The Financial Crisis From A To Z

Tunku Varadarajan at Forbes has a pretty clever piece titled "The Financial Crisis From A-Z". Here are a few of the items that tickled my fancy:

C is for Credit Default Swaps, defined for me by a Wall Street watcher as: Risk whatever you want, and we insure it; risk too much, taxpayers insure it.

L is for leverage (a means of maximizing your losses), liar loans, Lehman (pronounced "lemon")--and the losses/liabilities that unite them all.

M is for where it all started: the mortgage (which, aptly, means death-pledge). Like the dog, it comes in a variety of breeds, "sub-prime" being a cross between a pit bull and a chihuahua.

Q is for quants, who forgot that, every so often, past performance is no indicator of anything at all.

S is for securitization, the process by which one passes off cat food as caviar.

The other 21 letters are pretty good too. Read the whole thing here.

HT: The Big Picture.

Fear Hits CD Market

I just heard an interesting story from a colleague (a former Wall Street lawyer who decided to become a lecturer at my university after retiring from his former career). I'm sure I'll be using it in class as an example of overreaction for the next few years (hey - I still talk about the Carter Years.

My colleague opened up his brokerage statement and noticed something verrrrry interesting (as Arte Johnson would have said).

He had two negotiable CDs - one from Washington Mutual and one from Lehman Bank. They originally had a 5-year maturity, but now had roughly 6 months until expiration, and were both under the FDIC limit. Here's the kicker - they were quoted at 92 and 93. In other words, you could buy them at 92% of face value, and would receive the full face amount at maturity 6 months later. This works out to a compound annual return of over 18% for the one quoted at 92, and about 15 1/2% for the one at 93. And this is for an FDIC-insured instrument.

So, he called his broker to see if there was an error. He was told that a significant number of people panicked when they saw the WAMU or Lehman name, and wanted to get out of their CDs at all costs. So, although the brokerage firm didn't advertise the fact, if my friend wanted to buy more CDs, he could have them at that price.

It's quite a story, and it illustrates how many people overreact in times of stress. 18% in a federally-insured instrument.

Simply amazing.

Bernanke's Bubble Laboratory (from the WSJ)

There's a great article on the front page today's Wall Street Journal titled "Bernanke's Bubble Laboratory" about three economists at Princeton (Harrison Hong, Wei Xiong, and Markus Brunnermeier) who were hired by Bernanke prior to his becoming Fed Chief. They do research on market bubbles.

This one's a keeper, and will probably end up being discussed in a lot of investment and markets classes. It does a pretty good job of laying out some of their research. Here are a smattering of things these three have found that are discussed in the article:

• Major innovations (or big changes) like the rise of the Internet in the mid/late 1990s and the recent credit innovations cause large disagreements between investors about fundamental valuations. Difficulties and costs associated with shorting overvalued stocks allows the most bullish investors to drive prices.
  
• In markets with fewer shares available (like China's A/B shares markets), optimists can really push the prices up
• Skeptics that might drive prices back down won't move in a booming market until they're pretty sure other skeptics will also be on board. So, when the "pessimists" finally start moving, prices can drop much more quickly than they rose.

All in all, a worthy piece, and one that's digestible by people without a graduate degree in finance. Read it here (pay subscription may be required).

Gotta go - classes are done, grades have been handed in, and I have CFA to study for and my own research to work on. It may not be focused on bubbles, but I still like it...

Some Interesting Uses For The VIX

David Merkel at The Aleph Blog has put up several great pieces on the VIX (the CBOE Volatility Index):

In this post, he relates changes in the VIX to changes in the S&P (a % change in the VIX results in about a 10 basis point change in the S&P in the opposite direction), with an R-squared of about 50% (i.e. variation in the VIX explain about 50% of the variation of the S&P). He also notes the mean-reversion in the VIX, and that the S&P tends to be high when the VIX is low (and vice-versa).

He lays out some of the math of VIX mean reversion here (caution - serious nerd alert ahead), and gives a few applications here (including a slick way of using implied vcolatility to get beta).

And yes, he's been added to the blogroll.

Red Tuesday

Today was a good day to be teaching investments. My student managed investment fund class was a bit shell shocked at losing 3 1/2 % of the fund's value in one day (we meet on a MWF schedule, so there wasn't class on Tuesday). .And 100% of our 20+ positions in the fund ended in the red for the day (hence the title of this post). So, there was a lot of discussion about the various stories explaining the drop (Shanghai, bad economic news, and the ever-popular "Greenspan said we're due for a recession").

The biggest positive of this experience is that it has sharpened their focus on the "downside" of being in the market. If you're going to be in the market, you have to see a major correction at some point, and it's better to see it earlier than later (and it's even better if you can experience it with some else's money). We spent a lot of time discussing some positions we plan on exiting and whether or not to sell now, wait and see, or put in stop losses. Of course, I won't tell you what they decided.

But on the good side, the fund has clawed back almost 8/10 of a percent today. It's still not great, but it is an improvement over yesterday's results.

update: It was interesting teaching CFA last night - I got to talk with a couple of equity traders. One had been at it for about 7 years, and had a lot of relatively young guys in her group (almost all had started post 9-11). She enjoyed the panic they expressed since they'd never experience a correction like this. So it's not just my students.