One major weakness of quantitative trading is that it’s based on the concept of how correlated various instruments and instrument classes are. Today I’m planning to rant about this, thanks to a reader who suggested I should. By the way, I do not suggest that anything in today’s post is new- I’m just providing a public service by explaining this stuff to people who may not know about it.
Correlation between two things indicates how related they are. The maximum is 1 and the minimum is -1; in other words, correlation ignores the scale of the two things and concentrates only on the de-scaled relationship. Uncorrelated things have correlation 0.
All of the major financial models (for example Modern Portfolio Theory) depend crucially on the concept of correlation, and although it’s known that, at a point in time, correlation can be measured in many different ways, and even given a choice, the statistic itself is noisy, most of the the models assume it’s an exact answer and never bother to compute the sensitivity to error. Similar complaints can just as well be made to the statistic “beta”, for example in the CAPM model.
To compute the correlation between two instruments X and Y, we list their returns, defined in a certain way, for a certain amount of time for a given horizon, and then throw those two series into the sample correlation formula. For example we could choose log or percent returns, or even difference returns, and we could look back at 3 months or 30 years, or have an exponential downweighting scheme with a choice of decay (explained in this post), and we could be talking about hourly, daily, or weekly return horizons (or “secondly” if you are a high frequency trader).
All of those choices matter, and you’ll end up with a different answer depending on what you decide. This is essentially never mentioned in basic quantitative modeling texts but (obviously) does matter when you put cash money on the line.
But in some sense the biggest problem is the opposite one. Namely, that people in finance all make the same choices when they compute correlation, which leads to crowded trades.
Think about it. Everyone shares the same information about what the daily closes are on the various things they trade on. Correlation is often computed using log returns, at a daily return horizon, with an exponential decay weighting typically 0.94 or 0.97. People in the industry thus usually agree more or less on the correlation of, say, the S&P and crude.
[I'm going to put aside the issue that, in fact, most people don't go to the trouble of figuring out time zone problems, which is to say that even though the Asian markets close earlier in the day than the European or U.S. markets, that fact is ignored in computing correlations, say between country indices, and this leads to a systematic miscalculation of that correlation, which I'm sure sufficiently many quantitative traders are busy arbing.]
Why is this general agreement a problem? Because the models, which are widely used, tell you how to diversify, or what have you, based on their presumably perfect correlations. In fact they are especially widely used by money managers, so those guys who move around pension funds (so have $6 trillion to play with in this country and $20 trillion worldwide), with enough money involved that bad assumptions really matter.
It comes down to a herd mentality thing, as well as cascading consequences. This system breaks down at exactly the wrong time, because after everyone has piled into essentially the same trades in the name of diversification, if there is a jolt on the market, those guys will pull back at the same time, liquidating their portfolios, and cause other managers to lose money, which results in that second tier of managers to pull back and liquidate, and it keeps going. In other words, the movements among various instruments become perfectly aligned in these moments of panic, which means their correlation approaches 1 (or perfectly unaligned, so their correlations approach -1).
The same is true of hedge funds. They don’t rely on the CAPM models, because they are by mandate trying to be market neutral, but they certainly rely on a factor-model based risk model, in equities but also in other instrument classes, and that translates into the fact that they tend to think certain trades will offset others because the correlation matrix tells them so.
These hedge fund quants move around from firm to firm, sharing their correlation matrix expertise, which means they all have basically the same model, and since it’s considered to be in the realm of risk management rather than prop trading, and thus unsexy, nobody really spends too much time trying to make it better.
But the end result is the same: just when there’s a huge market jolt, the correlations, which everyone happily computed to be protecting their trades, turn out to be unreliable.
One especially tricky thing about this is that, since correlations are long-term statistics, and can’t be estimated in short order (unless you look at very very small horizons but then you can’t assume those correlations generalize to daily returns), even if “the market is completely correlated” on one day doesn’t mean people abandon their models. Everyone has been trained to believe that correlations need time to bear themselves out.
In this time of enormous political risk, with the Eurozone at risk of toppling daily, I am not sure how anyone can be using the old models which depend on correlations and sleep well at night. I’m pretty sure they still are though.
I think the best argument I’ve heard for why we saw crude futures prices go so extremely high in the summer of 2008 is that, at the time, crude was believed to be uncorrelated to the market, and since the market was going to hell, everyone wanted “exposure” to crude as a hedge against market losses.
What’s a solution to this correlation problem?
One step towards a solution would be to stop trusting models that use greek letters to denote correlation. Seriously, I know that sounds ridiculous, but I’ve noticed a correlation between such models and blind faith (I haven’t computed the error on my internal estimate though).
Another step: anticipate how much overcrowding there is in the system. Assume everyone is relying on the same exact estimates of correlations and betas, take away 3% for good measure, and then anticipate how much reaction there will be the next time the Euroleaders announce a new economic solution and then promptly fail to deliver, causing correlations to spike.
I’m sure there are quants out there who have mastered this model, by the way. That’s what quants do.
At a higher perspective, I’m saying that we need to stop relying on correlations as fixed over time, and start treating them as volatile as prices. We already have markets in volatility; maybe we need markets in correlations. Or maybe they already exist formally and I just don’t know about them.
At an even higher perspective, we should just figure out a better system altogether which doesn’t put people’s pensions at risk.
I love this New York Times article, first because it shows how much the Occupy Wall Street movement has resonated with young people, and second because my friend Chris Wiggins is featured in it making witty remarks. It’s about the investment bank recruiting machine on college campuses (Yale, Harvard, Columbia, Dartmouth, etc.) being met with resistance from protesters. My favorite lines:
Ms. Brodsky added that she had recently begun openly questioning the career choices of her finance-minded friends, because “these are people who could be doing better things with their energy.”
Kate Orazem, a senior in the student group, added that Yale students often go into finance expecting to leave after several years, but end up staying for their entire careers.
“People are naïve about how addictive the money is going to be,” she said.
Amen to that, and wise for you to know that! There are still plenty of my grown-up friends in finance who won’t admit that it’s a plain old addiction to money keeping them in a crappy job where they are unhappy, and where they end up buying themselves expensive trips and toys to try to combat their unhappiness.
And here’s my friend Chris:
“Zero percent of people show up at the Ivy League saying they want to be an I-banker, but 25 and 30 percent leave thinking that it’s their calling,” he said. “The banks have really perfected, over the last three decades, these large recruitment machines.”
Another piece of really excellent new: Judge Rakoff has come through big time, and rejected the settlement between the SEC and Citigroup. Woohoo!! From this Bloomberg article:
In its complaint against Citigroup, the SEC said the bank misled investors in a $1 billion fund that included assets the bank had projected would lose money. At the same time it was selling the fund to investors, Citigroup took a short position in many of the underlying assets, according to the agency.
“If the allegations of the complaint are true, this is a very good deal for Citigroup,” Rakoff wrote in today’s opinion. “Even if they are untrue, it is a mild and modest cost of doing business.”
