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Harassment is an Art, Not a Science

08-Jun-10

The TSA continues to find new and innovative ways of harassing airline passengers:

TSA screeners trained to pick out suspicious or anomalous behaviour in passengers. There are about 3,000 of these officers working at some 161 airports across the United States, all part of a four-year-old programme called Screening Passengers by Observation Technique (SPOT), which is designed to identify people who could pose a threat to airline passengers. [link]

I found this off the Economist‘s travel blog, Gulliver:

The programme, known as SPOT, for “Screening Passengers by Observation Technique,” is intended to allow airport security officers to use tiny facial cues to identify people who are acting suspiciously. The British government is currently launching a new screening regime modelled on the Americans’ SPOT. There’s just one problem with all this: there’s no evidence that SPOT is actually effective. [link]

The creator of such techniques, is a psychologist Paul Ekman.

In the 1970s, Ekman co-developed the ‘facial action coding system’ for analysing human facial expressions, and has since turned it into a methodology for teaching people how to link those expressions to a variety of hidden emotions, including an intent to deceive. He puts particular emphasis on ‘microfacial’ expressions such as a tensing of the lips or the raising of the brow — movements that might last just a fraction of a second, but which might represent attempts to hide a subject’s true feelings. [link]

The only problem is that the technique is not scientifically valid.

“Simply put, people (including professional lie-catchers with extensive experience of assessing veracity) would achieve similar hit rates if they flipped a coin,” noted a 2007 report1 from a committee of credibility-assessment experts who reviewed research on portal screening.

“No scientific evidence exists to support the detection or inference of future behaviour, including intent,” declares a 2008 report prepared by the JASON defence advisory group. And the TSA had no business deploying SPOT across the nation’s airports “without first validating the scientific basis for identifying suspicious passengers in an airport environment”, stated a two-year review of the programme released on 20 May by the Government Accountability Office (GAO), the investigative arm of the US Congress. [link]

The TSA (after doing this since 2006) is now commissioning a study to see if it actually works.

In response to such concerns, the TSA has commissioned an independent study that it hopes will produce evidence to show that SPOT works, and the DHS is promising rigorous peer review of its technology programme. For critics, however, this is too little, too late. [link]

This from the organization that allowed at least one (unsuccessful) terrorist onto an airplane, and has harassed countless numbers of non-terrorists. I’m not holding my breath. First, it was nail clippers, then liquids, then shoes. Now what? Faces? Underwear? This is definitely another area that requires radical reform. Most importantly, people need to realize that the real work is not done in airports, but outside them.

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An Interesting Debate

08-Jun-10

I found this on Capital Gains and Games, but really, it is a debate (mostly) between Paul Krugman and Raghuram Rajan. Here is a brief synopsis:

Of all the canards that have been offered about the financial crisis, few are more repellant than the claim that the “real cause’’ of the mortgage meltdown was blacks and Hispanics.

Oh, excuse me — did I just accuse someone of racism?   Sorry.  Proponents of the above actually blame the crisis on “government policy’’ to boost home-ownership among low-income families, who just happened to be disproportionately non-white and immigrant.  Specifically, the Community Reinvestment Act “forced’’ banks to make bad loans to irresponsible borrowers,  while Fannie Mae and Freddie Mac provided the financial torque by purchasing billions worth of subprime paper.

The argument has been discredited time and again, shriveling up almost as soon as it’s exposed to sunlight.  But it keeps coming back, mainly because the anti-government narrative gives Republicans a way to deflect allegations that de-regulation allowed Wall Street to run wild.   It’s the financial version of Sarah Palin’s new line that “extreme environmentalists”  caused the BP oil spill.

