Any actuaries, finance, or wall-street people in the house?

[Fenixgoon]

While going over some basics in one of my classes, my teacher got on the subject of distributions.

He claimed that most people base predictions in life based on Gaussian distributions, and as such, rare events that are predicted to virtually never happen do in fact happen (see the book "The Black Swan"). As such, events follow more of a Boltzmann distribution where the highly rare events at the extremes, though still unlikely, are more likely to occur than if represented by a Gaussian distribution (ie, economic behavior, etc.) and is one of the reasons why shit hit the fan economically.

I'm just curious if anyone can provide some insight on how things like this are predicted in real life - whether it's for finance/investing, insurance companies, whatever, and if the Gaussian distribution is indeed the one that is primarily used

Not bashing anyone, just genuinely curious

 

[BrownTown]

The reason the shit hit the fan wasn't some tiny number of outliers at one end, it was the fact that a LARGE percentage of loans did not make economic sense. There are two reasons for this really. First is that the government encouraged (read: forced) banks to give bad loans since the idea was that everyone should be able own a house even though many are not responsible enough to make the payments. The other is the fact that gains and losses were not accounted for equally in individuals pay. For example if you were a banking executive an the company made alot of money, you get a large bones, if they lose alot of money they don't take away your base salary though. As such this means that there is a very limited downside to losing money, but a huge upside for making money. As such highly risky behavior is encouraged which works so long as things are going good, but as soon as they start going bad it creates a death spiral.

I wish it were just a small outliers that caused teh economic collapse, the the reality is that the MAJORITY of people live beyond their means and take excessive risk with their money.

 

[Dissipate]

Originally posted by: Fenixgoon
While going over some basics in one of my classes, my teacher got on the subject of distributions.

He claimed that most people base predictions in life based on Gaussian distributions, and as such, rare events that are predicted to virtually never happen do in fact happen (see the book "The Black Swan"). As such, events follow more of a Boltzmann distribution where the highly rare events at the extremes, though still unlikely, are more likely to occur than if represented by a Gaussian distribution (ie, economic behavior, etc.) and is one of the reasons why shit hit the fan economically.

The problem with this thinking is that a rare event at the extreme might happen to one person, or even a few people, but multiply that by millions and you get an astronomically small probability. The idea that the current financial crisis was caused by a series of improbable random events is false. A much much more likely theory is that those who exercise large influence over the financial system set the seeds for the crisis. One can argue over the details of what they did wrong, but it is a statistical fact that they did something to trigger the crisis.

 

[Nathelion]

I can't find it just now, but there was an article I found awhile back (on Ars, i think?) talking about how a Gaussian fibula estimate of risk (something along those lines) had contributed to the misestimation of risk that brought on the current financial crisis.

Honestly though, it sounds like one of those things your professor says that you need to take with a grain of salt.

 

[Fenixgoon]

Originally posted by: Nathelion
I can't find it just now, but there was an article I found awhile back (on Ars, i think?) talking about how a Gaussian fibula estimate of risk (something along those lines) had contributed to the misestimation of risk that brought on the current financial crisis.

Honestly though, it sounds like one of those things your professor says that you need to take with a grain of salt.

probably. the idea seemed intriguing, so i figured i'd see if anyone around here knew how things actually worked in the real world

 

[JJChicken]

I think the replies in this thread have been spot on. Shit hit the fan because people on Wall Street and everyone else in the finance industry was greedy, didn't know what they were getting into and were incompetent.

