More Quants shifting to Behavioral Finance

Behavioral finance, which once was a footnote in most advanced economics textbooks is now coming to the forefront of financial engineering as quants realize that models must account for the facts that market participants - when pushed beyond their comfort zone - will rarely act efficiently.
As followers of this blog will know I never bought into the EMH, and so have a perennial interest in modeling behavior in the markets. Exploiting inefficiencies is the true path to arbitrage profits.
Of course if quant models start trading against what they perceive as erratic human behavior it's inevitable that they themselves will act erratic at times. It's a Catch-22 of trying to predict the unpredictable.
The added volatility this brings should make things a lot more interesting in the coming years. It will also make whoever can decipher the decision pathways of both the black boxes and gray ones a whole lot of money.

clipped from www.nytimes.com IN the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. “When trust in counterparties is lost, and markets freeze up so there are no prices,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business. The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research. “You don’t need a model of human psychology to see that there was a danger of impending disaster,” Mr. Farmer observed. “But economists have failed to make models that accurately model such phenomena and adequately address their couplings.”

I highly recommend reading the rest of the article for a look at two very different approaches to modeling investor behavior.

Private Sector: 1 Washington: -75,000,000,000

Doesn't take a genius to figure out that reducing a borrower's principal closer to market value is more effective at keeping them in their home long term than a temporary payment cut, but the USS Failboat and its crew of merry morons are too intent on steering us into an iceberg. The sheer idiocy of our government is only matched by our administration's undeserved arrogance.

clipped from www.bloomberg.com March 4 (Bloomberg) -- Patricia Greenberg’s townhouse in Irvine, California, was losing about $10,000 a month in value when she received a letter in February 2008 that looked too good to be true: An investor was offering to cut her $472,000 mortgage by 26 percent and her monthly payment by a third. It was no ruse. New York hedge fund manager Ralph DellaCamera Jr. says he’d purchased the mortgage for 60 cents on the dollar and forced the originator, MLSG Home Loans of Reno, Nevada, to eat the loss. Protecting his investment, DellaCamera lowered Greenberg’s debt to keep her in the home. DellaCamera reduced Greenberg’s mortgage by $121,300 and her interest rate to a fixed 6.375 percent from an adjustable 9.629 percent. The changes allowed DellaCamera to lock in a $65,900 profit [holy crap, capitalism works! and no phantom Keynsian multipliers anywhere!]. Greenberg now pays $2,400 a month instead of $3,800 and plows some of her savings into upgrading the Cape Cod-style residence [i.e. stimulating the economy]. One in five borrowers in the $10.5 trillion U.S. mortgage market owes more than their property is worth, but just one in 10 have received the principal reductions that research demonstrates is more effective at preventing defaults than the temporary payment reductions promoted by banks and the federal government. One reason banks resist lowering borrowers’ principal is that doing so could threaten their solvency. In the worst slump since the Great Depression, the banks’ unrealized losses exceed their capital cushions by $400 billion, according to Nouriel Roubini, a professor of economics at New York University’s Leonard N. Stern School of business. [so let's keep propping them up at the taxpayer's expense and pray that this problem will magically dissappear] “If your collateral is worth significantly less than the loan, it may be better to compromise and get half a loaf than hold out for the whole loaf and get nothing,” says David Dietze, president of Point View Financial Services Inc., an investment adviser based in Summit, New Jersey. [why would I take half a loaf now when I can milk the government so much I'll be too bloated to even eat a crumb!] “The banks need to flush out all the bad assets, says Louis Amaya, 44, NAD’s chief investment officer. “Let guys like us buy them, service them, reliquefy them into good loans.” The process will “put a lot of them out of business,” Amaya says. “There’s going to be some hard, short-term pain that needs to happen in order for us to start rebounding.” [wait, now I'm not even getting half a loaf for running my business into the ground?! American people don't want pain, they want unicorns shitting skittles and they want them now! Hedge funds are eeeevil! Don't listen to their logic, they're not even government regulated!] President Barack Obama announced a $75 billion rescue plan Feb. 18 that promotes more affordable monthly payments for as many as 9 million borrowers through government-subsidized interest rates and extended loan terms up to 40 years. While buying time for the financial system to stabilize and the economy to recover, the government program steers clear of restoring homeowners’ lost equity, a more effective method of stemming foreclosures, according to research by Credit Suisse Group AG, Goldman Sachs Group Inc. Bank resistance to more aggressive action was reflected in a December study by the Comptroller of the Currency, a federal banking regulator. After six months, more than 55 percent of the loans modified last year re-defaulted, that report showed. By comparison, 28 percent of homeowners whose modifications trimmed their principal by a fifth or more were late after six months. The Obama administration’s failure to close the negative- equity gap means that its plan “will likely join the dud parade of federal rescues,” says John Kiff, an International Monetary Fund economist in Washington. [Don't listen to the IMF! They're only concerned with helping the rich get richer! All I'm trying to do here is keep my poor bank from going bankrupt! Won't anyone think of the bankers?!]