A revised settlement would probably have to include “an agreement as to what the actual facts were,” said Darrin Robbins, who represents investors in securities fraud suits. Robbins’s firm, San Diego-based Robbins Geller Rudman & Dowd LLP, was lead counsel in more settled securities class actions than any other firm in the past two years, according to Cornerstone Research, which tracks securities suits.
Investors could use any admissions by Citigroup against the bank in private litigation, he said.
This raises a few questions in my mind. First, do we really have to depend on a randomly chosen judge having balls to see any kind of justice around this kind of thing? Or am I allowed to be hopeful that Judge Rakoff has now set a precedent for other judges to follow, and will they?
Second, something that came up on Sunday’s Alt Banking group meeting. Namely, how many more cases are there that the SEC hasn’t even bothered with, even just with Citigroup? I’ve heard the SEC was only scratching the surface on this, since that’s their method.
Even if they only end up getting $285m, plus the admission that they did wrong by their clients, could the SEC go back and prosecute them for 30 other deals for 30x$285m = $8.55b? Would that give us enough leverage to break up Citigroup and start working on our “Too Big to Fail” problems? And how about the other banks? What would this litigation look like if the SEC were really trying to kick some ass?
We had a interesting, lively #OWS Alternative Banking group meeting yesterday, where we split into three groups: the Volcker Rule commenting group, the shadow banking system, and Too Big to Fail (TBTF). I was impressed by the number of people who could come even on Thanksgiving weekend.
These topics have lots of overlap, a fact which came through at the end when we got back together and disseminated our thoughts. Specifically, the question of “regulation arbitrage” came up repeatedly. This is the idea that, no matter what laws you pass on how the banks can behave, they will get around the spirit of the law with some clever sleight of hand. In other words, it’s really hard to avoid a bad outcome if you have to list all of the things that someone isn’t allowed to do- they can avoid a rule governing having repos of no longer than 7 days by inventing a new instrument, which they may call a “nepo,” which has an 8 day lifespan.
It’s frustrating, since real regulation is clearly needed right now, and it makes you want to depend more on standards than specific rules. However, the problem with standards is that they can be avoided as well, by the sheer fact that they are always open to interpretation. Moreover, both of these approaches run the risk of being essentially too complicated for regulators to understand, but the standards one is particularly open to that.
If anyone has a third option that I haven’t thought of, please tell. Oh wait, someone suggested one to me: jailtime. This is actually a good point, and also possibly the best idea I’ve heard of to give some balls back to the SEC and other regulators: give them handcuffs and the authority to use them.
It occurs to me that the software testing community may have an answer, or at least an approach. It may make sense to set up a series of exhaustive tests which evaluates the resulting portfolio of the bank for certain characteristics which would indicate whether the bank has been following the standards appropriately.
To some extent this is being done, using various risk measures, for example looking at the volatility of the PnL to determine if someone is really market making or not. But I’m not sure the super nerds have thought about this onetoo much. I’d be interested to talk to anyone who knows.
There are two articles I wanted to bring up today. First, we have this Huffington Post article about the Volcker Rule commenting group Occupy the SEC, which has been meeting with us on Sundays and whom I’ve blogged about here and here. Some key quotes:
A handful of protesters at Occupy Wall Street are doing what the authors of a complex piece of financial legislation may have hoped no one would do. They are reading it.
The Occupy Wall Street movement, now in its third month, has drawn fire from people who say its members are too vague in their criticism of the financial system. Occupy the SEC, which consists of between four and eight New York protesters, would seem immune to such charges. Its members are compiling a list of highly specific points, and their ultimate goal is to submit a letter to regulators detailing their concerns before the Jan. 13 deadline.
Anyone can send in comments on the draft of the Volcker rule — and regulators will review those submissions before producing a final version of the measure — but, as in most cases where draft rules are made available for public scrutiny, not everyone has the time or inclination to parse hundreds of pages of regulatory jargon. Goldstein noted that most of the comments on financial rules end up coming from the banks themselves, arguing for greater leniency.
Paul Volcker himself has expressed displeasure with the current proposal, which is 30 times as long as the version originally included in Dodd-Frank.
Next, during the meeting yesterday where we were discussing Too Big to Fail (TBTF) and what can be done about it, Bloomberg published this article, which ranks among the best I’ve seen from them (up there with the Koch brothers article from a few weeks ago which I blogged about here).
The article describes the extent and amount of the secret Fed loans given to each bank for “liquidity” purposes during the credit crisis. Here’s a good quote:
While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger.
Thank you! Why doesn’t everyone see that it makes no sense to say “we were paid back” when the underlying problem is still there (in fact worse) and we have given up our standards? On a related note:
The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.
Even if the $13 billion is arguable (I don’t have an opinion about that), I know it’s an underestimate because the alternative to this secret unlimited liquidity was bankruptcy, not less revenue.
The article brings up lots of interesting issues, beyond the asstons of cash money that were thrown at the banks during that time. Among them:
- To what extent would Congress have blocked TARP if they had know the size of the Fed program? Remember they actually voted TARP down before coming back and changing their mind after the stock market dropped by 10%. My favorite quote for this question comes from Sherrod Brown, a Democratic Senator from Ohio: “This is an issue that can unite the Tea Party and Occupy Wall Street. There are lawmakers in both parties who would change their votes now.” I agree- this is a non-partisan issue.
- How much freaking power does the Fed have to do stuff behind closed doors? To what extent was this motivated by their feelings of shame that they’d let the housing bubble inflate for so long? Related quote from the article: “I believe that the Fed should have independence in conducting highly technical monetary policy, but when they are putting taxpayer resources at risk, we need transparency and accountability,” says Alabama Senator Richard Shelby, the top Republican on the Senate Banking Committee.
- Geithner seems to be against the idea of ending TBTF: “Geithner argued that the issue of limiting bank size was too complex for Congress and that people who know the markets should handle these decisions.” The article then goes on to say that Geithner suggested we just let the international economic community decide the new rules, i.e. Basel III. But as we know, that treaty has zero chance of being adopted by the U.S. at this point, so the end result is that Geithner put off the discussion by arguing that it would be dealt with internationally, but then it hasn’t been, at all. Moreover, the article mentions that the Dodd-Frank bill has a mechanism for closing down too-big-to-fail banks, decided by a committee of which Geithner is chair. I’m not holding my breath.
The most embarrassing part of the article is next, and deals again with the TBTF issue.
Lobbyists argued the virtues of bigger banks. They’re more stable, better able to serve large companies and more competitive internationally, and breaking them up would cost jobs and cause “long-term damage to the U.S. economy,” according to a Nov. 13, 2009, letter to members of Congress from the FSF. The group’s website cites Nobel Prize-winning economist Oliver E. Williamson, a professor emeritus at the University of California, Berkeley, for demonstrating the greater efficiency of large companies.