 

[PowerEngineer]

Looks like this is a fairly popular suggestion:

Mathematical theory and stock market crashes

The mathematical characterisation of stock market movements has been a subject of intense interest. The conventional assumption has been that stock markets behave according to a random Gaussian or "normal" distribution.[23][24] Among others, mathematician Benoît Mandelbrot suggested as early as 1963 that the statistics prove this assumption incorrect.[25] Mandelbrot observed that large movements in prices (i.e. crashes) are much more common than would be predicted in a normal distribution. Mandelbrot and others suggest that the nature of market moves is generally much better explained using non-linear analysis and concepts of chaos theory.[26] This has been expressed in non-mathematical terms by George Soros in his discussions of what he calls reflexivity of markets and their non-linear movement.[citation needed]

Research at the Massachusetts Institute of Technology suggests that there is evidence the frequency of stock market crashes follows an inverse cubic power law.[27] This and other studies such as Prof. Didier Sornette's work suggest that stock market crashes are a sign of self-organized criticality in financial markets.[28] In 1963, Mandelbrot proposed that instead of following a strict random walk, stock price variations executed a Lévy flight.[29] A Lévy flight is a random walk that is occasionally disrupted by large movements. In 1995, Rosario Mantegna and Gene Stanley analyzed a million records of the S&P 500 market index, calculating the returns over a five year period.[30] Their conclusion was that stock market returns are more volatile than a Gaussian distribution but less volatile than a Lévy flight.

Researchers continue to study this theory, particularly using computer simulation of crowd behaviour, and the applicability of models to reproduce crash-like phenomena.

...from Wikipedia...

Chaos theory? Seems appropriate given the chaos that the market collapse has caused. :laugh:

I'll also add my non-technical view that the invention (and lack of regulation) of new investments like credit default swaps and other mortgage-based securities allowed somewhat unscrupulous middle-men to bundle risky mortgagaes and sell them to people/institutions that didn't understand the risks involved.

Applying distribution theory to movements in a well defined market makes sense, but I don't see how it can predict the market response when new "products" effectively redefine the market.

 

[Aluvus]

Originally posted by: Dissipate

The problem with this thinking is that a rare event at the extreme might happen to one person, or even a few people, but multiply that by millions and you get an astronomically small probability. The idea that the current financial crisis was caused by a series of improbable random events is false. A much much more likely theory is that those who exercise large influence over the financial system set the seeds for the crisis. One can argue over the details of what they did wrong, but it is a statistical fact that they did something to trigger the crisis.

The financial instruments that abruptly collapsed had been valued based on the assumption that it was very unlikely that a large percentage of home owners would default on their loans at essentially the same time.

In other words, it was assumed that defaults were not-strongly-uncorrelated random events. Implicitly, this means that a large number of defaults (which is what occurred and set the whole house of cards tumbling) would be a very unlikely event. In a healthy economy, that would be true. However, in the face of a large-scale external shock, correlations can change dramatically. There is an often-modified saying that "in a crisis, all correlations go to one", which is overstated but does get the idea across.

@OP: I'm not deeply familiar with the mathematics or what type of model is most appropriate for this purpose. But I do know that the mis-assessment of risk was based in part on the use of the Gaussian copula, which does assume Gaussian distributions. Wired has a piece on its less than illustrious history in finance.

When Genius Failed by Roger Lowenstein profiles a different (but analogous) failure of a hedge fund, which also occurred principally because of an under-estimation the possibility of a major disruption. Also always, there were plenty of other contributing factors (they were insanely over-leveraged, competitors were making their method less effective, etc.).

 

[Fenixgoon]

Originally posted by: Aluvus

Originally posted by: Dissipate

The problem with this thinking is that a rare event at the extreme might happen to one person, or even a few people, but multiply that by millions and you get an astronomically small probability. The idea that the current financial crisis was caused by a series of improbable random events is false. A much much more likely theory is that those who exercise large influence over the financial system set the seeds for the crisis. One can argue over the details of what they did wrong, but it is a statistical fact that they did something to trigger the crisis.

The financial instruments that abruptly collapsed had been valued based on the assumption that it was very unlikely that a large percentage of home owners would default on their loans at essentially the same time.

In other words, it was assumed that defaults were not-strongly-uncorrelated random events. Implicitly, this means that a large number of defaults (which is what occurred and set the whole house of cards tumbling) would be a very unlikely event. In a healthy economy, that would be true. However, in the face of a large-scale external shock, correlations can change dramatically. There is an often-modified saying that "in a crisis, all correlations go to one", which is overstated but does get the idea across.