Paul Krugman caught a whiff of it in a recent commentary by Raghuram Rajan in the FT, and quickly denounced it. [link]

Here’s what Rajan said:

The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet. Chastise the banker who hankers after his bonus, but also pity him for he is looking for his primary measure of self-worth to be restored. Rather than attempting to instill social purpose in him, however, it is probably more useful for society to target the forces that distorted the market. [link]

And here’s Krugman’s response:

That’s a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don’t listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it’s not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties:

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:

while securitization by private players surged:

Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It’s convenient to believe that somehow, this is all Barney Frank’s fault; and so that belief will continue. [link]

The debate continues here, as Rajan responds to Krugman.

To complete the circle, let’s go back to Capital Gains and Games. Here’s the last word on the debate from Edmund Andrews:

The big lesson here was not about government distortions to the market (except perhaps the Fed’s low interest rates).  The big lesson here was that unrestrained, unregulated lending practices by the private sector can be dangerous for consumers and for the financial system as a whole.   To the extent that “government policy” contributed to the crisis, the first failure was in not stopping the reckless private-sector lending and the second failure was in not stopping Fannie and Freddie from following suit. [link]

‘Nuff said, I think. And rightly so.

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FAIM 608: Spreadsheets Uploaded

03-Jun-10

I’ve uploaded some spreadsheets to help you with:

  1. Understanding conversion factors.
  2. Convexity adjustments.
  3. Solving Problem 3.23.
  4. Understanding the relationship between futures and expected spot using CAPM (from Chapter 5).

See the sidebar to the right (Lectures 6, 7 and 8).

I’ll be talking about #s 1, 2 and 3 in class today. See you then.

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Banning Naked CDSs

24-May-10

A little late in the posting, but Brad Delong on banning naked CDSs:

I say, narrowly, no–that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can’t get proper clearing, transparency, and capital adequacy requirements in place then we should ban them.

Let’s go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:

  • They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away to others, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given the magnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurance make a positive expected value bet.
  • Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.
  • People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets, and everyone else wins because after they have bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:

  • People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.
  • People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.
  • A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else’s information through insider trading.
  • A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression. [link]

I agree. He goes on to quote Geithner:

My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome…. [T]he absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system… [link]

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Rated XXX

24-May-10

While the reform bill has gone through, there is still a lot of cleaning up to do. The WSJ talks about firms that can still shop around the ratings agencies, getting the best “deal” for themselves:

In the wake of the financial crisis, the companies that rate bonds have been lambasted for being asleep at the switch and for assigning rosy ratings to questionable mortgage bonds in order to win business. Those ratings companies have made numerous changes, but one thing remains the same: Issuers still “ratings shop” among firms for the most favorable opinions on deals.

The fate of ratings-shopping now hangs in the balance. The financial-regulation overhaul bill passed by the Senate on Thursday would limit the ability of bond issuers to pick firms to rate their securities. But the House version of the bill contains no such provision, and some key lawmakers have raised concerns about the idea. It remains to be seen whether the proposal will survive as the two chambers begin efforts Monday to reconcile their differences. [link]

Quite simply, paying agencies to rate something for you is a clear conflict of interest. This is a huge problem, and poses serious future risks. We shall see what develops, but methinks not too much is going to change down the line. Maybe next time…

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FAIM 608: Hunt Brothers (Japanese Version) And Copper Hoarding

13-May-10

If you thought the Hunt brothers story we discussed in class had a moral which was implemented, think again. It was repeated almost two decades later, with very similar consequences. This time though, it wasn’t silver, it was copper. And it wasn’t the US, it was Japan. And the firm was in on it. And just when you think it couldn’t get worse – so were the Chinese. What a sordid tale.