Party Like A Rock*

Seriously people, I can't make this ish up.
If you thought forcing a quant to take estrogen at SAC was the fruit-battiest Wall Street got ...well, just wait till you meet Tiger - the gay go-go dancer.

clipped from www.nytimes.com A life of private jets and black-tie balls ended with Seth Tobias, a wealthy investment manager and a familiar presence on CNBC, floating face down in the swimming pool of his mansion [in Palm Beach, FL]. Bill Ash, a former assistant to Mr. Tobias, said he had told the police that Mrs. Tobias confessed to him that she had cajoled her husband into the water while he was on a cocaine binge with a promise of sex with a male go-go dancer known as Tiger. Mr. Ash has a past: he has been arrested at least 11 times on charges ranging from larceny to prostitution; He has been called Mr. Madam because of a past connection he says he had to Heidi Fleiss, the Hollywood Madam [and because he likes going to galas in fancy sequined dresses]. Through her lawyers, Mrs. Tobias refused to comment for this article. In a recent interview with The Palm Beach Post, she said, “I’m broken. I haven’t gone out in six weeks. I’ve been in and out of the hospital. I just pray all day and wonder why people could be so evil.” [If a socialite didn't go out for six whole weeks - you know it's serious. If she just wanted the money she'd clearly be spending it - and not just on hiding the evidence...] Mrs. Tobias spent $9,628 to have the pool drained and resurfaced days after her husband died, according to documents filed in an unrelated case. In court filings, the Tobias brothers invoke Florida’s “slayer statute,” which prohibits inheritance by a person who murders someone from whom they stand to inherit. They claim she “intentionally killed” her husband “by asphyxiation and drowning.” One lawyer representing Mrs. Tobias, Gary Dunkin, said he was shocked by the accusation. “In my 25 years practicing law, this is the most reckless allegation I have ever seen,” he said in court. [Dunkin' has never seen relatives accuse a socialite of murdering her estranged husband for money because he spent most of his 25 years practicing law at Krispy, Dunkin & Happy, which lardly deals only in cases pertaining to deliciousness.] Mrs. Tobias' [other] lawyers, which include her prior husband [with whom she'll share the "legal fees" paid by the husband's estate if she doesn't win], Jay J. Jacknin [aka Triple J, Jizza Jack, and Jack'n J], have asked the court to put off her depositions, citing her “psychiatric condition”. They said she hired contractors to empty the pool because she was distraught over her husband’s death [not going according to plan]. Mr. Tobias never ran with the titans of Wall Street. He was a small player in an industry where successful managers command billions or even tens of billions of dollars [so you can't even imagine what kinda crazy shit goes down at the Cohen and Simons houses]. Mr. Tobias’s life was apparently as volatile as his investment returns. [Mr. & Mrs. Tobias] secretly frequented a gay bar called Cupids in West Palm Beach, in a strip mall along a main thoroughfare. It was there, according to Mr. Ash, that Mr. Tobias first met Tiger. “Seth used to come in here back when it was crazy,” said Adiel Hemingway, the longtime manager of Cupids. As a flat-screen television blared hard-core gay pornography, he said that Mr. Tobias often came to the club with his wife. Hemingway took out a picture of Tiger. Tiger is blond and covered with tattoos that look like stripes. “I know exactly who he is, but I’m not telling you,” Mr. Hemingway said.

Goldman Sachs Is Perfect...

...everyone else is just cramping their style:

clipped from www.bloomberg.com Goldman Sachs Group Inc. blamed its $3 billion in hedge-fund losses this month on too many quantitative managers making the same trades. "Successful quant managers will have to rely more on unique factors, while we have developed a number of these factors over the last several years, in hindsight we did not put sufficient weight on these relative to more popular quant factors." {Hate to break this to ya, but this statement means your model was not unique as a whole and furthermore that you didn't give these "unique" factors enough weight to actually trade based on them - i.e. the factors are crap used for marketing materials, and you have the same damn model as every other quant fund.} Goldman's quantitative funds use six major investment ``themes'' that it identified as momentum, earnings quality, valuation, profitability, analyst sentiment and management impact. All suffered ``extreme negative returns'' from July 30 through Aug. 10. {Gee whiz these sure would sound unique...if it was 1960s when Vinnys roamed the floor of the NYSE like brightly colored dinosaurs.} Last week, ``quantitative portfolios fell (and rose) by unprecedented amounts -- far more than at any time in the history of our data,'' according to the Goldman report. {The only thing that rose was the P&L at Goldman's prop desk who found out about the liquidations early and front ran the trades, notes an inside source.} The world's most profitable securities firm and second-largest hedge-fund manager lost $1.4 billion, or 28 percent, in its Global Equity Opportunities fund this month while the flagship Global Alpha, fell 27 percent year to date. {Fortunately, unlike Smelly Bear Stearns Goldman's got plenty of money in the Sachs to keep these funds afloat - if they were to liquidate their reputation would take a hit and cause serious long term damage to the firm. Bear, on the other hand, has no reputation to speak of and is thus scrappily taking all of their investor's money so they can keep themselves afloat long enough to get CEO Jimmy Cayne's golf score down to non-laughable levels.}

