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December 2009

On CDO ratings

I came across an excellent working paper thanks to a post on Sebastian Pokutta's blog: "The Economics of Structured Finance" by Joshua Coval, Jakub Jurek and Erik Stafford, available on Harvard Business School's website. In particular, the authors "show how modest imprecision in the parameter estimates can lead to variation in the default risk of the structured finance securities [instruments pooling together bonds, mortgages or other assets, such as collateralised debt obligations (CDO)] which is sufficient, for example, to cause a security rated AAA to default with reasonable likelihood." 

The article caught my attention because I am teaching financial optimization again this coming semester (a Master-level course that is required of the students in the Analytical Finance program and is also widely taken by other Master students in the department); last year the structuring of asset-backed securities via dynamic programming was one of the very last topics I had time to cover, using the Optimization Methods in Finance textbook by Gerard Cornuejols and Reha Tutuncu, before the semester ended. This year I am planning to spend more time on dynamic and stochastic programming, and in particular on CDO design.

The HBS working paper contains an excellent introduction to CDOs that should be within grasp of anyone with a basic knowledge of probabilities, as well as numerical simulations to justify their conclusions. The two fundamental steps in CDO design are known as pooling and tranching. First, risky assets such as mortgages are pooled together; later, securities with different cash flow risks are manufactured by assigning them different priorities, which is known as tranching.

The three main types of tranches are junior, mezzanine and senior. Junior tranches default if only a small number of the underlying assets default; in exchange for this higher level of risk, investors receive higher interest rates. Senior tranches are the last ones to default, and carry a much lower interest rate. Mezzanine tranches are in the middle, between junior and senior tranches. (There are some additional subtleties - for instance, the tranches have different maturities, with the senior tranches being paid first and the junior tranches being paid last, which explains why the junior tranches are the riskiest. All tranches receive interest payment at first but only the senior tranches receive payment of principal. Lower-priority tranches start receiving principal payments once the senior tranches have been retired, i.e., paid in full.)

Such prioritization of claims is fundamental in creating CDOs with much lower estimated risk of default than the underlying assets, and in particular, creating AAA-rated tranches out of bonds or mortgages that were not AAA-rated. Coval and his co-authors give a great example (pp.6-7) to explain how this works. Consider two bonds bundled together, each with the same probability of default, paying $0 in case of default and $1 otherwise. The junior tranche bears the first $1 of losses, which means an investor buying it gets nothing if either of the bonds defaults. The senior tranche bears the second $1 of losses, i.e., both bonds need to default in order for the investor owning the senior tranche. Therefore, the risk associated with the senior tranche is determined by the joint probability of the bonds defaulting (that is, the probability that they default at the same time). This notoriously difficult task has been the subject of many articles in the media following the financial crisis, including Wired's "Recipe for Disaster: the Formula that Killed Wall Street" by Felix Salmon, about which I wrote here and here. If the defaults are uncorrelated and the probabilities of each bond defaulting are both equal to 0.1, the senior tranche will have a default probability of 0.01, making it much safer than the underlying assets.

Coval and his co-authors also extend this example to a case with three $1 bonds and three tranches (see p.7). The junior tranche defaults if at least one bond defaults, the mezzanine tranche defaults if at least two bonds default, and the senior tranche defaults if all three bonds default. Using similar assumptions as above, the probabilities of default of the junior, mezzanine and senior tranches can be computed as, respectively: 1-(0.9)^3=0.271 for the junior tranche (probability of at least one bond defaulting is one minus the probability of no bond defaulting, the probability of no default for one bond is 1-0.1=0.9 and the defaults are independent), 1-(0.9)^3-3*(0.1)*(0.9)^2=0.028 for the mezzanine tranche (3*(0.1)*(0.9)^2 comes from picking which bond, out of 3, will not default [this happening with probability 0.1] in the case where exactly two default) and (0.1)^3=0.001 for the senior tranche. The message conveyed by the authors is that "by including a third bond in the pool, two-thirds of the capital - as measured by the tranche notional values - can be repackaged into claims that are less risky than the underlying bonds."

