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The SEC's Rocket Scientist: He Aimed for the Stars, He Hit ...

Scientists, Secrets and Wall Street’s Lost $4 Trillion

by PAM MARTENS

Thanks to an ever growing influx of Ph.D.s from the Ivies and an insatiable demand for an algorithmic trading edge by secretive hedge funds and proprietary trading desks at the largest firms, Wall Street has become part physics lab, part casino, part black hole.

What Wall Street bears no relationship to any longer is its primary mission in the U.S. economy: to be a fair and efficient allocator of capital to worthy businesses and innovators to propel job growth while also providing a medium for allowing investors to buy or sell stocks and bonds of those businesses at a fair price.

Stock brokers who previously scoured over annual reports and price to earnings multiples and bond prospectuses to build individualized portfolios for clients based on the client’s investment time horizon and comfort level with risk are so yesterday.  The big firms lean on their brokers to turn their clients’ money over to impersonal “money managers” who use incomprehensible computerized risk modeling to manage the life savings of people they’ve never met.  The business motivation for this was that the earnings of the big firms would not be dependent on the brokers’ inconsistent commission streams from trading by replacing them with a steady annual stream of money management fees.   These huge pools of consolidated money have now joined the huge pools of hedge fund and proprietary trading monies, leaving small investors at the mercy of giant “pools,” the exact same word that dominated investigations after the 1929 crash.   (Those intensive Senate investigations of the early 30s that turned up corruption at the highest echelons of Wall Street are also so yesterday.)

Taking the human relationship, and human brain, out of investing for others and turning it over to computer formulas has produced stark results: a lost decade of retirement savings for most Americans; a multi-trillion dollar collapse of the financial system; a taxpayer bailout of the most incompetent and negligent firms in finance; the greatest wealth transfer to the top 1 percent in the history of the country — which has contributed to  43.6 million people in America, including one in every five children, living below the poverty level. 

And despite all this, Wall Street’s top cop, the Securities and Exchange Commission (SEC), continues to treat Wall Street as an overly rambunctious adolescent that needs merely a little slap on the wrist from time to time. 

Consider the recent example of how Citigroup was punished by the SEC for willfully “scripting” announcements to investors to hide $39 billion of its exposure to subprime debt.   According to the SEC’s order of July 29, 2010, only Gary Crittenden, CFO during the period of the order, and Arthur Tildesley, head of Investor Relations at the time, were singled out and given fines of $100,000 and $80,000 respectively.  They were not barred from Wall Street; their collaborators in the debt deception, who were known to the SEC via emails obtained from the firm, were not named in the SEC order or fined.  The following is from the SEC order:

In late September and early October 2007, Crittenden, the chief financial officer (“CFO”) of Citigroup Inc. (“Citigroup”) and Tildesley, the head of Citigroup’s Investor Relations (“IR”) department, both helped draft and then approved, and Crittenden subsequently made, misstatements about the exposure to sub-prime mortgages of Citigroup’s investment bank. Citigroup then included a transcript of the misstatements in a Form 8-K that it filed with the Commission on October 1, 2007. The misstatements were made at a time of heightened investor and analyst interest in public company exposure to sub-prime mortgages and related to disclosures that the Citigroup investment bank had reduced its sub-prime exposure from $24 billion at the end of 2006 to slightly less than $13 billion. In fact, however, in addition to the approximately $13 billion in disclosed sub-prime exposure, the investment bank’s sub-prime exposure included more than $39 billion of “super senior” tranches of sub-prime collateralized debt obligations and related instruments called “liquidity puts” and thus exceeded $50 billion. Citigroup did not acknowledge that the investment bank’s sub-prime exposure exceeded $50 billion until November 4, 2007, when the company announced that the investment bank then had approximately $55 billion of sub-prime exposure.