In an interview, Williamson says that the organization took his research out of context and that efficiency is only one factor in deciding whether to preserve too-big-to-fail banks. “The banks that were too big got even bigger, and the problems that we had to begin with are magnified in the process,” Williamson says. “The big banks have incentives to take risks they wouldn’t take if they didn’t have government support. It’s a serious burden on the rest of the economy.”
Nice! Hey FSF, you may want to find a new quote! Oh wait, that link no longer works, interestingly…
I’m planning a follow-up blog post to discuss what our group decided to do with respect to TBTF. Hint: it has something to do with a Republican presidential candidate.
A few years ago my family was veering into dangerous gifting territory. It was the year my oldest son was almost 2, and everyone in the family, my parents, my brother, and my brother’s wife, was buying outrageous, huge presents for him. He was more into the boxes than the presents, of course, and we kept cajoling him to hurry up and get through the huge mound of presents. It was actually pretty unpleasant since he was a focused little nerd kid and didn’t see the point at all.
But it didn’t stop there. It was also the year that the wine opener which looks like a bunny and can remove corks in a single deft move was on the market, but it’s cheaper copycat version wasn’t. I spent an outrageous amount of money buying that for my wine-collecting father on ebay, but what’s even more outrageous is how much time it took.
At the end of the orgy of opening presents, I don’t even think we could fit all of the wrapping paper and packaging into one garbage bag. And that was with one kid, who was crying because the best stuff was thrown away. Since I was pregnant at the time, I could see where this was going.
I waited a few months, and then I made a motion: no presents for grownups. At least I wasn’t going to buy any presents for grownups. And moreover, nobody spends more than $50 ever. It was passed. Since then we’ve been able to concentrate on how cute our kids are playing with their boxes. Really the presents we give to each other, to the other grownups, is the effort we make in showing up in the same town and dealing with how annoying we all are (read: they all are) for 2 full days (maybe 1 if I can pare it down to perfection).
I just don’t get the holiday gift giving thing. I mean, I think I’m actually a pretty generous person, but it doesn’t mean I need to go overboard at Christmas. I pretty much like to give people stuff all the time. I cook for them, I knit things, I immediately give away books that are awesome to people who would get something out of them. Why focus on Christmas? I say share a meal in March instead.
What really ticks me off are the commercials which indicate that you should give someone a new car for Christmas. What? Who does that? Who even buys new cars? Don’t they know how much money they’re throwing away? I’m seriously anti-that. Luckily our TV is gone (our 3-year-old, then 2, pulled it off the stand onto the floor – he’s fine) so I’m not seeing those commercials any more. Nor the diamonds-are-a-girls-best-friend commercials. I told my husband 10 years ago that if he ever buys me a diamond I’m divorcing him immediately. We shook on it.
I’d like to say a word against “showers” as well, since I’m on a roll. I am proud to say that I’m married with three kids and I’ve never had any kind of shower, wedding or baby, nor did I have wedding presents (actually one of my relatives ignored my request not to give us anything but what can you do).
I think the idea of wedding presents is fine- it was created for the purpose of setting up a household for a young couple who has nothing. But in modern times, where I lived with my husband for months before we got married, it shouldn’t be a surprise that we already had a bed and dishes. If that’s not the purpose of wedding gifts, then what is?
Back to showers. The basic idea is, come to my house for the purpose of giving me presents. It’s like having a party where the guests do all the work. How about you just have a party? And if you have time to knit a cute little sweater for the new baby, bring it over one day and we can have coffee and talk about contractions and epidurals or something while we admire your handiwork.
I’ve gone to one good wedding shower; it took place in a karaoke bar in Koreatown, and there was a cake shaped like a penis and both men and women attended. So in other words it was just a raunchy party. That’s my kind of wedding shower.
Sometimes the night falls
and I fall with it, those
inner reefs no match
for the outer currents.
Sometimes the day comes
and I’m not ready, the
sunlight streaming, too
binding for a dip in the dark.
Sometimes the rain breaks,
pouring down, washing me
out down the street past storefronts
of fruit, where my boys linger.
This is how I interact with the world,
fully engaged, and a bit unable to
loosen the harness.
This is how I make peace with the world,
too, the personal battles played out against
the ebb and flow of greater forces.
For I am a force to be reckoned with. Know that.
But even gravity finds its match in
by Manya Raman Sundström
For Cathy O’Neil, whom I barely met
Umeå, Nov. 7, 2010
is a woman
She’s soft as silk,
then bold and wild.
She scolds and sulks,
She’s the kind of wind
the palm trees bow down to:
is a flamenco temptress
She rewards with a caress
is an enraged mother,
a heart breaker,
a scorned lover, yes
She’s a rabble rousing
in a dress.
She’ll rattle the gates
drum at the door
flirt with the warden
if that’s what it takes.
Freedom! my child,
Freedom! she moans.
She’s howling for you:
Woman to woman.
By Becky Jaffe
Inspired by tonight’s blustery wind, and by the kick-ass women in my life (that’s you!)
Nov. 2, 2011
If there’s one thing we need right now in the Occupy movement, it’s a bit of inspiration, hope, and silliness. I was touched to hear that 300 people ate Thanksgiving dinner at Zuccotti Park yesterday (although the standoff with police over the drumming didn’t sound awesome) but let’s face it, it hurts that the park was cleared of tents.
It’s really easy to slide into a funk right about now: there’s bad press, the Eurozone is looking doomed, and politicians are frozen in conflict. I say don’t let it happen. Don’t take everything too seriously, because these things take a long time to work, and so much progress has already been made. Let’s look at winter as a time to hunker down and work on our projects so that in the Spring we can get together and be amazed by how far we’ve come.
I really like the idea of Occupying Black Friday- today will be the first time I actually participate at all, except for the time we drove all the way to Ithaca for Thanksgiving before realizing we forgot our suitcase and we ended up buying clothes and toothbrushes on Friday. That doesn’t really count though.
So I’m planning to be a consumer zombie today at the mall near Columbus Circle. That just means I’ll walk around like a zombie and wearing a sign that says “consumer”. I’m bringing my 3-year old; I’m thinking of putting a sign on his back saying “consumer in training” or something.
But here’s what I’m really into. Flash mob singing. Yeah, seriously, the inner musical performer in me is dying to get a group of people and come up with a seriously awesome song and associated line dance. In a mall or maybe a public space like Times Square. Something that makes people baffled and happy, that makes them think about how love works.
To see how I was thus inspired, see this wonderful Occupy Oakland protest. For those of you who don’t know me, I am the barefoot girl in the bright pink cocktail dress with a matching boa and backpack. I mean, not really since I haven’t gone to Oakland recently, but that’s who I am, if you can dig it.
So who’s in? I’m taking suggestions for song, dance, and venue. If you’re not local you can still participate by coming up with ideas! If you are local, grab your boa.
One of the most aggravating things about the credit crisis, and the (lack of) response to the credit crisis, is that the banks were found to be gambling with the money of normal people. They took outrageous risks, relying on the F.D.I.C. insurance of deposits. It is clearly not a good system and shouldn’t be allowed.