Stealing money from your friends for political advancement

John Edwards clearly learned something (besides poverty) at Fortress - life, like trading, is a zero sum game and someone always has to take a loss. In this case - his former colleagues.
Johnny was overheard saying from behind his modest ivory and platinum desk while lighting a handrolled Cuban with a $1000 bill - "Hey, it was either that or no more $400 clips, and I gotta look good for the campaign. The wifey aint gonna last past the primaries."

clipped from online.wsj.com Democratic presidential candidate John Edwards proposed increasing taxes on private-equity and hedge-fund managers in three ways [through extortion, pogroms and inquisitions] saying it would make the tax code more fair without damaging U.S. capital markets [it's not like those hedgies could just go public on the LSE and move themselves to London or Dubai]. Taken together, the former North Carolina senator asserted, these steps would raise [steal] $4 billion to $6 billion a year [that will fund a program to rid the world of sex slaves by buying the market and putting them into a safe compound adjacent to the White House]. Mr. Edwards, himself a former adviser to the hedge fund Fortress Investment Group, thus became the first major Democratic candidate to wade deeply into the controversy sparked by the explosive growth and profitability of hedge-fund and private-equity firms [because making money by improving failing companies is un-American - if you want to be a capitalist bastard go to China!]. While making amelioration of poverty a centerpiece of his campaign, the one-time trial lawyer earlier this year reported that he had received $1.7 million in salary and investment income from Fortress, where his holdings total $16 million [but not for long! Unexpected drawdowns are a bitch.] Mr. Edwards's stance could help shore up his populist credentials after criticism of his personal wealth and lifestyle have eroded his poll standings [surely you jest!].

How I Spent My Summer Vacay

Ahh, to have the Treasuries keel over, the Pound rally to the 2 spot again and big LBO bets come to fruition. Certainly makes one's mind wander to things like G5s, Breguets and single malts twice your age. To that effect, I found this Forbes article both inspirational and useful.

clipped from www.forbes.com Assuming they can pry themselves away from their computers for a quick break this summer, hedge fund partners are planning to spend a fair amount of money enjoying the good life. Many in the business are already anticipating that their funds' strong performance so far this year will morph into a big incentive payoff come winter. The average hedge fund partner plans to drop $82,000 on watches and jewelry alone this summer. The biggest-ticket item of the summer seems to be yacht rentals, where the average budget is $446,000. But only 14 of the 301 partners in the survey plan to rent a yacht. The rest of them probably own. Hedge fund clients want unusual and off-the-beaten path destinations, challenges to take their minds off number crunching. Surfing down the ash covering a volcano in Nicaragua, heliskiing in Chile, anaconda hunting in the Amazon and motorbike safaris in Namibia are all popular. They plan to spend an average of $96,000 on "experiential" vacations.

There's more than one way to film a money shot.

Hedge Funds doing Hollywood? Old news. Hedge funds doing Hollywood (San Bernardino county anyways)? Now we're cooking with gas (but still less volatile gas than the one Brian Hunter was cooking with). Hope it's gonna be a hot summer for both of them.
Might expand this post after visiting the site at home...

clipped from www.dailybreeze.com Francis Koenig, a former hedge-fund manager in New York, moved to L.A. last year with one goal: directing traditional money to a nontraditional investment. That nontraditional investment is porn. His Beverly Hills-based company is called AdultVest, and he said it's the first and only one geared toward matching investors and successful entrepreneurs with growing adult-entertainment companies and adult entertainers looking to start up, expand, acquire or be acquired. "And they have absolutely no institutional financial participation, no venture funds, angle funds or private equity funds for this industry," he said. His first convention will be later this year in Hollywood, and he's looking for actors and actresses who want to fund a production or other venture to submit a proposal to his Web site, www.adultvest.com. The fundraising started last fall and Koenig said the money is coming in at a steady pace and there are some high-profile participants, though he declined to name names.