There are systemic ramifications to secrets like the above which, still today, proliferate across Wall Street.  The SEC has assigned a former rocket physicist, Gregg Berman, to lead the investigation into the Flash Crash of May 6, 2010.  On that day the market lost a staggering 998 points intraday, sold off some blue chip stocks at 20 to 40 per cent below their opening price, knocked some S&P 500 stocks to a penny, then turned on a dime and shot upward in a bizarre financial bungee jump, with the Dow closing down 348 points.  It apparently hasn’t occurred to the SEC that the American people do not want their life savings in a venue that requires a rocket scientist to explain how it works. (A CNBC/Associated Press poll conducted between August 26 and September 8 of this year found that 86 percent of survey respondents view the stock market as unfair to small investors.  Half the respondents say they have little or no confidence in the ability of regulators to make the market fair for all investors.)

Dr. Berman holds a B.S. in Physics from M.I.T. and a Ph.D. in Physics from Princeton.   On September 24, 2009, the SEC announced that Dr. Berman had been named “a Senior Policy Advisor in its newly-established Division of Risk, Strategy, and Financial Innovation.”   Queried last week, a spokesman for the SEC says Dr. Berman is now working for the Division of Trading and Markets. 

Prior to joining the SEC, Dr. Berman served in various executive positions over 11 years  with RiskMetrics Group, a risk modeling firm incubated at JPMorgan in the early 90s, spun off as a separate firm in 1998, and became a publicly traded company on January 25, 2008, making a lot of instant multi millionaires among the ranks of senior executives.  According to the company’s web site, RiskMetrics serves 72 of the 100 largest investment managers, 35 of the 50 largest hedge funds, 16 central banks.

RiskMetrics is acknowledged as the firm that created a highly complex model called Value at Risk, or VaR, which attempts to express how much money a financial institution or trading desk can lose over a set period of time, such as the next 24 hours, week or month.  As can be seen by the SEC order against Citigroup officials, if the risk modelers are not aware of an extra $39 billion of risk hiding in an offshore vehicle, the risk model is worse than useless because it’s actually creating a false sense of security.  Or, as another example, you could run a computer calculation as to the probability of a $10 billion portfolio of AAA collateralized debt obligations blowing up over the next 3 months and find you had a 1 per cent probability of that happening.  But if you ran the same calculation through your brain, it might go like this: what is the probability that you can bundle $10 billion of loans from high risk borrowers who have low credit scores and get a legitimate AAA rating on that paper. (Brain: probability zero.)  What is the probability that if you go ahead and bundle junk bonds and get the credit rating agencies to rate them AAA, they will perform like a AAA bond . (Brain: probability zero.)  Across Wall Street, human questioning was getting in the way of taking those oversized, insanely leveraged risks that would lead to fat bonuses.  So the human brain was turned off and the VaR brain, or a proprietary clone of it, was turned on.  According to insiders, those highly complex Collateralized Debt Obligations (CDOs) that consisted of subprime loans stacked in convoluted tranches were plugged into the risk model as a simple AAA bond.  Garbage in, garbage out.

The risk models used computer methodology; the corruption that was human-inspired could not be adequately translated to binary code.  The risk models, for example, did not understand the ramifications of actions like the ones described by an Assistant Manager, Gail Kubiniec, at a unit of Citigroup, CitiFinancial:  

“I and other employees would often determine how much insurance could be sold to a borrower based on the borrower’s occupation, race, age, and education level.  If someone appeared uneducated, inarticulate, was a minority, or was particularly old or young, I would try to include all the coverages CitiFinancial offered.  The more gullible the consumer appeared, the more coverages I would try to include in the loan….”

A patent application pending at the U.S. Patent and Trademark Office naming Dr. Berman and two others as inventors, and RiskMetrics as the assignee, suggests where the idea of risk modeling is heading next.  The patent, if approved, would enshrine a concept of allowing money managers such as hedge funds to keep the actual positions in their portfolio a secret while providing a risk analysis to investors.  (According to a spokesman at the patent office, the application has been pending since 2008 because their examiners are swamped with backlog.) 

One of the most outspoken critics of the risk modeling technique known as  VaR is Dr. Nassim Taleb,  who holds impressive academic credentials himself: a Wharton M.B.A., a B.S., M.S. and Ph.D. in Management Science from the University of Paris.  Dr. Taleb testified as follows on September 10, 2009 before the U.S. House Subcommittee on Investigations and Oversight of the Committee on Science and Technology.  (Despite this testimony, fourteen days later, the SEC hired Dr. Berman.)