In fact, the Volcker Rule, part of the Dodd-Frank bill which is supposed to set in place new regulations and rules for the financial industry, is supposed to address this very issue, or risky trading on deposits. Unfortunately, it’s unlikely that the Volcker Rule itself goes far enough – or its implementation, which is another question altogether. I’ve posted about this recently, and I have serious concerns about whether the gambling will stop. I’m not holding my breath.
Instead of waiting around for the regulators to wade through the ridiculously complicated mess which is the financial system, there’s another approach that’s gaining traction, namely draining the resources of the big banks themselves by moving our money from big banks to credit unions.
I’ve got a few posts about credit unions from my guest poster FogOfWar. The basic selling points are as follows: credit unions are non-profit, they are owned by the depositors (and each person has an equal vote- it doesn’t depend on the size of your deposits), and their missions are to serve the communities in which they operate.
There are two pieces of bad news about credit unions. The first is that, because they don’t spend money on advertising and branches (which is a good thing- it means they aren’t slapping on fees to do so), they are sometimes less convenient in the sense of having a nearby ATM or doing online banking. However, this is somewhat alleviated by the fact that there are networks of credit union ATM’s (if you know where to look).
The second piece of bad news is that you can’t just walk into a credit union and sign up. You need to be eligible for that credit union, which is technically defined as being in its field of membership.
There are various ways to be eligible. The most common ones are:
- where you live (for example, the Lower East Side People’s Federal Credit Union allows people from the Lower East Side and Harlem into the field of membership)
- where you work
- where you worship or volunteer
- if you are a member of a union or various kinds of affiliated groups (like for example if you’re Polish)
This “field of membership” issue can be really confusing. The rules vary enormously by credit union, and since there are almost 100 credit unions in New York City alone, that’s a huge obstacle for someone to move their money. There’s no place where the rules are laid out efficiently right now (there are some websites where you can search for credit unions by your zipcode but they seem to just list nearby credit union regardless of whether you qualify for them; this doesn’t really solve the problem).
To address this, a few of us in the #OWS Alternative Banking group are getting together a team to form an app which will allow people to enter their information (address, workplace, etc.) and some filtering criteria (want an ATM within 5 blocks of home, for example) and get back:
- a list of credit unions for which the user is eligible and which fit the filtering criteria
- for each credit union, a map of its location as well as the associated ATM’s
- link to the website of the credit union
- information about the credit union: its history, its charter and mission, the products it offers, the fee structure, and its investing philosophy
It’s a really exciting project and we’ve got wonderful people working on it. Specifically, Elizabeth Friedrich, who has amazing knowledge about credit unions inside New York City (our plan is to start withing NYC but then scale up once we’ve got a good interface to add new credit unions), Robyn Caplan, who is a database expert and has worked on similar kinds of matching problems before, and Dahlia Bock, a developer from ThoughtWorks, a development consulting company which regularly sponsors social justice projects.
The end goal is to have an app, which is usable on any phone or any browser (this is an idea modeled after thebostonglobe.com’s new look- it automatically adjusts the view depending on the size of your browser’s window) and which someone can use while they watch the Daily Show with Jon Stewart. In fact I’m hoping that once the app is ready to go, we go on the Daily Show and get Jon Stewart to sign up for a credit union on the show just to show people how easy it is.
We’re looking to recruit more developers to this project, which will probably be built in Ruby on Rails. It’s not an easy task: for example, the eligibility by location logic, for which we will probably use google maps, isn’t as easy as zipcodes. We will need to implement some more complicated logic, perhaps with an interface which allows people to choose specific streets and addresses. We are planning to keep this open source.
If you’re a Rails developer interested in helping, please send me your information by commenting below (I get to review comments before letting them be viewed publicly, so if you want to help, tell me and won’t ever make it a publicly viewable comment, I’ll just write back to your directly). And please tell your socially conscious nerd friends!
I wrote recently about the #OWS Alternative Banking working group preparing public comments on the Volcker Rule. I wanted to give a little bit more context. This is especially important right now because the watering-down period by financial lobbyists is getting intense.
The original Volcker Rule essentially states that banks shouldn’t do proprietary trading at all and they should also not invest in hedge funds or provate equity funds or in any way be liable for losses on such funds.
The idea is that the government and thus the taxpayer is backing (through the FDIC) the money inside banks and those banks shouldn’t use that insurance while at the same time risking the deposits themselves just to make a quick buck. To actually see this law, see Section 619 in the Dodd-Frank act. The law itself is only 11 pages, and some of that is around timing of implementation, so it’s a quick read.
Again, this 11-page document states what the Volcker Rule is supposed to implement. It summarizes the high-level thinking behind the rule. More importantly, the regulators’ mandate is to write a detailed rule that complies with what’s written in the law. When they ask for comments on the rule, they’re asking how well the rule implements the law.
This sounds pretty clean cut, but of course there are grey areas: for example, the law states that if banks fail to comply with the no-prop trading or hedge fund investing rules, then they’ll get punished by having higher capital requirements as well as fines. But it fails to say how stringent those punishments will be. So one way to technically implement the law is to make the punishment trivial.
The law also claims that the banks should be allowed to trade outside their clients’ direct interests in the name of hedging risks. The granularity of that allowed “hedging” is critical, since if they are hedging at the trade level, that’s very different from hedging at the macro level. The best example I’ve heard of this is that the bank may decide there’s “inflation risk” in their portfolio and start investing in long-term inflation hedges; then this really becomes more of a bet than a hedge but it depends on how you look at it and more importantly how one defines the word hedge.
To a large extent I feel like this could be resolved if we force a short-term horizon on the hedging basis. In other words, it’s a hedge if you can argue that you bought a bunch of 1-month puts so you need to hedge your risk on that one month period. However, a 5-year inflation outlook is clearly more of an opinion. On the other hand, forcing banks, as a group, to think in short horizons has its own dangers.
The law also states that banks are allowed to invest in certain U.S.-backed agencies:
PERMITTED ACTIVITIES… The purchase, sale, acquisition, or disposition of obligations of the United States or any agency thereof, obligations, participations, or other instruments of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision thereof.
There are those who claim that we need to expand the above rule for the sake of national security and to prevent a deep, world-wide depression. Specifically, in this article in the Financial Times, the lobbyists are working hard to allow prop trading in European bonds, a huge market which is currently stipulated to be out of bounds:
They point out that Dodd-Frank exempts US sovereign bonds from the general prop trading ban for fear of disruptions. “What happens if you remove the US banks from Europe and they dump the stuff? Prices could collapse,” said Doug Landy, a regulatory lawyer at Allen & Overy.
There are lots of other permitted activities that don’t necessarily make sense to the historian of how other firms have gotten themselves into trouble: interest rate swaps (which are surely necessary tools for hedging basic bank hedging but it doesn’t seem to be restricted to hedging), spot commodities, foreign currency, and all kinds of loans (including repos). There are plenty of ways for banks to put deposits at risk within these instrument classes.