Doug Ellin: Working for Money is Immoral

Read the quick interview with Entourage creator Doug Ellin, whose next show will be about a couple guys running hedge funds and making money that "makes Vince look like a pauper." I though that given Ellin's expertly apt and guilt-free portrayal of the Hollywood entourage there would finally be a show about finance that didn't have the message of Wall Street, Boiler Room, et.al. - that money always corrupts and the people who make markets are the devil incarnate.

Perhaps I was wrong.

Ellin calls the Entourage boys who do nothing but sleep, drink and fuck "good guys who have each other’s back", and his homies who nonchalantly buy Bentleys make him laugh, while hedgies working their ass off and making billions sadden him. Is it because actors are idiots who couldn't be doing anything else, whereas Harvard-educated hedgies could be "trying to cure cancer"? Why aren't you shooting a documentary about fuckin' Darfur then, Ellin? Get off your hybrid high horse and kiss my wingtips. People who succeed do what they are most passionate about, and all the best traders and dealmakers, the ones who really have a gift for the game, would still be doing it for free. At their level "money is just a way to keep score," as Kravis said. Not to mention that Wall Street players give a whole lot more of their wealth away than your average Hollywood celeb trying to campaign for the it cause of the day because somehow being able to act [i.e. big tits or a nice jaw line] makes one naturally adept at understanding the intricacies of world politics.

Ellin then has the gall to say that people go to finance to hit a home run and take a shortcut to wealth. This is what worries me the most as it sets up the show to be completely unrealistic. As we all know there is no easy money in finance. You earn every penny you make, sometimes you just have a bit of tailwind. True, there are a very few brilliant traders out there who make a killing early on an keep on doing it, but even 80% of them spent years studying the trade before they got a chance to hit one out of the park. And I assure you - none of them could have cured cancer even if they tried.

clipped from www.nytimes.com Q: Why do you find the subject of money so interesting? Sadly, right now, that’s the world people are aspiring to. You have Harvard-educated medical doctors who would rather work at an investment bank than try to cure cancer. Q: The desire to make money is nothing new. No, but now people are looking for the home runs constantly. That’s the difference. People are seeing shortcuts and easy routes. Q: Is [Entourage] intended as a sendup of Hollywood excess? No. I consider the show 100 percent realistic. I have friends who wake up in the morning and want a Bentley and they go get it. I find it funny. I look at them [the Entourage cast] as good guys who have each other’s back and just want to take care of each other. They watch out for each other like family. Q: How much do you earn? I’m not going to tell you. Q: About $3 million a year? Yeah, you can put it in that neighborhood.

Red Losers - Crybaby Hedgies Whine about a Bear's Fierce Chomp

To sum up: 30 different funds who did speculative CDS trades on subprime names with Bear are suing the bank for allegedly manipulating the market by flexing its renowned fixed income muscle and buying up some subprime bonds and servicing a few mortgages which would tighten up the CDS and cause the aformentioned hedge funds to incur losses serious enough that it could start that downward spiral of investors withdrawals.

Unfortunately for the hedgies, the fact is that Bear can make its own bets regardless of what its prime brokerage clients do. In fact, as counterparty by default (no pun intended) to the CDS trade it is entirely rational that Bear would scale its risk as needed. It's job as PB is to ensure that all trades are booked and executed correctly, nothing more. To those in the business who still haven't realized it yet - the prime broker is not your friend. It's not even a very good butler. More like the butler from Clue (sometimes helpful, most of the time full of shit), but that's just how the game works.
In any case, there's little that the hedgies could do against the dirty Bear even if they were correct. Neither the SEC, nor any other regulatory body has direct jurisdiction over CDS contracts.

clipped from online.wsj.com Hedge-fund managers accuse Wall Street's Bear Stearns Cos. of attempting to manipulate the market for securities backed by subprime loans by purchasing shaky mortgages. Bear's main antagonist in the squabble, hedge-fund executive John Paulson of Paulson & Co., used to work for the investment bank. "All we're after is very simply to maintain the market's integrity," says Kyle Bass, a former Bear employee who is now managing partner of Hayman Capital, which oversees about $3 billion in the subprime market. Bear is one of Wall Street's largest players in the market for credit default swaps, or CDS, instruments that act as insurance policies on various kinds of bonds. Many hedge funds have bought these swaps, effectively making a bet on an acute downturn in subprime home loans. Bear is widely believed to have taken the opposite position, selling swaps and making a bet that conditions will improve or won't deteriorate as much as some people think. Bear's mortgage desk had sent Paulson a copy of new language it was proposing to the International Swaps and Derivatives Association. The proposed rules would codify its right to prop up a faltering pool of home loans in a mortgage security, even if it knew its clients bet those loans wouldn't perform. "We were shocked," says Paulson vice president Michael Waldorf, that a firm "like Bear would introduce language that would try to give cover to market manipulation."