@OP: I'm not deeply familiar with the mathematics or what type of model is most appropriate for this purpose. But I do know that the mis-assessment of risk was based in part on the use of the Gaussian copula, which does assume Gaussian distributions. Wired has a piece on its less than illustrious history in finance.

When Genius Failed by Roger Lowenstein profiles a different (but analogous) failure of a hedge fund, which also occurred principally because of an under-estimation the possibility of a major disruption. Also always, there were plenty of other contributing factors (they were insanely over-leveraged, competitors were making their method less effective, etc.).

thanks for the links to the article and wiki. highly informative and very interesting! :thumbsup:

 

[deputc26]

Interesting piece, government encouragement to offer sub-prime loans was a huge mistake but I blame the consumer as well. Consumer complacency and short-sightedness are as much to blame as the banks. All parties share the blame for the failure of a system.

 

[wwswimming]

Originally posted by: deputc26
Interesting piece, government encouragement to offer sub-prime loans was a huge mistake but I blame the consumer as well. Consumer complacency and short-sightedness are as much to blame as the banks. All parties share the blame for the failure of a system.

Do the parties that knowingly engage in fraud related to these transactions receive (get ?) more blame than the parties that made a good faith effort to be honest ?

a loaded question, i think most people would say the parties that knowingly committed fraud get more blame.

this was a huge scam, credit derivatives & mortgage-backed securities, that is. in $ numbers, many $ trillions. the losses booked & hidden in the 2007-2009 timeframe were in the trillions, and the financial services industry that cooked up these products made many more trillions "on the way up", in the 1997-2007 time-frame.

sometimes in the media this is presented as a surprise, but it is similar to some of the other scams that have hit the history books, e.g. the S&L machinations that involved the Keating 5 & McCain. not to point the guilty finger specifically at the Republicans, the Democrats were approximately as involved.

i had an engineer friend who worked for a while for Home123.com, one of the primary sub-prime lenders. i spent an afternoon in 2005 at one of their sales offices, just resting in one of their office chairs while i waited for a ride to go have dinner with his family. so i spent a few hours hearing the pitches. i wouldn't want to say anything my friend wouldn't appreciate but it was VERY interesting, i can say that !

 

[pockets83]

have you guys heard of the new michael moore film? that might be a good thing to watch related to this

 

[BrownTown]

Originally posted by: pockets83
have you guys heard of the new michael moore film? that might be a good thing to watch related to this

I highly doubt that a Michael Moore film will include any significant mathematical or statistical analysis to attempt to explain the recession. Such films are usually predicated around an appeal to emotion and are designed with an end in mind (the point the filmmaker is trying to convey) and as such it is highly likely only half of the argument will ever be shown.

However, on the discussion of interesting statistical approaches to evaluating what happened. I believe the point I just made above about emotions is a very important one to consider. The non-linearity of the market is due in large part to emotional responses. Small fluctuations in investments (say 10%) are not a huge deal to most people and are normally dealt with in a logical fashion. However when a person sees they have lost say 20% of their money in a month they will panic and make irrational decisions such as selling off their positions immediately which further drives prices down. Its important to note the same effect is jsut as deadly on the upswing. People will see large gains in their portfolios and increase the riskiness of their investments to try to increase gains (not keeping enough cash on hand, or investing in high risk stocks or volatile commodities). This can later result in them take huge losses when a market correction happens to adjust the prices of such stocks and commodities to a level more fitting to the fundamentals instead of the hype and speculation.

 

[deputc26]

Originally posted by: wwswimming

Originally posted by: deputc26
Interesting piece, government encouragement to offer sub-prime loans was a huge mistake but I blame the consumer as well. Consumer complacency and short-sightedness are as much to blame as the banks. All parties share the blame for the failure of a system.