My conclusion is that, when the Alternative Banking group sends feedback to the regulators, we should separate comments on the implementation of the rule (e.g., what risk measures should be used and in how much detail they should be specified) from comments on the underlying law (e.g., whether this is actually preventing conflicts of interest).
The regulators are supposed to fix problems with the rule, but they can’t fix problems with the law (it takes an act of Congress to fix those). To the extent that we have problems with what’s in the law itself, it is worth a separate discussion about what the best way is to get those addressed.
One of my readers sent me a link to this blogpost by James Wimberley, which talks intelligently about safety nets and their secondary effects (it also has a nifty link to the history of bankruptcy laws in the U.S.).
I want to hone in on one aspect he describes, namely how, in spite of people in the U.S. considering themselves entrepreneurial, we are not so much. His theory is that it’s because of a lack of safety net: people are worried about losing their health insurance so they don’t leave the safety of their job. Here’s Wimberley’s chart of entry density, defined as the rate of registration of new limited liability companies per thousand adults of working age, by country:
The question of who takes risks is interesting to me, and made me think about my experiences in my various jobs. In fact this dovetails quite well with another subject I want to post on soon, namely who learns from mistakes; I have a theory that people who don’t take risks also don’t learn from mistakes well. But back to risktakers.
It kind of goes without saying that people in academics are not risk-taking entrepreneurs, but I’ll say it anyway – they aren’t. In fact it was one reason I wanted out- I’m much more turned on by risks than the people I met inside academics. In particular I don’t want to have the same job with the same conditions for the rest of my life, guaranteed. I want adventure and variation and the excitement of not knowing what’s next. When I went to a hedge fund I thought I would find my peeps.
However, most of the people I worked with at D.E. Shaw were really not risk takers at all, in spite of the finance cowboy image that they are so proud of. In fact, these were deeply risk averse people who wanted total control over their and their children’s destinies.
Moreover, the students I meet in finance programs (I took a few classes at Columbia’s when I knew I was leaving academic math) and who hope to someday work at JP Morgan are some of the most risk averse people ever. They are essentially trying to lock in a huge salary in return for working like slaves for a huge system.
Fine, so finance attracts people who are risk averse (and love money). That may be the consequence of its reputation and its age. So where are the risk takers? They must be some other field. How about startups?
What has surprised me working at a startup is that a majority of them are also not what I’d consider risk takers. There are a few though. These few tend to be young men with no families. Kind of the “Social Network” model of college aged boys working out of their dorm rooms. The women tend to be unmarried.
This is completely in line with Wimberley’s theory of safety nets, since it seems like once these men find a wife and have a kid they settle (speaking in general) into a risk averse mode. Once the women get married they tend to leave altogether.
In fact I’m kind of an oddball in that I’m married and have three kids and I actually love risk taking. Part of this is that I get to depend on my husband for health insurance, but that’s clearly not the only factor, since you’d expect lots of women whose husbands had steady jobs to be joining startups, but that’s not true.
I also have a feeling that the enormous amount of effort people tend to put into proving their credentials has something to do with all of this- when you take risks you are without title, you win or lose on your own luck and hard work. For a culture with a strong desire to be credentialed that’s a tough one.
I don’t really have a conclusion today but I’m thinking that the story is slightly more complicated than just safety nets. I feel like maybe it starts out as a safety net issue but then it becomes a cultural assumption.
The Alternative Banking meeting yesterday was really good, and interesting. During the discussion someone raised the point that when we describe a bank as “too big to fail,” we almost always measure that in terms of their assets under management, or the percent of deposits they have, or their net or gross exposures. In other words, we measure the size of the individual institution.
However, what’s just as important in terms of being “too big” is the extent to which a given bank is too interconnected, meaning they are in deals with so many other counterparties that if they go under, they would set off a cascade of contractual defaults which would cause chaos in the entire system. In fact Lehman was like this, too interconnected to fail. It’s funny but I’m pretty sure Lehman wasn’t too big to fail under many of the current definitions.
Although this question of counterparty risk is brought up consistently, it’s never adequately addressed in terms of risk; we are still more or less asking people to measure the volatility of their PnL, and we typically don’t force them to expose their counterparty exposure in stress tests and whatnot.
What if we addressed this directly? How could we regulate the interconnectedness of a given institution? What would be the metric in the first place and what limits could we set? How could we set up a regulator to convincingly check that institutions are sticking to their interconnectedness quotas?
I’ll keep thinking about this, they are not easy questions. But I think they are important ones, because they get to the heart of the current problems more than most.
A further question brought up yesterday was, how do we know when the entire financial system is too big? I guess we don’t need any fancy metrics to say that for now we just know.
We’re meeting from 3-5pm today at 1401 International Affairs Building on Columbia Campus. That’s at Amsterdam and 118th, on the 14th floor. The meeting is open to everyone.
It’s going to be an interesting meeting today. Lots has happened this week with the movement, obviously, and it’s super important to keep the conversation going and productive. We got some press coverage in the Financial Times and perhaps because of that I’ve added quite a few new names to the email list. I’m very much looking forward to meeting the new members of our group.
Bloomberg’s decision with removing the tents from the park and the 2-month anniversary protests got lots of attention, not all of it positive. I participated in the protest the other day with my son, and since then I’ve had a few thoughts about it.
This movement is a big deal and can potentially be a bigger deal. It’s certainly one of the things I care about deeply. I understand people’s frustration and defiance, because even just thinking outside the system when it’s this huge and embedded is an act of defiance. But what I don’t want to see is the movement losing its head and giving in to anger and rage. Especially because it inevitably becomes something extremely narrow- us against the police, or us against Bloomberg.
The truth is the police, at least the ones on the ground in riot gear, have very little to do with setting up this system. Bloomberg has more to do with it, but he’s still just another scavenger picking out the juiciest meat of the system. What we need to do is understand the bigger picture and try to improve things in a meaningful and positive way.
That’s not to say that I want to work within the system to change it. I’m not that naive to think that people give up their honeypots so easily: this will be a war against corruption and vested interests. But I’d rather spend my time rooting out real corruption (like Jack Abramoff has done in this amazing Bloomberg article) and proposing realistic alternatives than being vaguely angry at the wrong things.
The democratic system that the OWS movement has created is based on the idea of mutual respect and trust. We need to enlarge that sense of trust to more and more people, including the cops and including the mayors. We want to invite them to join us, or at least to respect us.
It’s my experience that most people want to live in a just world- even if they take advantage of injustices for themselves. The majority of people working in the financial system see it as unfair and unreasonable. One reason they let things slide is that they really don’t believe the system could be changed; they don’t have the imagination or the faith to believe that. So that’s actually what we can and should provide: imagination and faith.
