Monday, June 15, 2009

Tony Guernsey has been in the wealth management business for four decades. But clients have started asking him a question that at first caught him off guard: How do I know I own what you tell me I own?

This is the existential crisis rippling through wealth management right now, in the wake of the unraveling of Bernard L. Madoff’s long-running Ponzi scheme. Mr. Guernsey, the head of national wealth management at Wilmington Trust, says he understands why investors are asking the question, but it still unnerves him. “They got their statements from Madoff, and now they get their statement from XYZ Corporation. And they say, ‘How do I know they exist?’ ”

When he is asked this, Mr. Guernsey says he walks clients through the checks and balances that a 106-year-old firm like Wilmington has. Still, this is the ultimate reverberation from the Madoff scandal: trust, the foundation between wealth manager and client, has been called into question, if not destroyed.

“It used to be that if you owned I.B.M., you could pull the certificate out of your sock drawer,” said Dan Rauchle, president of Wells Fargo Alternative Asset Management. “Once we moved away from that, we got into this world of trusting others to know what we owned.”

The process of restoring that trust may take time. But in the meantime, investors may be putting their faith in misguided ways of ensuring trust. Mr. Madoff, after all, was not charged after an investigation by the Securities and Exchange Commission a year before his firm collapsed. Here are some considerations:

CUT THROUGH THE CLUTTER Financial disclosure rules compel money managers to send out statements. The problem is that the statements and trade confirmations arrive so frequently, they fail to help investors understand what they own.

To mitigate this, many wealth management firms have developed their own systems to track and present client assets. HSBC Private Bank has had WealthTrack for nearly five years, while Barclays Wealth is introducing Wealth Management Reporting. But there are many more, including a popular one from Advent Software.

These systems consolidate the values of securities, partnerships and, in some cases, assets like homes and jewelry. HSBC’s program takes into account the different ways firms value assets by finding a common trading date. It also breaks out the impact of currency fluctuation..

These systems have limits, though. “Our reporting is only as good as the data we receive,” said Mary Duke, head of global wealth solutions for the Americas at HSBC Private Bank. “A hedge fund’s value depends on when the hedge fund reports — if it reports a month-end value, but we get it a month late.”

In other words, no consolidation program is foolproof.

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The bears aren’t dead and buried yet

March 30, 2009

The SPX only stayed above the 50 day simple moving average this time for 5 days.  At the turn of the year, it at least managed 7.  The 2002 lows are crucial support to test the will of new buyers.  If they fail to hold, the 741 level will serve as the canary to warn of a possible complete retest of the March lows.

So far, we have only another headfake to the upside created by jawboning from the Feds.  We still believe this is part of a bottoming process, but we need more honest buying (not short covering) to confirm the lows are already in.

spxtesting800033009


The Fight Over Who Will Guard Your Nest Egg

March 28, 2009

By JASON ZWEIG
wsj.com

A power struggle in Washington will shape how investors get the advice they need.

On one side are stockbrokers and other securities salespeople who work for Wall Street firms, banks and insurance companies. On the other are financial planners or investment advisers who often work for themselves or smaller firms.

Brokers are largely regulated by the Financial Industry Regulatory Authority, which is funded by the brokerage business itself and inspects firms every one or two years. Under Finra’s rules, brokers must recommend only investments that are “suitable” for clients.

Advisers are regulated by the states or the Securities and Exchange Commission, which examines firms every six to 10 years on average. Advisers act out of “fiduciary duty,” or the obligation to put their clients’ interests first.

Most investors don’t understand this key distinction. A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest. Advisers always have those duties, but brokers often don’t. The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.

Brokers can sell you any investment they have “reasonable grounds for believing” is suitable for you. Only since 1990 have they been required to base that suitability judgment on your risk tolerance, investing objectives, tax status and financial position.

A key factor still is missing from Finra’s suitability requirements: cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.

If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years.

Richard G. Ketchum, chairman of Finra, has begun openly using the F-word: fiduciary. “It’s time to get to one standard, a fiduciary standard that works for both broker-dealers and advisers,” he told me. “Both should have a fundamental first responsibility to their customers.”

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The Sky already fell?

March 25, 2009

The Commerce Department said sales of newly built U.S. homes rose 4.7 percent to a 337,000 annual pace, the fastest increase since last April, from 322,000 in January.

Despite the increase, February sales were the second lowest ever after the drop in January to the slowest pace in records going back to 1963, the department said. Economists, who had forecast another decline in sales, were still encouraged.

“This completes a trifecta of positive housing reports for February. A sustained increase in housing demand would be the best tonic for the credit crisis and a major sign that the worst of the recession is behind us,” said Sal Guatieri, an economist at BMO Capital Markets in Toronto.

Sales of previously owned homes rose 5.1 percent in February, while housing starts soared 22.2 percent that month.

Stabilizing the housing market, the main trigger of the current economic slump, is crucial for the economy’s recovery.

The median sales price in February fell a record 18.1 percent to $200,900 from a year earlier, the department said.

The inventory of homes available for sale in February was at 330,000, the smallest since June 2002. The February sales pace left the supply of homes available for sale at 12.2 month’s worth.

“New and existing home sales have hit their lows for this cycle. We expect housing inventory-to-sales ratios to fall from still-high levels as 2009 unfolds,” said Michael Darda, chief Economist, MKM Partners in Greenwich, Connecticut.

“Home prices should begin to flatten out after inventories fall to 7-8 months, which we expect before the year is up.”

In other good news for the housing market and the economy, applications for home loans jumped last week as interest rates hit record lows after the Federal Reserve announced it would buy longer-term U.S. government debt.


Contrarian Quotes

March 19, 2009

“Follow the path of the unsafe, independent thinker. Expose your ideas to the dangers of controversy. Speak your mind and fear less the label of ‘crackpot’ than the stigma of conformity. And on issues that seem important to you, stand up and be counted at any cost.”
– Thomas Watson

“Whenever you find yourself on the side of the majority, it’s time to pause and reflect.”
– Mark Twain

“The ‘crowd’ is most enthusiastic and optimistic when it should be cautious and prudent; and is most fearful when it should be bold.”
– Humphrey Neill


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