Do the parties that knowingly engage in fraud related to these transactions receive (get ?) more blame than the parties that made a good faith effort to be honest ?

a loaded question, i think most people would say the parties that knowingly committed fraud get more blame.

this was a huge scam, credit derivatives & mortgage-backed securities, that is. in $ numbers, many $ trillions. the losses booked & hidden in the 2007-2009 timeframe were in the trillions, and the financial services industry that cooked up these products made many more trillions "on the way up", in the 1997-2007 time-frame.

sometimes in the media this is presented as a surprise, but it is similar to some of the other scams that have hit the history books, e.g. the S&L machinations that involved the Keating 5 & McCain. not to point the guilty finger specifically at the Republicans, the Democrats were approximately as involved.

i had an engineer friend who worked for a while for Home123.com, one of the primary sub-prime lenders. i spent an afternoon in 2005 at one of their sales offices, just resting in one of their office chairs while i waited for a ride to go have dinner with his family. so i spent a few hours hearing the pitches. i wouldn't want to say anything my friend wouldn't appreciate but it was VERY interesting, i can say that !

Are you saying that the banks and the government knowingly engaged in fraud? or are you referring to Madoff and such? I don't believe that the feds and the banks knowingly engaged in fraud but I do think that they acted irresponsibly by offering loans to EVERYONE. The consumer was equally irresponsible for accepting loans that they were not certain to be able to repay.

 

[Gannon]

Originally posted by: BrownTown
There are two reasons for this really. First is that the government encouraged (read: forced) banks to give bad loans since the idea was that everyone should be able own a house even though many are not responsible enough to make the payments.

Please don't peddle this garbage here, the government did no such thing. The banks and people doing the lending knew exactly what they were doing, up here in canada they want to know EVERYTHING about you before they even lend you any kind of money, they won't lend you money if you don't meet certain requirements, this whole american spiel about the US government forcing banks to do shit is just such a load of bullshit. Sometimes I wonder what is in the water down there that makes certain americans so batshit stupid.

http://blogs.chron.com/lorenst...9/palins_revision.html

 

[soccerballtux]

Originally posted by: Gannon

Originally posted by: BrownTown
There are two reasons for this really. First is that the government encouraged (read: forced) banks to give bad loans since the idea was that everyone should be able own a house even though many are not responsible enough to make the payments.

Please don't peddle this garbage here, the government did no such thing. The banks and people doing the lending knew exactly what they were doing, up here in canada they want to know EVERYTHING about you before they even lend you any kind of money, they won't lend you money if you don't meet certain requirements, this whole american spiel about the US government forcing banks to do shit is just such a load of bullshit. Sometimes I wonder what is in the water down there that makes certain americans so batshit stupid.

http://blogs.chron.com/lorenst...9/palins_revision.html

Lol, lalallalaa fingers in your ears. This one has been beat to death and you're late to the game, everyone knows about the CRA, and FM&FM providing poor loans.

Day late and a dollar short I'm afraid bud.

 

[ssmith232]

I know this is a late reply, but I must say that if we have politicians making economic decisions, should they not be required to have strong fundamental backgrounds in finance, accounting, or even economics. I think in the voting process we all look to charisma and the ability to unite people, but the fact of the matter is most candidates will waffle on almost any previous statement if they feel it will not him/her back in to office.

As for the comment from Gannon, I understand that you may dislike lending practices that hinder people from getting loans. But, you must understand the American taxpayers, which does include myself, must now absorb these cost. Canada as a whole has maintained a strong position during most of the global financial meltdown. As we can look to banks such as RBC. Though I do understand we all have our opinions, as a financial analyst, I see no reason to dislike the practice of fair, yet stringent lending policies.

 

[deputc26]

Originally posted by: ssmith232
I know this is a late reply, but I must say that if we have politicians making economic decisions, should they not be required to have strong fundamental backgrounds in finance, accounting, or even economics. I think in the voting process we all look to charisma and the ability to unite people, but the fact of the matter is most candidates will waffle on almost any previous statement if they feel it will not him/her back in to office.