No system is perfect, of course, but there are certainly systems that are less imperfect, and we should be envisioning them and a path towards them which is reasonable and not terrifying. If we could do that we would get support rather than pepperspray. I know I’m sounding idealistic, but that’s actually what we need right now. After all the original protest started with nothing more than silly hand signals and ideals; its international growth has proven that ideals resonate with people.
One of the subgroups of the Alternative Banking group is an #OWS group called Occupy the SEC. Their goal is to make comments on the Volcker Rule before the public commenting period ends on January 13th, 2012.
At our last meeting we distributed a sheet where people put their email addresses and listed fields of expertise so that the people in Occupy the SEC could ask us specific clarifying questions about what the current version of the Volcker Rule says.
If you think you could have time to help them, please email them at firstname.lastname@example.org and tell them what your fields of expertise are. They are mostly looking for financial expertise and people who speak legalese, but anyone who is a good and careful reader will be super useful too.
My experience at Riskmetrics working with Value-at-Risk (VaR), where I was actually working on methodology questions of VaR usage for credit instruments like CDS, makes me pretty useful to these guys.
This morning I’ve been reading about the proposed risk reporting requirements for the “covered bank entity”. Basically they are required to report daily 99th percentile VaR. But left out are all other details, including:
- whether they should use parametric, historical, or MonteCarlo VaR methods,
- what their lookback period is (if historical)
- what their decay length is (if MonteCarlo)
- what exactly they need to admit as risk factors
- why they would ever use parametric VaR outside of stocks, since parametric VaR sucks outside of stocks.
They are also asked to report the skew and kurtosis of their daily PnL, but I believe are only required to report this for daily numbers on a quarterly basis, which means there’s no chance in hell those will be meaningful numbers.
How about this instead: report all three kinds of VaR, with a year lookback for historical VaR, and with various decay lengths for MonteCarlo VaR. Specify the risk factors and ask for each risk factor’s sensitivity (which is like a partial derivative if we are using parametric VaR) as well as min and max returns (if we are using historical VaR). Report skew and kurtosis using daily numbers with 2 years of data.
Even better if they abandon this altogether and go for something benchmarked as I discussed in this post.
There seems to be no stipulated need to report counter-party exposure or risk, at least in this section (Appendix A). This seems particularly egregious considering the current situation, namely that we are waiting for European sovereign debt defaults to cause broken CDS hedges through collapsing counterparties. We know this would happen, but we somehow don’t want to know more details.
This is only a few pages of the Volcker Rule, though, out of I think something like 550. We need your help for sure!
I don’t know where you’re going today after work but there’s going to be a massive protest in front of city hall starting at 5pm.
See outrageous footage of this morning on Wall Street here coming from the Wall St. Journal.
I’m thinking of going with my oldest son, who is very excited about it and desperately wants to join, especially if it means missing school (but I think his enthusiasm would be sustained if he got to go to bed late as well). I actually brought him with me that very first day I went down to check out the protest on day 13, and he’s been bragging about being in the “opening bell march” ever since.
He also thinks kids should be able to vote (and wants to join the Alternative Banking working group). Here’s an article suggesting we should do something even more extreme, namely let people vote from birth. It’s an interesting idea and could encourage families to engage in politics more.
The truth is my son thinks and cares about issues of politics and justice more than most grownups. In fact he once was a huge Obama supporter, and around the election he’d watch Obama’s speeches after finishing his homework. I thought he must just be missing most of it, since it was mostly rhetoric, and after all he was only 8 years old at the time, but then something happened which changed my mind.
We were leaving a restaurant after eating dinner, and he held the door open for me to push the stroller through with his baby brother (I think this was actually the first time we ever went out to eat with the baby). As the door closed I saw little girl, maybe 3, who looked dangerously close to getting her hand caught in the door, and I jumped back to hold the door open. My son told me he felt bad that he almost let the door hurt the little girl, to which I replied, “first of all she wasn’t really that close to the door, and second of all it’s not your responsibility to worry about other people’s kids.” My son replied, “but when Obama says that we rise and fall as a people, he means that’s exactly what our responsibilities are!”
I heard rumors that people in Zuccotti Park, who I think are still being let in single-file through a big gate with cops doing a kind of airport check-in, have been told that they aren’t allowed to “carry signs inside the park.” First of all that’s ridiculous and second of all that’s not going to make the Bloomberg administration look reasonable. Is Bloomberg going for a legacy of squelching a non-violent legal protest? I thought he was all about bringing engineering to New York.
Here’s the poster for today’s protests. I’m a bit confused by the juxtaposition of the word “non-violent” and the presence of tanks,
maybe someone could explain that one to me this is a reference to Tiananmen Square I’ve been told:
When I was five years old my parents moved to Lexington, Massachusetts. My first friend, so my oldest friend, was my next door neighbor Sally Hale, the mom of the twin boys next door Ezra and Caleb, two years older than me and the same age as my brother. Sally, who also had two older boys, so four altogether, took me under her wing as the daughter she never had. I understand that so well now that I have three sons and the boy downstairs from us has a sister. I want to adopt her, I want her to always feel welcome in my home and part of the Sunday morning pancakes ritual (she is).
I grew up in Lexington, not moving away until college, and Sally and her family were an essential part of my life. Looking back at it now it was pretty amazing; Sally and Ken were lefties, had parties with Noam Chomsky and other activists (Ken was a linguist at M.I.T.), they were super involved with all sorts of underrepresented groups through Ken’s field work with various undocumented and mostly dying languages. I have a story about Ken, which may be a myth but gives you an idea of the values I was exposed to.
Ken was called as an expert witness in Australia on the question of whether some indigenous people had the rights to land. The court wanted documented evidence that they had been there for so many thousands of years to grant the rights, but they didn’t have any written records. Ken, being an expert on evolution of languages, argued that due to the aspects of their language compared to the languages in the area, he could confirm their location there for much longer. They got the land.
As a child, of course, I didn’t know anything about politics or even much about human rights, so my experience with them was through their everyday life. I was always invited in to Sally’s house (it was the family’s house but it was really Sally’s house), and the warmth and kindness they bestowed on each other and me made me visit often, if not every day during certain times, especially when my brother and Caleb and Ezra regularly played D&D.
Sally introduced me to music, a gift I will always thank her for, a private world of unrestrained beauty, which was particularly precious to me because outside of this world I was a chubby, nerdy misfit. She taught me to play the penny whistle when I was 5 or 6, and encouraged me to start the piano when I was 7. She taught me to sing rounds (“hey ho nobody home”) and seemed to never get tired of singing them with me. Sometimes she’d take out her guitar and sing old 60′s folk songs about peace and love and teach me to harmonize. When I started playing the violin, I would play fiddle tunes in the evenings on the porch with Ken. We even entered fiddle contests together a few times (we never won anything but we were proud to be part of it).
