For banks, nothing is illegal

This would be literally unbelievable, except that we've all become desensitized to the double standard of our justice system -- enforcement of laws against ordinary people, and systematic collusion with large banks and corporate offenders to keep anyone from going to jail. I think Matt Taibbi offers the most honest take on this shameful decision to slap HSBC with fines only, rather than pursuing what should have been slam-dunk prosecutions for money laundering and drug smuggling on a global scale:

Wow. So the executives who spent a decade laundering billions of dollars will have to partially defer their bonuses during the five-year deferred prosecution agreement? Are you fucking kidding me? That's the punishment? The government's negotiators couldn't hold firm on forcing HSBC officials to completely wait to receive their ill-gotten bonuses? They had to settle on making them "partially" wait? Every honest prosecutor in America has to be puking his guts out at such bargaining tactics. What was the Justice Department's opening offer – asking executives to restrict their Caribbean vacation time to nine weeks a year?

So you might ask, what's the appropriate financial penalty for a bank in HSBC's position? Exactly how much money should one extract from a firm that has been shamelessly profiting from business with criminals for years and years? Remember, we're talking about a company that has admitted to a smorgasbord of serious banking crimes. If you're the prosecutor, you've got this bank by the balls. So how much money should you take?

How about all of it? How about every last dollar the bank has made since it started its illegal activity? How about you dive into every bank account of every single executive involved in this mess and take every last bonus dollar they've ever earned? Then take their houses, their cars, the paintings they bought at Sotheby's auctions, the clothes in their closets, the loose change in the jars on their kitchen counters, every last freaking thing. Take it all and don't think twice. And then throw them in jail.

Sound harsh? It does, doesn't it? The only problem is, that's exactly what the government does just about every day to ordinary people involved in ordinary drug cases.

And people wonder why the US falls year after year a little further down the Corruption Perceptions Index? As of 2012, we're just slightly ahead of Chile, Uruguay and The Bahamas. 

Elements of a stable financial system

It's hardly a hell raising demand for revolution, but this speech by Michael Cohrs of the Bank of England is worth a quick read and offers some pretty encouraging signs that authorities -- in the UK, at least -- are moving (slowly) toward financial regulations that seem pretty sensible and might really help avoid future crises or make them less frequent. I read it as a kind of wish list, but of wishes that are fairly realistic.

On a theoretical level, perhaps the most important thing Cohrs calls for is greater awareness of economic and financial history, with the idea that we might prepare our minds better for the natural instabilities that seem to create crises so frequently:

At the heart of much of the current policy debate is how the FPC, PRA and FCA develop better processes for anticipating the next problem – whether the problem is an asset bubble, poor risk mismanagement or a flawed or misunderstood financial product. And these are important steps to take. But it seems to me there is an inherent tendency for policymakers to re-fight the last war. As I said above, I am a believer that understanding the past provides a foundation on which to assess the future. But we shouldn’t pretend we can eliminate financial crises completely. Nor that the next crises will necessarily be a carbon copy of the last one.

My anxiety about getting financial regulation to better mitigate future risks has its roots in the issues one sees in the financial crises of the past couple of hundred years or so. Virtually every type of financial institution has been the cause of a crisis at some point in history – country banks back in 1825, universal banks in 1931, small banks in the 1970s, savings and loan companies in the 1980s, international banks in the 1980s and 1990s (debt crises in Latin America and Asia respectively), and even a hedge fund in 1997.

Pretty much all types of financial institution got involved in the problems of 2007/2008. The roll call included insurance companies (although thankfully not those in the UK) alongside investment banks as well as some more traditional commercial and mortgage banks. I find it hard to see a common thread (other than high leverage ratios) amongst the types of institutions that struggled or the mistakes that they made. It is not clear that the reforms we are putting into place today would have, or could have, averted all the problems faced in these crises. Therefore, experience tells me its origins are unlikely to be in an institution and from a product that is obvious to us now. ... I realize this uncertainty is rather unhelpful.