The world copper market is immense; nonetheless, a single trader, apparently, was able and willing to dominate that market. You might have thought that the kind of secrecy required for such a massive market manipulation was impossible in the modern information age–but Hamanaka pulled it off, partly by working through British intermediaries, but mainly through a covert alliance with Chinese firms (some of them state-owned). And as for the regulators … well, what about the regulators? [link]

We will be talking more about copper and the consequences of hoarding copper today in class, when we discuss commodity futures, backwardation and do the contango (not an Argentian dance). Meanwhile, here’s something from The Economist‘s Buttonwood:

A commodity ETF will normally buy the future, not spot, to avoid storage costs.  But sometimes the commodity will be in backwardation (futures prices are below spot) and sometimes in contango (futures are above spot). Backwardation gives futures funds an additional positive return, as they buy low and sell high; contango reduces the return, leaving the futures buyer trailing the spot. And a lot of markets have been in contango. [link]

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Does This Pop Your Corn?

11-May-10

Since we’re talking about movies and documentaries today, this post from Marginal Revolution rounds out the trifecta pretty well:

I’ve lately found a new empirical paper on why popcorn is so expensive in the movie theater.  The authors are Ricard Gil and Wesley Hartmann.  Here is the abstract:

Prices for goods such as blades for razors, ink for printers and concessions at movies are often set well above cost. Theory has shown that this could yield a profitable price discrimination strategy often termed “metering.” The idea is that a customer’s intensity of demand for aftermarket goods (e.g. the concessions) provides a meter of how much the customer is willing to pay for the primary good (e.g. admission). If this correlation in tastes for the two goods is positive, a high price on the aftermarket good allows firms to extract a greater total price (admissions plus concessions) from higher type customers. This paper develops a simple aggregate model of discrete-continuous demand to motivate how this correlation can be tested using simple regression techniques and readily available firm data. Model simulations illustrate that the regressions can be used to predict whether aftermarket prices should be above, below or equal to their marginal cost. We then apply the approach to box-office and concession data from a chain of Spanish theaters and find that high priced concessions do extract more surplus from customers with a greater willingness to pay for the admission ticket.

In other words, price discrimination is one (not the only) plausible rationale for why popcorn is so expensive at the movie theater, relative to marginal cost.  For other MR posts, on this problem, type “popcorn” into the MR search box on the left hand side of the page. [link]

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Wall Street Alchemy

11-May-10

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Back To The Futures

11-May-10

In March, we read that Cantor Fitzgerald was about to monetize the moviegoing industry by taking what the website HSX.com had done with play money, and bringing it to the real world. For those of you who have not heard of HSX (short for Hollywood Stock Exchange), it is a site where you can bet play money on whether a movie will be a hit or a flop, and get little more than bragging rights if you are right. That site was bought by Cantor Fitzgerald back in 2001, and they hoped to lure people from movies into other commodities exchanges.

Somewhere along the way, they changed their mind about luring people to futures contracts for other commodities, and decided to create a futures exchange on a movie’s box office receipts. Gains and losses are based on people’s expectations of how well (or badly) a movie will do.

In the real market, contracts on the Cantor exchange will trade at $1 for every $1 million a movie is expected to bring in — a figure determined by traders — at the domestic box office during its first few weeks in theaters. So if “Robin Hood” is expected to bring in $100 million in its opening weeks, a single contract could be bought for $100 by a trader who thinks Russell Crowe’s role in the movie will drive sales far above expectations. If that trader guesses right, and the movie sells $150 million in tickets, the trader makes $50. [link]

While people’s expectations are one thing, they are not necessarily correct. Apparently, they were completely off about Avatar at HSX, with most users predicting that it would flop. Still, if your expectations don’t match up with the majority, you could always go short.

If a distributor thinks a movie it is backing will struggle at the box office, the company can sell contracts in the futures market. If the distributor shorts a $100 contract and the movie grosses $50 million, the distributor will make $50, thereby limiting the company’s total losses from a film.

Cantor is in the process of getting approval from the Commodity Futures Trading Commission (which regulates futures markets). It things work out, it looks like a movie which initially ruined your mood could then later improve it with your futures gains on its box office receipts.

The creation of this exchange is very timely, as The Economist just had an article last week about how, despite older populations and decreasing GDP, people are flocking to the cinemas. (Is it an inferior good? Discuss). Box office revenues are seeing surprising increases in the age of the internet, DVDs and piracy.

