Stochastic Evaluation

See a History of Rating.

It seems that current practice in trading securities is for the buyer to trust the seller as to the quality of the security. This has seemed to be a civilized thing to do when the seller was an investment bank that had been in business for 158 years. Current events suggest that buyers should look closer at such investments.

Stochastic Evaluation

A recent article noted that in 1970 annual reports from investment funds would include pictures of factories—but in recent years, there were pictures of traders instead. I suspect that the 1970 pictures served the ends I advocate here except that those pictures were selected by those selling the product and thus biased.

If there were more online transparency then it would be possible to drill down thru layers of financial indirection to the real fundament economic assets, like factories and houses, in order to sample and thus assess the real value of securities. Smart yet unsophisticated investors could then see an unbiased sample of their real or proposed investment. The current system is like buying a house without knowing whether it is built on sand.

This interesting article says that some hedge funds are much more transparent than others. It mentions without endorsing some reasons that fund managers give for secrecy.

Indeed, while many investors are asking how regulators could have missed a towering Ponzi scheme, some are beginning to question the whole process of due diligence. This particular scheme seems to have been fraud; sampling is especially good for detecting fraud. A standardized form of disclosure would drastically lower the cost of sampling.

That some hedge funds are more transparent allows the hope that if investors demand transparency the problem could be solved without government intervention, aside perhaps for establishing such a standard. (Not all standards are government sponsored.)

Designing sampling strategies is tricky but robust even in an adversarial context—the sampler wins, but it is not trivial. Some such strategies rely on the veracity but not the wisdom of the sampled institutions. The current flap is over unwise investments, not lies. More complex and expensive strategies detect some sorts of fraud. We need a conceptually simple technology to see into our investments.

I hear of European banks buying billion dollar instruments based ultimately on american mortgages. What if the purchasing agent had said to the seller:

I will first evaluate the instrument with an unbiased, value weighted, sample of 10 of your fundamental assets. This would surely have revealed at least one borrower where the current value of the remaining payments exceeded the current market value of the house. I pick on European banks here only because they are presumedly more at arm’s length from the creators of the securities.

Due to the complexity of today’s derivatives, this drilling process is slightly convoluted. If the expected value of some sub-asset were contingent on being insured, by some company, then the drilling would branch, on the flip of a biased coin, to the solvency of that company. In short ‘Follow the money stochastically.’, or better ‘Sample the assets stochastically.’. Even if current financial tools don’t understand common mode failures, the smart, yet unsophisticated investor will, even if he does not know it by name.

Designing a technology and industry of such evaluation remains to be done. It is vital for the institutional investor which may be able to perform it itself. It is important to make this available to the average investor. It will take time.

The credit agencies are laughable today. Their descent began with laws that predicated certain transactions on their reports. A monopoly, especially a legislated monopoly, is fatal.

Next, the game.

Multi dimensional risk I quote:

Taleb replied: “Altimeters have errors that are Gaussian. You can compensate. In the real world, the magnitude of errors is much less known.”

I disagree with both—they both see a 1D distribution. It seems to me that you must deal with some scenario set as would a chess player.

Later:

In a crisis, Brown, the risk manager at AQR, said, “you want to know who can kill you and whether or not they will and who you can kill if necessary. You need to have an emergency backup plan that assumes everyone is out to get you. In peacetime, you think about other people’s intentions. In wartime, only their capabilities matter. VaR is a peacetime statistic.” And then:

And yet, instead of dismissing VaR as worthless, most of the experts I talked to defended it. The issue, it seemed to me, was less what VaR did and did not do, but how you thought about it. Taleb says that because VaR didn’t measure the 1 percent, it was worse than useless — it was downright harmful. But most of the risk experts said there was a great deal to be said for being able to manage risk 99 percent of the time, however imperfectly, even though it meant you couldn’t account for the last 1 percent.

something between cronyism and regulatory capture