The paper is full of insights on the mechanism of structured finance and makes a convincing case that the ranges of default likelihoods determining investment-grade ratings such as AAA or AA were too narrow; interestingly, the ranges for speculative-grade bonds are wider (see Table 1 p.32). Thus, imprecisions in estimating probabilities will often result in marked changes in a CDO rating. The authors do not offer any guidelines for future improvements on the rating system, but I think it would be reasonable to either offer a range of ratings for structured finance products, to convey the much greater difficulty in analyzing the cash flow risk of CDOs (than of traditional instruments), or a different rating scale, say from 0 to 10, to make sure investors realize a top-rated CDO has a different risk profile than a top-rated company bond.

The authors point out: "[M]ost securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities' default risks, and how likely defaults were to be correlated." They also state: "The structure of collateralized debt obligations magnifies the effect of imprecise estimates of default likelihoods [...] These problems are accentuated [... in the case of] collateralised debt obligations of CDO tranches, commonly known as CDO-squared. (CDO^2)" They argue that "CDOs of mortgage-backed securities are effectively CDO^2's", which might explain the severity of the recent housing crash.

This paper will be a valuable read for anyone interested in structured finance.

"Into Thin Air" by Jon Krakauer

I recently finished reading "Into Thin Air," by Jon Krakauer - a best-selling eyewitness account of the 1996 Everest tragedy, where eight climbers were killed and many others were stranded near the top of Everest during a storm in May 1996. I decided to write a post on the book when I realized it held many valuable lessons on leadership for students and graduates, even if they have no interest in mountain-climbing.

Krakauer was at the time a journalist for Outside magazine with significant mountain-climbing experience. He had gained a spot on the team of famed guide Rob Hall, who had launched his Adventure Consultants company to guide clients on top of the world's highest mountains, in order to write about the commercialization of Mount Everest, i.e., the idea that wealthy people who had done relatively little mountain-climbing could get to the top of Everest if only they were willing to spend the money (the fee was about ยง65,000). The Adventure Consultants team happened to be on Everest at the same time as another commercial expedition led by accomplished climber Scott Fischer and his Mountain Madness company, as well as several other teams, some apparently inexperienced.  

I can't do the book any justice in a few paragraphs, so I'll simply mention the points that struck me most and hope that interested readers will buy Krakauer's book to get the full picture. It is worth saying upfront that both Rob Hall and Scott Fisher, who come across in the book as exceptionally competent and talented, died on Everest that day, along with some of their clients and a Sherpa. (The other Sherpa mentioned in the dedication page died later.)

A fundamental challenge in ascending peaks like Everest is that air above 8,000m becomes extremely rarefied. There are only fourteen mountains in the world with maximum altitudes higher than 8,000m and while top climbers strive to conquer every single one of them, that also means their brain faculties become severely impeded at such elevations and they cannot spend much time in the zone above 25,000 feet without endangering their lives, even when there is no storm. According to Krakauer, Rob Hall had a rule about turnaround times (to make sure his exhausted clients would be able to make it back to camp before dark, since they traveled light to the summit and did not have much equipment with them.) He had announced before the summit bid that the turnaround time on that day would be either 1pm or 2pm, depending on conditions. He does not appear to have communicated the actual time to anyone, including any of the other guides. On May 10, he waited until 4pm on the summit for his last client to arrive, before starting the descent.

An important question Krakauer raises is: why didn't Hall enforce his own rule? The journalist suggests several answers. That last client was a postal worker who had been turned around short of the summit the previous year, and had worked two jobs to fulfill his dream of climbing Everest. Little kids had sold T-Shirts to help him fund the trip. He was writing them postcards during the trip. The postal worker seems to have become increasingly focused on making the summit during the year between the two summit bids, and Hall had convinced him to give it another try by giving him a discount. Therefore, Hall was far more emotionally invested than usual in that specific client reaching the summit. (Which he did, but he died during the descent.)

In addition, both Hall and Fisher needed to guide as many clients to the top as possible to gain new clients in future years and see their climbing companies prosper. Although they respected each other, they also competed for business. The number of clients they would be able to bring to the top would directly affect their income stream in following years. Therefore, Hall and Fischer might have taken more risks than they would have with professional mountaineers. (Of course, it is likely neither Hall nor Fischer realized they were taking serious risks with their clients' lives and their own at the time, until it was too late.) Another point Krakauer courageously makes, although he is obviously uncomfortable with it, is that the presence of a journalist in the group (himself), who had been assigned the task of reporting on the expedition, might have pushed Hall and Fischer beyond their limits, again because they wanted good PR. The tragic outcome of the 1996 expedition emphasizes how emotional involvement can override rational safeguards and lead to catastrophes.

