This piece by Martin Hutchinson is a useful addendum to Stanley Morgan's piece - particularly regarding the mathematics...
B

Helicopter over Wall Street
August 12, 2007

Martin Hutchinson is the author of "Great
Conservatives" (Academica Press, 2005) -- details can
be found on the Web site www.greatconservatives.com

Federal Reserve Chairman Ben Bernanke first achieved
fame with a November 2002 speech in which he repeated
Milton Friedman’s assertion that the Fed could “drop
money out of helicopters” if deflation or a credit
crunch occurred. The Fed and the European Central Bank
now appear to be doing this, having injected $300
billion into the world monetary system in the last two
business days. What Bernanke didn’t tell us in 2002
was that his helicopter would hover only over Wall
Street.

Friedman and Bernanke were quite right that dropping
money from helicopters would provide reflation,
although since 1931-32 the United States has not had
an economy in which such an action would have been
remotely appropriate (fiat currency central banks,
being political creatures, universally err on the side
of too much, not too little money in the system.)

One can indeed imagine in a difficult economy the
welcome whirr of chopper blades as the Bernanke
helicopter carried out its mercy mission. It would
hover lengthily over the rusting steel towns of Ohio
and Western Pennsylvania, would circle twice over the
wasteland of downtown Detroit, would avoid the major
farm states, already excessively subsidized by the
U.S. taxpayer, but would provide welcome relief to the
ghettoes of Watts and the South Bronx.

What it wouldn’t do, in a world of even reasonable
equity, is spend any time over Wall Street.

The injection of money by the Fed and the ECB feeds
directly into Wall Street. It’s huge in amount -- $215
billion by the ECB and $58 billion by the Fed – and it
consists of short term loans granted by the central
banks to banks and investment banks which had been
unwilling to make interbank deposits except at a
substantial premium over the central bank’s target
short term interest rate. Admittedly the injections
are only loans – but if they are not quickly removed
they will have added around 2% to the US and EU broad
money supply. This will worsen the already serious
global inflation problem, thus exacerbating the
difficulties the world economy already faces. They
will however bail out Wall Street and its European
competitors.

The level of panic in financial markets is quite
extraordinary. Stock prices are down less than 10%
from their all time peaks, and still up on the year,
while bond yields have retreated substantially from
their recent highs and are well within their trading
ranges of the year. The only general market factor
that has changed significantly is that volatility has
increased, in other words instead of going up and down
50 or 100 points each day the Dow Jones index is now
zooming up and down 200 or 300 points, even though at
the end of the week it has gone nowhere very much.

The increased volatility is key to the entire market
turbulence, because of what can only be described as a
gross misuse of mathematics in the trading rooms of
the world.

In the capital markets of the 1960s and earlier, banks
would no more have considered hiring mathematicians
than they would have bet their entire capital in short
term speculation. With the valuation methods of that
period, mathematicians were superfluous – any
reasonably numerate accountant could understand them.
However, after the invention of the Black-Scholes
options valuation model in 1973, mathematicians came
into fashion.

The model offered the enormous benefit of providing a
“value” however spurious for any option position. This
allowed banks to offer their clients options both
direct and disguised while ”marking to market” their
trading positions at the close of each business day.
The model was however completely incomprehensible to
non-mathematicians. Bank managements therefore decided
to import some mathematicians to interpret it and act
as risk managers. This proved a sensible move; Barings
tried to run a modern trading desk with large options
positions with only Old Etonian liberal arts majors to
manage the traders, with catastrophic results

Having imported mathematicians, and recognized that if
they were going to take on these huge risks they
needed to be able to manage them, bank managements
then asked the mathematicians to produce a risk
management metric. Unfortunately bank managements did
not suspect mathematics’ most closely guarded guilty
secret: only a tiny minority of possible equations are
solvable using currently existing mathematical
techniques.

Rather than confessing failure and losing their jobs,
which were paid beyond the wildest dreams of
mathematical academia, the mathematicians therefore
bent the reality to fit the equations they could
solve, and came up with the “Value at Risk”
methodology. By assuming that securities prices move
continuously with no jumps, that they are random and
normally distributed, and that market trends don’t
exist, mathematicians were able to produce a risk
management model that was convincing to top management
and worked most of the time. The occasions on which
the models didn’t work were dismissed as market
anomalies, although in reality it was the models not
the markets that were anomalous.

Value at Risk suffers from two main defects. One is
that it breaks down in times of market turbulence; the
theoretical maximum “value at risk” can be an
arbitrarily small fraction of the true risk when
things go wrong.

The other is the way VAR deals with volatility. Under
VAR, the risk of a position depends on its volatility,
so that if volatility changes suddenly the risk
changes also. Banks measure volatility either based on
the past average over a 30 day period, or from the
prices of some widely traded option contracts (these
two methods can produce widely different estimates of
volatility.) When volatility changes – either very
volatile days are introduced into the average or
options prices jump – the VAR of the position changes
also.

If as in the last few weeks markets suddenly become
more volatile after a lengthy period of calm the VAR
of every position held by a large bank suddenly jumps,
generally to a multiple of its previous level. In such
cases, even if markets don’t overall move that much
(as they haven’t in equities markets, down less than
10% from their peak) the bank has to reduce its
positions. Since all participants are looking at the
same volatilities, every bank and hedge fund is forced
to unwind its trades and reduce its positions at the
same time. Needless to say, this produces highly
unstable markets, which themselves increase volatility
and exacerbate the problem.

This is the first time the markets have done this
since the introduction of VAR in the early 1990s, with
the limited exception of the Long Term Capital
Management crash in 1998. In 2000-2002, the equity
bear market was not accompanied by any increase in
volatility in other markets and was fairly orderly.
This was a sign that the cathartic effect of the bear
market, aborted by Fed Chairman Alan Greenspan’s
massive injection of liquidity into the US economy,
did not go nearly far enough to wipe out the
over-optimism and gullibility of the late 1990s
bubble.

Needless to say this bizarre effect of current risk
management techniques has now resulted in a market
panic, quite unjustified given the modest movements in
the stock and bond markets themselves. The ECB and the
Fed have reacted to the panic rather than the markets,
and have bailed out European and US banks with oceans
of additional liquidity. This of course has introduced
moral hazard into the system in large amounts, if we
are unlucky and the central banks’ liquidity
injections stabilize the market and allow unjustified
speculation to resume. Hopefully the liquidity
injections won’t work and the long overdue corrective
market crash will overwhelm the speculators.

Whether this somewhat artificial panic will cause the
Fed to abandon inflation control altogether and drop
interest rates remains to be seen. If it does so the
rest of the world will suffer from a 1970s style
stagflation in which savings, jobs and above all
retirement incomes become highly insecure. At that
point we can reflect gloomily upon the second rate
mathematicians hired by Wall Street and the second
rate central bankers whose helicopters never assist
the middle class or the poor.

Contrary to populist theory, it is fiat money,
controlled by politicians and unaccountable central
bankers, and not the deflationary but mechanistic Gold
Standard, that is the true instrument of Wall Street.

login or register to post comments