Archive for November, 2011

What’s the Volcker Rule?

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.

Categories: #OWS, finance

Who takes risks?

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.

Categories: hedge funds, rant

What does “too big to fail” mean?

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.

Categories: #OWS, finance

Alternative Banking meeting today

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.

Categories: #OWS

Occupy the SEC: commenting on the Volcker Rule

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 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!

Categories: #OWS, finance

Protest today

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:

Categories: #OWS

In memory of Sally Hale

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.

Categories: Uncategorized