Another lesson of the book revolves around money as a motivator. I have already mentioned that money seems to have played an important role in Hall's and Fischer's decisions because they needed good PR to keep their companies in business. More generally, climbers needed to guide clients to the top in order to come up with the money to secure expedition permits, but some climbers do not come across, in Krakauer's book, as overly enthusiastic about focusing on clients. Anatoli Boukreev in particular, a top Russian guide on Scott Fischer's team, made the ascent without additional oxygen (something Krakauer points out is very unusual for guides, who need all their brainpower to help clients if the latter get in trouble), and started the descent once he had reached the summit without waiting for late clients (a decision necessitated by the fact he had no additional oxygen). This reminded me that not everyone who is technically skilled makes a good manager/supervisor. Boukreev did courageously attempt to rescue stranded climbers once he realized they were in trouble, but his portrayal in Krakauer's book created much animosity between Krakauer and him, as well as a co-author who helped Boukreev write his own version of what had happened. Even if Boukreev did perform heroically on the summit (something that will never be known for sure, since he died in 1997 on another mountain), Krakauer strongly suggests financial pressures played an indirect role in the tragedy, because guides were forced to accept people of various abilities on the team and needed the money to enjoy their own passion of the mountains in a financially viable scheme.

I was surprised to read about the ferocity of the personal attacks Krakauer was subjected to, after the publication of his book, from Boukreev's co-author (because Krakauer's version of the facts did not suit him, for obvious reasons). Krakauer provides a glimpse into some readers' reactions in the postscript, and shows that the truth antagonizes certain people more than any work of fiction would. Some people will not hesitate resorting to personal attacks to gain the upper hand, but Krakauer's book is now heralded as "one of the great adventure books of all time" by the Wall Street Journal.

Finally, I enjoyed reading about the drive and determination of the various protagonists, including the clients of the expeditions. In an environment where students face intense pressure to fit - and especially to shrink to fit - it is refreshing to read about people passionate about their lifestyle and pursuing their endeavors with single-minded determination.

My Book Choices For 2009

Every year I give a book recommendation for Christmas; in 2007, I picked "American Prometheus: The Triumph and Tragedy of J. Robert Oppenheimer" by Kai Bird and Martin Sherwin and in 2008 I chose "The Rise of The Creative Class" by Richard Florida. This year I did not want to pick just one book, so here are a few nonfiction paperbacks I read this year and could not put down, in no particular order:

  • "Franklin and Winston," by Jon Meacham: an account of the friendship between Franklin Roosevelt and Winston Churchill.
  • "A Hope in the Unseen," by Ron Suskind: the story of a black kid from a blighted DC neighborhood, who is admitted to Brown University against the odds. The book covers his last two years in high school and his first year in college and is one of my favorite books of all times. I first learned about the book thanks to NPR's You Must Read This series.
  • "Influence: The Power of Persuasion," by Richard Cialdini. I blogged about the book here and here.
  • "The Pixar Touch," by David Price: a history of the animation company Pixar. I did not expect the book to be such a page-turner, but it was. I became interested in Pixar after I read an article in Harvard Business Review about "How Pixar Fosters Collective Creativity"; that article remains one of the most recommended by readers on the HBR website.

Lehigh News

Here are a couple of Lehigh-related links I've saved over the past few months and didn't get the chance to write a post on:

  • "Lehigh recognized as one of nation's top universities": Lehigh press release dated August 20, 2009 about being ranked 35th in the 2010 US News Rankings of Best Universities.
  • The New York Times has mentioned Lehigh in several articles over the past few months. For instance:
  • Lehigh held its annual summer engineering camp for middle-school girls in July. It is called CHOICES, which stands for Charting Horizons and Opportunities in Careers in Engineering and Science. The press release following the week-long event is here. I was invited to serve on the three-member panel on the last day, to discuss careers in engineering with the girls. It was a lot of fun.