Actually, I think it is very helpful. Nothing is more dangerous than belief that now , as we know how things can go wrong, we can probably perform a few engineering tricks and hence avoid further problems in the future. This was the facile belief furthered in the decade prior to the past crisis, especially in basic textbooks of economics and finance and research papers furthering belief in the inevitable "spiral to efficiency" of modern markets (infamously described in this rather embarrasing 2005 paper by Robert Merton and Zvi Modie, which was published even as the markets were on the verge of collapse!).

Cohrs goes on to discuss a number of ideas all being pursued with the idea of making finance more "sustainable." These include establishing simple rules by which large institutions can be wound down and let fail safely when they ought to (this might include using penalties or taxes to establish insurance funds beforehand to handle such events), making financial institutions LESS CONNECTED and changing the culture of finance as well so that financial institutions themselves "ensure they can be regulated." Ok, that final one may be a rather huge challenge.

The good thing is that people from the Bank of England are going around saying these things. Let's hope they can manage to put some of these principles in place, especially in some globally consistent way.

The Leverage Cycle

My latest Bloomberg column will appear sometime Sunday night, I expect. I wanted to give readers a few links here to various key papers of John Geanakoplos on the leverage cycle, as well as a little further discussion of a few points.

First, this is the most detailed paper Geanakoplos has published (as far as I know) describing the leverage cycle -- the natural feedback process that repeatedly drives economies through cycles in which leverage rises, driving increasing asset prices, and then falls as investors become uncertain, more cautious, and demand more collateral, Prices then crash down accordingly. His argument is that leverage (determined by collateral rates) is a key macroeconomic variable completely independent from interest rates, and often just as important to the economy at large. In particular, increasing (decreasing) leverage is one key direct cause of increasing (or decreasing) prices. As evidence, look at the figure below for housing prices from 2000 through 2009. It shows how the average down payment required for sub-prime mortgages went up and then down, in both cases just in advance of housing prices. (Okay, this isn't proof of a causal link, I suppose, but it's enough to convince me.)

But before reading the "serious" paper I recommend first reading the text of this talk that Geanakoplos gave two years ago in Italy. It's much less formal and makes all the main points in a clear way.

From a practical point of view, I think two things stand out to me in his arguments:

First, given the clear importance of leverage in driving economic outcomes, it is quite remarkable that the Federal Reserve Bank has not in the past made any systematic effort to collect the kind of data it would need to monitor average collateral rates in the economy. Between 2000 and 2005, for example, no one at the Fed was going to banks and collecting information on how much collateral they were demanding when lending. This was just not considered a crucial macroeconomic variable. Judging from the tone in his talk, Geanakoplos finds this pretty amazing too. He mentions that the Fed contacted him in 2008 or so to get hold of data of this kind that he had collected. It seems that the Fed has now accepted the systemic importance of leverage and is seriously considering including leverage as a key variable in future macroeconomic monitoring. Whether banks and hedge funds will be required to report leverage levels, I don't know, but this idea is at least on the table. Good thing, I think.

A second interesting point is one that seems kind of obvious in retrospect. The leverage that drives the rise of prices in Geanakoplos's picture is leverage in long positions, which enables optimistic investors to buy more than they would otherwise be able to buy. Leverage in the opposing sense, short leverage allowing pessimists to speculate on a collapse in the market, would act to depress prices. Hence, it is probably more than a little significant that credit default swaps (CDS) for mortgage backed securities were created in 2005. These most likely acted as a key trigger of the beginning of the crash. As Geanakoplos writes,

In my view, an important trigger for the collapse of 2007–9 was the introduction of CDS contracts into the mortgage market in late 2005, at the height of the market. Credit default swaps on corporate bonds had been traded for years, but until 2005 there had been no standardized mortgage CDS contract. I do not know the impetus for this standardization; perhaps more people wanted to short the market once it got so high. But the implication was that afterward the pessimists, as well as the optimists, had an opportunity to leverage. This was bound to depress mortgage security prices. ... this, in turn, forced underwriters of mortgage securities to require mortgage loans with higher collateral so they would be more attractive, which, in turn, made it impossible for homeowners to refinance their mortgages, forcing many to default, which then began to depress home prices, which then made it even harder to sell new mortgages, and so on. I believe the introduction of CDS trading on a grand scale in mortgages is a critical, overlooked factor in the crisis. Until now people have assumed it all began when home prices started to fall in 2006. But why home prices should begin to fall then has remained a mystery.