“Thirteen years ago, I warned that ‘VaR encourages misdirected people to take risks with shareholders,’ and ultimately taxpayers’ money.’ I have since been begging for the suspension of these measurements of tail risks [fat tail or extreme events]. But this came a bit late. For the banking system has lost so far, according to the International Monetary Fund, in excess of 4 trillion dollars directly as a result of faulty risk management… My first encounter with the VaR was as a derivatives trader in the early 1990s when it was first introduced. I saw its underestimation of the risks of a portfolio by a factor of 100 –you set up your book to lose no more than $100,000 and you take a $10,000,000 hit.  Worse, there was no way to get a handle on how much its underestimation could be.  Using VaR after the crash of 1987 proved strangely gullible.  But the fact that its use was not suspended after the many subsequent major events, such as the Long-Term Capital Management blowup in 1998, requires some explanation. [Long Term Capital Management was a hedge fund blown up by a group of Ph.D.s using massive leverage.] Furthermore, regulators started promoting VaR (Basel 2) just as evidence was mounting against it.

VaR is ineffective and lacks in robustness…VaR encourages ‘low volatility, high blowup’ risk taking which can be gamed by the Wall Street bonus structure.  I have shown that operators like to engage in a ‘blow-up’ strategy, (switching risks from visible to hidden), which consists in producing steady profits for a long time, collecting bonuses, then losing everything in a single blowup.  Such trades pay extremely well for the trader –but not for society.  For instance, a member of Citicorp’s executive committee (and former government official) [former Treasury Secretary Robert Rubin] collected $120 million of bonuses over the years of hidden risks before the blowup; regular taxpayers are financing him retrospectively.” 

The comments in [brackets] above are mine.  I don’t know why Dr. Taleb is only picking on Mr. Rubin’s $120 million when Sanford Weill, former CEO of Citigroup, sucked $1 billion out of the firm in compensation under the same set of circumstances.  Dr. Taleb goes on to chronicle in Appendix 1 of his testimony just how long he has been sounding the warning.  His prior statements are as follows:

“1996-97:VaR is charlatanism because it tries to estimate something that is scientifically impossible to estimate, namely the risk of rare events. It gives people a misleading sense of precision… 2003: Fannie Mae’s models (for calibrating to the risks of rare events) are pseudoscience.  2007: Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deems these events “unlikely.” [Fannie Mae is now a ward of the state.]… Banks are now more vulnerable to the Black Swan [high impact, rare event] than ever before with “scientists” among their staff taking care of exposures. The giant firm J. P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people’s risks…”

One certainly does have to wonder why, if the RiskMetrics risk model was so accurate and valuable for trading, JPMorgan effectively gave it away to the street by publishing the methodology publicly in 1994.  Having read reams of lawsuits filed in Federal Court where Wall Street firms pound the table to keep their proprietary trading secrets under seal, this whole episode does raise a few eyebrows.  To add to the curiosity, RiskMetrics, the firm created inside an incubator at JPMorgan was acquired on June 1 of this year by MSCI, a firm created inside an incubator at Morgan Stanley.  In other words, two of the largest investment banks whose primary job is to allocate capital fairly to the marketplace frequently create their own finance-related firms, then proliferate the “science” masterminded by these firms by spinning them off to the marketplace. 

Within a few weeks, the SEC will be releasing its investigative report of the May 6, 2010 Flash Crash.  Gregg Berman, a key executive of RiskMetrics just one year ago, whose clients at that time are the same firms engaged in the questionable events of May 6, will serve up the results of that investigation to the American people.  In the book “How I Became a Quant: Insights from 25 of Wall Street’s Elite,” Dr. Berman shares this with us:  “…I learned that once the billion-dollar spacecraft I had worked on finally reached Mars, it exploded.”  Dr. Berman is now two for two.  Is he the right man for unraveling the events of May 6?

PAM MARTENS worked on Wall Street for 21 years; she has no securities position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire.  She can be reached at pamk741@aol.com.

 

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