Sally knitted me mittens to keep my hands warm as I went sledding in her backyard with Caleb and Ezra and my brother. She knitted during movies we would all go to together downtown. For me, listening to the click click clicks coming from her knitting needles in the complete darkness of the movie was a kind of miracle. She later taught me to knit, and we spent many hours in my adulthood talking about knitting and sharing yarn and tips.
Sally was an expert seamstress and taught me to sew, and sewed me clothes when I was little and even helped me sew a dress for myself in graduate school. She loved going to house auctions and would buy beautiful little objects which came from some old lady’s sewing kits. Later when I started sewing and knitting for my kids she gave me some of her auction buttons, collections of perfect little white pearls strung together on ancient string. I still have some.
Sally baked; she’d call us in from outside to give us kids thick slabs of bread, still warm from the oven, with butter and cinnamon sugar for a snack. We’d be sitting on the kitchen stools, eager to get back to sledding, or flashlight tag, or hanging out on the tree fort, eating our delicious bread with some hot cocoa and having no idea of how lucky we all were.
I remember when Sally decided to get a degree in nursing. In fact I thought she was already qualified for absolutely anything, considering how ridiculously competent she was at everything involving nurturing and healing, but she explained to me how much she needed to study. I remember helping her quiz herself on anatomy, with a huge book with mysterious pictures of the human body.
Sally showed me the delights of creation and creativity and of nurturing them both. When I think about how to have kids, how to have a happy family, I think about her method of making sure the basic materials are there, fostering a supporting environment, fostering the desire and the know-how, and then letting go. She did all that for me, and I’m so grateful.
I am very lucky I was able to see Sally recently. I visited her after math camp ended, and I brought my two older sons with me to see her. I also got to see Ezra with his happy family. It was nice to be able to surround her with abundance, evidence of her legacy of warmth and creation. She passed away recently and I am honored to speak at her memorial service this coming weekend. I’m honored to have been so loved by her.
Police are keeping people out of the park.
In addition, the Atrium at 60 Wall is closed all day. They haven’t said when it will reopen.
You can register your opinion on this handy New York Times graphic.
They’re back in! Check it out live.
I recently read this article in the New York Times about a business owner’s experiences using Google Adwords.
For those of you not familiar with the advertising business, here’s a geeky explanation. As a business owner, you choose certain key words or phrases, and if and when someone searches on Google with that word or phrase, you bid a certain amount to have your business shown at the top of the return searches or along the right margin of the page. You fix the bid (say 4 cents) beforehand, and you only pay that 4 cents when someone actually clicks. The way your position in the resulting page is determined is through an auction.
Say, for example, you and your competitors have all bid different amounts for the keyword “monodromy”. Then every time someone searches for “monodromy”, all the bids are sorted after being weighted by a quality score, which is a secret sauce created by Google but can be thought of as the probability that some random person will click on your ad.
This weighting makes sense, since Google is essentially determining the expected value of showing your ad: the product of the amount of money they will get paid if someone clicks on it (again, because they only get paid when the click occurs) and the probability of that event actually happening. Quality scores are actually slightly more than this, and we will get back to this issue below.
Moreover, once the sorting by expected value is done, your actual payment is determined not precisely by your bid but by the minimum bid you’d need to still maintain your position in the auction. This is a clever idea that gets people to raise their bids in order to win first place in the auction but not need to pay too much… unless there’s another guy who is determined to win first place.
Of course, it’s not always necessary to pay Google to get clicks. Sometimes your business will show up in the “organic searches” anyway- say if the name of your company is well-chosen for your product. So if you’re selling oak tables and the name of your company is “Oak Tables” then you may not need to pay anything for the that key phrase (but you may be willing to pay for the phrase “tables oak cherry”).
Back to the business owner. He decided to experiment with turning off Adwords, in other words he decided to rely on the results of organic searching instead of paying for each click. It didn’t end well- he gave up after a week because business was bad. The thing that caught my eye in this article was the suggestion that, when he turned off the payment, Google also became stingy with showing his free results. In other words, Google seems to be juicing their results (which is likely done through the quality score function) to punish people for not being in the pay-for-clicks program:
What is surprising to me is the steep drop in organic visits, the clicks from free links. They have fallen 47 percent, from 328 to 173. Stopping the AdWords payments seems to have affected unpaid traffic as well. According to everything I’ve been told about search engine optimization, this shouldn’t have happened. But from a business standpoint, it makes sense to me. Google is in business to make money by selling searches. Why shouldn’t it boost the free listings of its paying customers — and degrade the results when they stop paying? It’s also possible that people are more inclined to click on free results when they see the same company has the top paid link. Maybe it’s conscious, maybe it’s not. I’d be interested to hear any theories readers may have as to why my organic traffic took such a fall.
One theory I have is that it’s unfortunately impossible to figure out, because Google doesn’t seem to think they need to explain anything to anyone, even though they have become the arbiter of information. It’s a scary prospect, that they have so much control over the way we see and understand the world, and between you and me their “do no evil” motto isn’t sufficiently reassuring to make me want to trust them on this completely.
A friend of mine recently had a terrible experience with Google which makes this lack of clarity especially frustrating. Namely, some nut job decided to post evil stuff about him and someone else through comments on other peoples’ blogs. There was no way for him to address this except by asking the individuals whose websites had been used to take down the posts. In particular, there was no way for my friend to address the resulting prominent Google search results through the people working at Google- they don’t answer the phone. It doesn’t matter to them that people’s lives could be ruined with false information; they decided many years ago that they are not in the client service industry and haven’t looked back. Their policy seems to be that, as long as there is no actual and real threat of violence, they have no obligation to do anything.
That would be okay for a small startup with little influence on the world, but that’s really not what Google is. Google wields tremendous powers, and their quality score algorithm is defining our world. At this point they have a moral responsibility to make sure their search result algorithms aren’t ruining people’s lives.
What if it were possible to mark a search results as “inappropriate”? And then, given enough votes, the quality score would be affected and the listing would go down to the bottom of page 19. I realize of course that this could be used for good as well as for bad – people could abuse such a system as well, by squelching information they don’t want to see. But the problem with that argument is that it’s already happening, just inside Google, where we have no view. So in other words yes, it’s a judgment call, but I’d rather have a person (or people) do that than an algorithm.
Under the orange
sticks of the sun
ashes of the night
turn into leaves again
and fasten themselves to the high branches —
and the ponds appear
like black cloth
on which are painted islands
of summer lilies.
If it is your nature
to be happy
you will swim away along the soft trails
for hours, your imagination
And if your spirit
carries within it
that is heavier than lead —
if it’s all you can do
to keep on trudging —
there is still
somewhere deep within you
a beast shouting that the earth
is exactly what it wanted —
each pond with its blazing lilies
is a prayer heard and answered
whether or not
you have ever dared to be happy,
whether or not
you have ever dared to pray.
from Dream Work (1986) by Mary Oliver
I’m glad I got a new laptop with sound, because now I can listen to and watch this awesome YouTube video with suggestions to keep Wall Street occupied.