...Of course, if CDS were introduced from the beginning, prices would never have gotten so high. But they were only introduced after the market was at its peak.

Not that the crisis wouldn't have happened in the absence of CDS contracts, but they probably hastened the collapse.

Finally, on a related matter, I think many people may find good value in this article by Ray Dalio, head of Bridgewater Investments. This is Dalio's attempt to give a simple explanation of "how the economy works" and he puts the expansion and contraction of credit at the very center. He is essentially making much the same argument as Geanakoplos, but in a less formal way. Fun to read and very instructive, in my opinion.

Transparency, no -- people might know they're being screwed

By way of Money Science, I had to read this twice just to believe I hadn't misread it. The argument is that transaction charges on credit cards should NOT be transparent to the customer because the customer might then feel cheated, become angry and upset, etc. Better if those charges were lumped into the bulk price of the purchase so the buyer won't know what the bank is charging. Don't upset people with things like this:

...the card operators and issuers are ripping off customers by taking percentage fees opaquely.  These fees are applied throughout the process, and the lack of visibility of charging means that customers don’t know they’re being ripped off.
The solution: more transparency.
Now I can see the argument and solution rationale, but I fundamentally disagree with it.
The reason I disagree is that customers are not rational when it comes to money.
They will happily pay fees to ATM operators, currency exchanges, PayPal and more if it is convenient and supports instant gratification.
I should know, as I’m one of them.
Do I count the fees and the breakdown of costs for every transaction?
No.
Do I object when I see the cost of a transaction?
Yes.
Take the example of booking an airline ticket and you see that there is £4.50 ($6) charge for booking the ticket using a credit card.
Do we get upset with the airline?
No.
Are we pissed off with the card company and the bank?
Yes.
Or take the example of my own bank who recently started itemising cross-border transactions with the charge per transaction.
Do I appreciate the transparency?
No.
Do I object to the fee per transaction?
Of course I do.
In other words, customers would far rather prefer everything bundled into one charge where the bank fees are hidden, rather than seeing the fees per transaction itemised explicitly.

Uh, no, actually, I'd rather see the fees made explicit. That way I think the company charging the fee might think twice about my reaction to it. What do others think?

A new take on causality

It's not often that something fundamentally new comes along on the topic of causality. That notion is one of the most basic concepts in science and philosophy, indeed in all human thinking (non-human as well, I would guess). Finding causal links helps us interpret the world, make predictions, render the unpredictable environment around us a little less unpredictable. But we still have a lot to learn about causality, and especially how to infer causal links using data.

This is clear from a fascinating recent study that I think will ultimately have quite an impact on applied studies of causal links in fields ranging from economics and finance to ecology. This paper by George Sugihara and colleagues -- its entitled "Detecting Causality in Complex Ecosystems" -- is well worth a few hours of study, as it explores some history of attempts to detect causal links from empirical data and then demonstrates a new technique that appears to be a significant advance on past techniques. 

The key problem in inferring causal links from data, of course, is that mere correlation does not imply causation. The two things in question, A and B, might both be linked to some other causal factor C, but actually have no causal links running from one to the other. In economics, Clive Granger became famous for proposing, in this paper 1969, a way to go beyond correlation. He reasoned that if some thing X causally influences some other thing Y, then including X in a predictive scheme should make predictions of Y better. Conversely, excluding X should make predictions worse. Causal factors, in other words, can be identified as those that reduce predictive accuracy when excluded.

This notion of ‘Granger causality’ makes obvious intuitive sense, and has found many applications, especially in econometrics. However, read the original paper and you quickly see that the theory was developed explicitly for use with stochastic variables, especially in linear systems. As Granger noted, “The theory is, in fact, non-relevant for non-stochastic variables.” Which is unfortunate as so much of the world seems to be more suitably described by nonlinear, deterministic systems.