Google and the Newspapers

Google's CEO Eric Schmidt recently wrote an op-ed for the Wall Street Journal, which was published last week ("How Google Can Help Newspapers," December 1, 2009, with the subtitle: "Video didn't kill the radio star, and the Internet won't destroy news organizations. It will foster a new, digital business model.")

Schmidt envisions a hand-held device that, a few years from now, will know "who I am, what I like, and what I have already read." Some stories will be available for free thanks to advertising revenues, some will cost a few pennies automatically charged to one's account, and some will be part of a monthly subscription. The user will get his or her news from a wide range of sources. Schmidt points out that "the Internet has broken down the entire news package with articles read individually, reached from a blog or search engine, and abandoned if there is no good reason to hang around once the story is finished."

He clearly wrote the op-ed in defense of Google, which he thinks has attracted the wrath of "frustrated newspaper executives [who] are looking for someone to blame"; Schmidt describes in some length why, in his opinion, Google is pulling its weight to make its relationship with the media a success. At the center of the debate is the controversial Google News. ("For years now, newspapers have quietly watched Google index their headlines and offer users a synopsis of their stories without paying them a dime," starts a May 2007 CNET article. But few executives have dared challenging Google - the CNET article gives the example of Belgian news organizations who ultimately entered an agreement with the company, even after winning their case in court, because it had led to Google News no longer indexing their articles. They might have needed the web traffic more than the fees.)

Another CNET article, this one from May 2009, delves in more detail into newspapers' gripes and their reasons for not simply shutting Google out. The author makes two important points: (i) some people will be satisfied by the headline and the snippet Google provides, and therefore will never click on the link to go to the newspaper's site, (ii) Google sometimes ranks amateur blogs higher than - or at least as high as - the websites of professionals, which is particularly galling to journalists when the blog's quality is far inferior to that of their articles, or when the blogger simply repeats their arguments but passes them off as his own. It is also clear, though, no one has the inclination to sever ties with Google because of Google News.

(As an aside, you can also sense the difficulty for some reporters to comprehend technology. What is wrong with the following sentences, taken from the article referenced earlier? "The task could be accomplished by inserting a single line of code into their URLs. If added a line such as, content from the site would be rendered invisible to Google." Answer: you don't add a line such as - and that certainly doesn't qualify as "inserting a single line of code into their URLs." What you do is you write a .txt file, for instance with Notepad, and upload it to tell Googlebot not to access (index) the site. For more information on robots.txt, click here.) CNET has many other interesting articles related to Google, including the testimony of Google's Vice-President for Search Products and User Experience at a Senate hearing in May 2009 (VP who echoes many of Schmidt's themes, such as the "atomic unit of consumption") and a September 2009 article on Google's micropayments.

A short article on the Washington Post website after the WSJ piece was published points out that Google's chief legal counsel used the same talking points at a meeting of the World Association of Newspapers in India, and summarizes Schmidt's op-ed as follows: "Don't shoot the gift horse that feeds you."

The three-year college degree

The October 26 issue of Newsweek had an article by Lamar Alexander (former US education secretary under President George H.W. Bush, president of the University of Tennessee, and governor of Tennessee, and now US Senator) on "The Three-Year Solution," where he asserts that helping students get their degree in three years would reinvent higher education and benefit parents, students and schools. The article is accompanied by excerpts of a discussion with Lee Bollinger, President of Columbia University, Michael Crow, President of Arizona State University, Elaine Tuttle Hansen, President of Bates College and Robert Zemsky, Professor at the University of Pennsylvania and author of "Making Reform Work".

The appeal of a degree earned in three years is of course that it lowers tuition costs. (That is because undergraduates are charged a set amount of tuition per semester, regardless of the number of credits they take, as long as they maintain full-time student status.) Alexander states that "[a]ccording to the US Department of Education's most recent statistics, about 5 percent of US undergraduates finished with bachelor's degrees in three years." This is in line with my own observations at Lehigh. Such students typically enter college with a substantial number of AP credits, which frees them from introductory classes and allows them to quickly focus on major-related coursework.