As for the comment from Gannon, I understand that you may dislike lending practices that hinder people from getting loans. But, you must understand the American taxpayers, which does include myself, must now absorb these cost. Canada as a whole has maintained a strong position during most of the global financial meltdown. As we can look to banks such as RBC. Though I do understand we all have our opinions, as a financial analyst, I see no reason to dislike the practice of fair, yet stringent lending policies.

Well said, couldn't agree more.

 

[gsaldivar]

Originally posted by: Gannon

Originally posted by: BrownTown
There are two reasons for this really. First is that the government encouraged (read: forced) banks to give bad loans since the idea was that everyone should be able own a house even though many are not responsible enough to make the payments.

Please don't peddle this garbage here, the government did no such thing. [/L]

Wow... I guess ignorance is bliss?

Yes, the government did implicitly guarantee risky/subprime mortgages, thus encouraging banks to give them:

"Fannie Mae increases CRA [Community Reinvestment Act] options... "HUD will soon require us to dedicate 50% of our business to low- and moderate-income families," said [Franklin Raines, CEO of Fannie Mae]. He noted that since 1997 Fannie Mae has done nearly $7 billion in specially targeted CRA business with depository institutions, but its goal is to push this to $20 billion by 2010." http://www.allbusiness.com/legal/laws/674793-1.html

"The CRA is clearly far from perfect ... its net effects on lower-income neighborhoods are difficult to measure with precision ... It appears that, at least in some instances, the CRA has served as a catalyst, inducing banks to enter underserved markets that they might otherwise have ignored." http://www.federalreserve.gov/.../Bernanke20070330a.htm

"Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005. For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down." http://online.wsj.com/article/SB122298982558700341.html

"The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970 ... implicitly [promising] these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk ... beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.
Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets." http://www.cnn.com/2008/POLITI...ron.bailout/index.html

 

[jimhsu]

Looks like this is a fairly popular suggestion:



Chaos theory? Seems appropriate given the chaos that the market collapse has caused. :laugh:

I'll also add my non-technical view that the invention (and lack of regulation) of new investments like credit default swaps and other mortgage-based securities allowed somewhat unscrupulous middle-men to bundle risky mortgagaes and sell them to people/institutions that didn't understand the risks involved.

Applying distribution theory to movements in a well defined market makes sense, but I don't see how it can predict the market response when new "products" effectively redefine the market.

To be specific, "chaos theory" has nothing to do with disorder - rather, it has to do with sensitivity to initial conditions. This can be appreciated - if a company reports earnings at consensus or earnings a penny above consensus = that makes a big difference, which coalesces into larger differences (people see the stock is going up, so they buy, causing a positive feedback loop that causes it to go higher).

I read Didier Sornette's book though (Why Stock Markets Crash); lots of interesting stuff there.

 

[jimhsu]

The reason the shit hit the fan wasn't some tiny number of outliers at one end, it was the fact that a LARGE percentage of loans did not make economic sense. There are two reasons for this really. First is that the government encouraged (read: forced) banks to give bad loans since the idea was that everyone should be able own a house even though many are not responsible enough to make the payments. The other is the fact that gains and losses were not accounted for equally in individuals pay. For example if you were a banking executive an the company made alot of money, you get a large bones, if they lose alot of money they don't take away your base salary though. As such this means that there is a very limited downside to losing money, but a huge upside for making money. As such highly risky behavior is encouraged which works so long as things are going good, but as soon as they start going bad it creates a death spiral.

I wish it were just a small outliers that caused teh economic collapse, the the reality is that the MAJORITY of people live beyond their means and take excessive risk with their money.

This is summarized conveniently by the term "moral hazard". Unfortunately, TARP and friends haven't done much to fix it (rather, they have been positive reinforcement).

 

[Blackjack200]

Benoît Mandelbrot wrote a brilliant book about this very subjuect called "The Misbehavior of Markets: A Fractal View of Financial Turbulence". Definitely get if from the library or pick it up on Amazon (it's like $8).

He completely shreds CAPM and almost all the risk metrics still used in financial anaylsis today.

One of the best financial book I've ever read (and I've read many).