Written and Sponsored by : The QFG Global Investments.
Last week MS reported they lost more than $3.7 billion in a trade gone bad, i.e., a bet on the decline of a portfolio of mortgage securities. MS is traditionally known as one the blue chip global investment banking companies, founded after the crash of 1929 by partners of the legendary J.P. Morgan.
MS usually makes a large percentage of its revenues from the advisory business and underwritings. Apparently to keep up with its rivals in the IB space MS engaged in the origination and trading of mortgage securities, based on the classical theory of finance, backed by sub-primed loans.
The trade:
The trade apparently was originated on the MBS trading desk staffed by Ph.Ds from Ivy League schools most likely. Most of these Ph.Ds have been trained in the classical theory of finance, i.e., the efficient market hypothesis, and the normal distribution. At GOIH Quantitative Finance Group, we have discarded classical financial theory, and adopted a new theory of finance based on, The Correlated Law of Large Numbers and The Behavioral Dynamics of Inefficient Market Theory. Both of these theories we originated and tested by our staff of quantitative professionals.
At MS the trading desk went short on $10 billion of MBS rated BBB with the theory that the market would continue to deteriorate and the portfolio would decline in value. Since MS was short as the portfolio declined in value they would make a profit on the trade. To execute a trade of this size MS had to find a counterparty willing to take the other side of the trade, i.e., a bet that the portfolio would not decline in value. There are only a few counterparties in the market with the credit rating and assets to execute a trade of this size, most likely a hedge fund or another investment bank whose trading desk has similar models of the MBS market.
To hedge its position MS went long on $1.0 billion of AAA rated subprimes thinking that the AAA rated bonds would hold their value even if the market turned and cause the $10 billion portfolio to decline in value. The AAA tranche was structured so the loss did not accumulate in the senior portion of the issue until a certain loss ratio was achieved.
Because MS Ph.Ds are trained in the classical theory of finance and their models were based on the normal distribution, certain assumptions were built into the trade, i.e., certain default scenarios are assumed based on a normal distribution and the standard deviation from the mean. Most likely the simulation MS ran to initiate the trade said the likelihood of the mortgage market melting down was a “5 sigma” event. That is the likelihood of the meltdown occurring was 1 in 50,000,000, this appears to be a safe bet. However, because the models are not based on actual market dynamics but on classical dynamics the models have flaws contained in their assumptions. The classical theory of finance is the equivalent of Newtonian physics which worked at speeds, i.e., velocities much less than the speed of light. However, Einstein proved there is a relativistic effect as velocities approached the speed of light, i.e., the classical theory failed to accurately predict certain scenarios. The models currently being used by the major investment banking companies are based on the classical theory of finance and failed as velocity, i.e., investor emotions and psychology, approach a threshold value, the Fear Indicator—(speed of light).
It is GOIH Global Capital Markets theory that in the modern economy where the markets are linked and communications technology enables information to propagate at the speed of light through the internet and other high speed communication networks, the investor Fear Indicator is equivalent to the speed of light in Newtonian physics and a new theory of finance-----a relativistic theory of finance----is needed to account for this new and rapid spread of investor sentiment. Stochastic investor sentiment is the “ether” of the relativistic theory of finance in the 21st century.
This new propagation of investor sentiment is not properly modeled using the normal distribution and a new probability distribution function is needed to accurately take into account several new variables of statistical behavioral finance the new relativistic theory of finance demands. We at GOIH and our Quantitative Finance Group have created the tools and the models to accurate predict market dynamics and events leading us to accurately model the performance of Etrade Finance and Country Wide Financial using our theory of Stochastic Relativistic Finance.
Negative Convexity Dynamics: Relativistic Behavioral Finance.
MS lost the $3.7 billion based on a flawed model, based on a flawed theory of finance. MS bet on the convexity of the trade based on the normal distribution. Convexity is the price-yield dynamics of a bond. For example, positive convexity indicates that for a drop in price on a bond the yield will rise. A traditional bond, i.e., CDs, treasury bonds, etc, would be a positive convexity instrument.
MS bet on MBSs which are bonds with negative convexity, i.e., their yield tends to drop as the price drops. MBS are pools of mortgages when interest rates drop homeowners tend to refinance at a lower rate paying off the high interest rate loan and replacing it with a lower rate loan. A portfolio comprised of the higher interest rate loans duration will be less and convexity being the second derivative of duration will increase as the duration decreases. Since MBSs are negative convex, as the duration decreases, convexity decreases.
GOIH Quantitative Finance Group’s models suggest that convexity is a stochastic variable consisting of a classical as well as a relativistic component. The relativistic component having the most effect on the performance of the portfolio, since refinancing is based on consumer sentiment, is the stochastic variable of interest rates comprised of behavioral components based on the Fear Indicator.
We will publish part 2 of this article later.