Since 2005 North American box-office receipts have risen by 20%. Ticket sales grew strongly during the recession, as people sought a cheapish night out, and have not slowed. Box Office Mojo, which tracks films, estimates that box-office receipts this year are running at 6% above last year’s level. Elsewhere cinema is healthier still. Ticket sales outside America and Canada have risen by 35% since 2005 and are now worth about two-thirds of the global total. A boom in multiplexes—that is, cinemas with at least eight screens—is unlocking latent demand. In 2006 Russians made a total of 89.5m visits to the cinema. Last year they made 132.3m. This is especially surprising in a country where the number of young people is falling. [link]

Despite growing profits, however, Hollywood is not happy about a futures exchange on itself. Felix Salmon writes, in an op-ed piece in the NYT:

Hollywood’s mouthpiece, the Motion Picture Association of America, has argued that the new market could tarnish “the reputation and integrity of our industry” and would constitute “unbridled gambling” — though there’s nothing “unbridled” about the regulatory strictures involved in being listed on a Chicago commodity exchange.

The real reason…is probably simply the age-old story of large, conservative institutions being averse to change. [link]

I don’t know what they mean when they talk about “reputation and integrity” (case in point: Starship Troopers), and they are only “shooting themselves in the fiscal foot,” as Salmon says, by resisting the creation of these contracts. He rightly brings up the case of futures on onions, a story that would bring a tear to one’s eye:

IN the 1950s, onion growers were often shocked at the low prices they were getting. Casting around for a villain to blame, they alighted on derivatives traders, and they persuaded Congress to ban any futures trading in onions.

Today onions are the only commodity for which futures trading is banned. Not coincidentally, onion prices remain extremely volatile: they doubled in 2008, and then fell by 25 percent in 2009. [link]

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New Discount on Swaps: Section 106

04-May-10

Last week’s The Economist has a write-up on the new regulations that will eventually control the several trillions of dollars of notional amounts underlying the OTC derivatives that are currently being traded. Firstly, it seems that the political theatre that was the Goldman scandal had some effect:

The fraud charges filed against Goldman Sachs, over synthetic derivatives, emboldened those looking to crack down on exotic instruments. On April 21st the Senate’s Agriculture Committee—which oversees the Commodity Futures Trading Commission (CFTC)—passed a surprisingly draconian set of derivatives provisions. Elements of this will be offered as an amendment to the main bill. [link]

The main part of the bill on the table is Section 106 which will deny access to the Fed’s discount window to those banks that trade swaps. The Fed’s discount window, as some of you may know, is that part of the central bank that lends directly to banks. The discount rate (the lending rate from the discount window) is usually about 100 basis points above the Fed Funds rate, which is the bank-to-bank lending rate. When banks can’t find other banks to provide them with some cash, they go to the Fed. In times of crisis, the discount window proves to be quite useful, and that is why, over the last two years or so, the Fed decreased the spread between the discount rate and the Fed Funds rate to 50 basis points, and extended the lending period from overnight to 30 days, and then to 90 days.

Whether the section is a bargaining chip or not, denying access to the discount window, the article states, will send banks scurrying off to spawn non-bank subsidiaries that do trade swaps, so not sure if that will change anything apart from inconvenience them. However, the parties most hurt by this are those who actually use the derivatives for hedging risk, e.g., airlines to hedge against rises in jet fuel prices, also known as “end-users”:

Many of those end-users, which collectively hold 10-15% of OTC derivatives outstanding, also want exemptions from clearing. Without one, they argue, increased collateral requirements for cleared trades would make hedging their everyday risks much more expensive. As things stand, some commercial firms would get an exemption, while others—such as sweetmakers hedging against swings in sugar prices—would not. [link]

We shall see how this unfolds. Meanwhile, entrepreneurs looking to cash in on the new regulations – here’s your next business idea: Start a derivatives exchange.

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