But many more students with AP credits graduate in four years with their classmates; graduating only one semester early also saves money but ends up being somewhat counterproductive because the recruitment process for undergraduates is very regimented: there are few job openings with starting dates in January, since most companies come to campuses in the Fall with the clear objective of recruiting college students after their May graduation. An issue with AP credits that is left out from both Newsweek articles is that some students think they are well-prepared for college work because they took Advanced Placement classes in high school, but struggle once they arrive in college and realize that, say, Calculus 1 is taught differently there. So knowing whether a student is truly as well-prepared as his high school transcript suggests is difficult to determine with certainty.

Another issue that is left out is the importance of a good college GPA to get a job. I am not aware of any company that views an applicant more favorably because he graduated in less time, especially when that applicant competes for a job against students who have the same major and used the extra time to obtain a minor or pursue extra-curricular activities. On the other hand, companies do care about GPAs a lot, and it is one of the little secrets of academia that some students prefer to retake courses they already got AP credits for (relinquishing the AP credit) to get an easy A or A- and thus increase their GPA - transfer credits (for AP courses or courses taken at any other college) never count toward a student's Grade Point Average, which is then computed on a smaller number of courses. For instance, a student with a 3.35 GPA when she graduates with 115 credits taken at her college and 15 AP credits, to fulfill her program's requirements of 130 credits total, would have had a GPA of 3.425 if she had chosen to retake the courses at the university and presumably received an A. This has even more implications for students who struggle with follow-up courses because they took the prerequisite, such as Calculus 1, elsewhere. (Note: I also wrote about AP tests here.)

Alexander also points out that it would be possible to pack four years of schooling into three if more students attended summer sessions (which generate their own costs for parents but are typically a bit less expensive because students take fewer credits than in a regular term). It is true that many lecture halls remain empty in July and August, although some courses are offered during the summer. But students do want to get home and see their family over the long break. It is a bit much to expect eighteen-year-olds who had been living at home until recently to give up seeing their relatives for any extended amount of time until they graduate from college.

At the same time, the place of summer breaks in a student's education is an important one and deserves more attention than it has been given. While the summer between junior and senior years is typically spent at a company for an internship, many students do not do much that is directly related to their education in the summers between freshman and sophomore years and sophomore and junior years. The few who do enroll in the community college by their home to fulfill non-major requirements. (For instance, engineering students often take humanities courses elsewhere.) This allows them to take more courses related to their interests during the schoolyear. I found myself wondering what would happen if four-year colleges and universities made more of an effort to attract other students - typically students from local families, home from college during the summer - to take courses for their degree over the summer. This would allow a better use of the facilities in addition to money from tuition fees, and would provide students with another, albeit brief, educational experience at a top college, which can always be useful. In the current economic crisis, community colleges have seen their enrollment skyrocket and are being stretched to their limits. I am surprised there aren't more efforts from four-year institutions to do more in the summer.      

I found Elaine Tuttle Hansen's comments particularly valuable. She is the President of Bates College and said that "[Bates College has] had a three-year option for over 40 years because we think students should have options, and we've always worried about affordability. [...] [B]ut I think we're seeing the interest trending down in part because there is so much we pack into four years. So much happens just in the junior and senior year at those ages." She was also quoted as saying: "I think too much in our culture is about doing things faster and simpler and easier. And what we can't let go of in higher education is that slower is actually better when it comes to learning and the kind of capacity for lifelong access to learning."

I was disappointed that almost nothing was said about the need for continuing education. Only Prof. Zemsky mentioned that "[t]he BA has just become another transition zone and we would better design it as a transition zone than an endpoint." This for me is the strongest argument for a three-year degree, and it should have been explored in more depth in the article. Back in the days where getting a college degree was indeed a spectacular achievement and few students went to graduate school, it made sense to have a four-year education, to teach students as much as possible while they were on campus. Nowadays, a BA or BS degree has become the norm, and students stay longer in school to get a Master degree and distinguish themselves from the crowd. In other cases, students return to school after a few years in the workforce. Many already know when they are in college that this will not be the end of their education. The fast pace of innovation, especially in technology-driven fields such as engineering, has made it a virtual necessity for workers to gain more education along the way to remain up-to-date, sometimes through Master degrees and sometimes through certificates and executive education programs. The real question is then: what are universities doing to address the need for continuing education?