It’s fascinated me for a while how people use language to indicated the relationship between money and morality. David Graeber’s book about debt took this issue on directly, but even before reading it I had noticed the disconnect between individual debt and corporate debt.
It was clear from my experience in finance that debt is something that, at the corporate level, is considered important – you are foolish not to be in debt, because it means you’re not taking advantage of the growth opportunities that the business climate affords you. In fact you should maximize your debt within “reasonable” estimates of its risk. Notable this is called leveraging your equity, a term which if anything sounds like a power move.
That just describes the taking on of debt, which for an individual is something they are likely not going to describe with such bravado, since they’d be forced to use measly terms such as “I got a loan”. What about when you’re in trouble with too much debt?
My favorite term is debt restructuring, used exclusively at the corporate (or governmental) level. It makes defaulting on ones debt a business decision by a struggling airline or what have you, and the underlying tone is sympathy, because don’t we want our airlines (or other american companies) to succeed?
When you compare this language and its implied morality (neutral) to the moralistic preaching of late-night talk radio, it’s quite stark. It’s made clear on such shows that debt is a sin, that the reason the show is a success is that it’s entertainment to hear how messed up the callers’ finances are, and to hear the radio host drill into their most private details in the name of ferreting out that sin.
The Suzy Ormon show is another example of this, and this blog entry is a great description of the emotional and spiritual repentance required in our culture when one is in debt, bizarrely combined with her urging you to go out and consume some more.
For the individual there is no debt restructuring available – at best you can get your debt consolidated, but the people who do that are themselves considered icky. There’s no clean way to deal with out-of-control debt as an individual.
Until now! I found an interesting article the other day which somehow excludes certain people from the moral failing of being in debt – namely, if they have the help of another powerful buzzword – a moral reclamation if you will – namely, “entrepreneur.” Because we all want our entrepreneurs to succeed!
The fact that the program doesn’t apply to most of a typical person’s student debt load is only partly relevant – for me, the fascinating part is the way that, when you stick in the word “entrepreneur,” you suddenly have the vision of someone who shouldn’t be saddled with debt, who is immediately forgiven for their sins. It brings up the question, can we perform this moral cleansing for other groups of people who are currently in debt?
What if we coopted the language of the corporations for the individual? I’d love to hear people talking about large-scale restructuring of their debt. Just the phrase makes me realize its possibilities. One of the main tools of leverage for such talks is the amount of money on the table. If sufficiently many people got together to formally restructure their credit card debts, what would the banks do? What could they do except negotiate?
Here’s a graphic I like just in case you haven’t seen it yet:
I’ve been enjoying watching Andrew Ng’s video lectures on machine learning. It requires a login to see the videos, but it’s well worth the nuisance. I’ve caught up to the current lecture (although I haven’t done the homework) and it’s been really interesting to learn about the techniques Professor Ng describes to avoid overfitting models.
In particular, he talks about iterative concepts of overfitting and how to avoid them. I will first describe the methods he uses, then I’ll try to make the case that they are insufficient, especially in the case of a weak signal. By “weak signal” I mean anything you’d come across in finance that would actually make money (technically you could define it to mean that the error has the same variance as the response); almost by definition those signals are not very strong (but maybe were in the 1980′s) or they would represent a ridiculous profit opportunity. This post can be seen as a refinement of my earlier post, “Machine Learners are spoiled for data“, which I now realize should have ended “spoiled for signal”.
First I want to define “overfitting”, because I probably mean something different than most people do when they use that term. For me, this means two things. First, that you have a model that is too complex, usually with too many parameters or the wrong kind of parameters, that has been overly trained to your data but won’t have good forecasting ability with new data. This is the standard concept of overfitting- you are modeling noise instead of signal but you don’t know it. The second concept, which is in my opinion even more dangerous, is partly a psychological one, namely that you trust your model too much. It’s not only psychological though, because it also has a quantitative result, namely that the model sucks at forecasting on new data.
How do you avoid overfitting? First, Professor Ng makes the crucial observation that you can’t possibly think that the model you are training will forecast as well on new data as on the data you have trained on. Thus you need to separate “training data” from “testing data”. So far so good.
Next, Professor Ng makes the remark that, if you then train a bunch of different models on the training data, which depend on the number of variables you use for example, then if you measure each model by looking at its performance on the testing data to decide on that parameter, you can no longer expect the resulting model (with that optimized number of parameters) to actually do so extremely well on actually new data, since you’ve now trained your model to the testing data. For that reason he ends up splitting the data into three parts, namely the training data (60%), a so-called validation data set (20%) and finally the true testing set (the last 20%).
I dig it as an idea, this idea of splitting the data into three parts, although it requires you have enough data to think that testing a model on 20% of your data will give you meaningful performance results, which is already impossible when you work in finance, where you have both weak signal and too little data.
But the real problem is that, after you’ve split your data into three parts, you can’t really feel like the third part, the “true test data”, is anything like clean data. Once you’ve started using your validation set to train your data, you may feel like you’ve donated enough to the church, so to speak, and can go out on a sin bender.
Why? Because now the methods that Professor Ng suggests, for example to see how your model is doing in terms of testing for high bias or high variance (I’ll discuss this more below), looks at how the model performs on the test set. This is just one example of a larger phenomenon: training to the test set. If you’ve looked at the results on the test set at all before fixing your model, then the test set is just another part of your training set.
It’s human nature to do it, and that’s why the test set should be taken to a storage closet and locked up, by someone else, until you’ve finished your modeling. Once you have declared yourself done, and you promise you will no longer tweak the results, you should then find the person, their key, and test your model on the test set. If it doesn’t work you give up and try something else. For real.
In terms of weak signals, this is all the more important because it’s so freaking easy to convince yourself there’s signal when there isn’t, especially if there’s cash money involved. It’s super important to have the “test data set”, otherwise known as the out-of-sample data, be kept completely clean and unviolated. In fact there should even be a stipulated statute of limitations on how often you get to go out of sample on that data for any model at all. In other words, you can’t start a new model on the same data once a month until you find something that works, because then you’re essentially training your space of models to that out-of-sample data – you are learning in your head the data and how it behaves. You can’t help it.
One method that Ng suggests is to draw so-called “learning curves” which plot the loss function of the model on the test set and the validation set as a function of the number of data points under consideration. One huge problem with this for weak signals is that the noise would absolutely overwhelm such a loss estimate, and we’d end up looking at two extremely misleading plots, or information-free plots, the only result of which would be that we’ve seen way too much of the test set for comfort.
It seems to me that the method Ng suggests is the direct result of wanting to make the craft of modeling into an algorithm. While I’m not someone who wants to keep things guild-like and closed, I just don’t think that everything is as easy as an algorithm. Sometimes you just need to get used to not knowing something. You can’t test the fuck out of your model til you optimize on every single thing in site, because you will be overfitting your model, and you will have an unrealistic level of confidence in the result. As we know from experience, this could be very bad, or it could just be a huge waste of everyone’s time.