I've just written for Nature Physics a short essay describing the Sugihara et al. work. I assume many people won't have access to that article (oddly enough, I don't either!) so I thought I'd include a few words here. One problem with Granger causality, the authors point out, is that intimate connections between the parts of any nonlinear system make ‘excluding’ a variable more or less impossible. They demonstrate this for a simple nonlinear system of two variables describing the direction interaction of, say, foxes and rabbits. Call the populations X and Y. Following Granger, you might exclude Y and see if you can predict X. If exclusion of Y reduces your ability to predict, then you've found a causal link. But this recipe yields nothing in this case, because of the nonlinearity. The mathematical model they study definitely, by construction, has a causal links between the two. But the Granger method won't show it.

Why? A key result in dynamical system theory — known as the Takens embedding theorem — implies that one can always reconstruct the dynamical attractor for a system from data in the form of lagged samples of just one variable. In effect, X(t) (fox numbers in time) is always predictable from enough of its earlier values. Hence, excluding Y doesn’t make X any less predictable. The notion of Grange causality would erroneously conclude that Y is non-causal.

To get around this problem, Sugihara and colleagues use the embedding theorem to their advantage. The reconstruction trick can be done for both variables X and Y. I won't dwell on technical details which can be found in the paper, but this yields two mathematical "manifolds" -- essentially, subsets of the space of possible dynamics that describe the actual dynamics that happen. Both of these describe the dynamical attractor of the entire system, one using the variable X, the other the variable Y. Now, sensibly, if X has a causal influence on Y, one should expect this influence to show up as a direct link between the dynamics on these two manifolds. Knowing states on one manifold (for Y) at a certain time should make it possible to know the states on the other (for X) at the same time.

That IS technical, but it's really not complicated. The original paper offers links to some beautiful simulations that aid understanding. The strength of the paper is to show how taking this small step into dynamical system theory pays big results. To begin with, it gives superior performance over the Granger method for several test problems. More impressively, it appears to have already resolved an outstanding puzzle in contemporary ecology.

Ecologists have for decades debated what’s going on with two fish species, the Pacific sardine and northern anchovy, the populations of which on a global scale alternate powerfully on a decadal timescale (see fig below). These data, some suggest, imply that these species must have some direct competition or other interaction, as when the numbers of one go up, those of the other go down. Failing any direct observation of such interactions, however, others have proposed that the global synchrony betrays something else — global forcing from changing sea surface temperatures which just happen to affect the two species differently.



Strikingly, the results from the new method -- Sugihara and colleagues give it memorable name "convergent cross mapping" -- seem to resolve the matter in one stroke. The analysis shows no evidence at all for a direct causal link between the two species, and clear evidence for a link from sea surface temperature to each species. In this case, the correlation is NOT reflecting causation, but simultaneous response to a third factor, though a response in opposite directions.

So there you go -- following the basic ideas of dynamical system theory and actually reconstructing attractors for nonlinear systems makes it possible to tease out causal links far more powerfully than correlation studies alone. This is a major advance on our understanding of causality and I find it hard to believe this technique won’t find immediate application in economics and finance as well as in ecology, neuroscience and elsewhere. If you're involved in time series analysis, looking for correlations and causal relations, give it a read. 

Weird and puzzling browser phenomenon

As a curiosity, I wonder if anyone out there can explain a peculiar phenomenon. When I click on a hypertext link on a web page -- this one, for example -- I typically right-click and then choose "Open Link in New Tab." That way I keep the original page open while also opening the new resource. Do this on the link above and the new tab will display the excellent page of Simolean Sense, a weekly collection of generally great articles from around the web related to human psychology and behavior, finance, biology, mathematics and other such things.

Now the mysterious phenomenon -- Simolean Sense is the ONLY web site I have ever visited where right clicking on links doesn't work for me in a reliable way. On that site, when I right click on a link, typically nothing happens. At first. I have to right click repeatedly, 2, 3,4,5, 8 times, until finally the box opens to show the "Open Link in New Tab" option. It's a completely random phenomenon. (I just noticed that left clicking gives odd behavior too.) My clicking just doesn't work in a reliable way on Simolean Sense, though it does everywhere else. Why is that?