Osinski’s “Manhattan Project”

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There’s an interesting story in the New York Magazine by Michael Osinski–the author of the main software package used to create the CMOs and CDOs that have helped cripple the financial system.

Osinski’s story is worth a read in its own right. But what I found curious about it was that he appears unaware of a flaw that existed in those products from the outset–the presumption that the standard mathematics of risk and return could be applied to financial assets. He doesn’t even mention this topic, but statements like the following imply that his software used a standard probability distribution to calculate risk and return for a given bond:

“Working with another programmer, I wrote a new mortgage-backed system that enabled investors to choose the specific combinations of yield and risk that they wanted by slicing and dicing bonds to create new bonds. It was endlessly versatile and flexible. It was the proverbial money tree…”

Though these distributions don’t have to be “Gaussian”–the “Normal Distribution” that lies behind the ubiquitous “Bell Curve”–all these distributions “tend” towards that one, and they certainly share one feature: they have finite variances around the mean outcome.

Sorry for some of the statistical jargon so far: the basic point is that, if some process–like rolling dice at a casino–follows one of these distributions, then you can calculate both the average score (which for a roll of two dice is 7) and the odds of a particular score (say 12, the odds of which are one in 36) coming up. You can also calculate that some outcomes are so rare as to be effectively impossible–such as rolling 12 twelve times in a row (such an outcome would occur only once in every 5 million trillion attempts).

The problem is that mortgage defaults aren’t like dice rolls. Which face on one dice turns up on the top doesn’t affect what the other dice do: a 6 on one dice has absolutely no impact on the likelihood of another dice also turning up 6. But if your neighbour defaults on a housing loan, you are more likely to do so too–because her mortgagee sale will depress the likely price for your house, and her disappearance from the neighbourhood will decrease incomes there, indirectly affecting yours, and so on.

Crucially, price rises in an asset market are also correlated: a rising asset market leads to the rising expectations that Minsky’s “Financial Instability Hypothesis” describes so well, and a falling one puts the process in reverse.

In this sense, asset price movements have more in common with earthquakes than with dice rolls. The best stylised model of an earthquake was built by a physicist called Per Bak–he called it “the sandpile model“.

Consider a child building a mound of sand at a beach by smoothly pouring dry sand out of a bucket. Initially, the sand spreads wide, then it gets to the point where sideways movement requires more force than each sand grain can impart, so the mound begins to rise up. It gets steeper–approaching a pyramid shape–and as it gets steeper, the structure gets precarious. Then another grain is added, and the whole structure suddenly collapses in an avalanche. The avalanche then stops, the pyramid is much less steep, the sand pile broader. The child continues adding sand, it pyramid rebuilds, then collapses at some trigger point, and so on.

The process building the sand pile doesn’t change–it’s always more sand grains dropping out of the bucket–but at somewhat unpredictable moments, the behaviour of the aggregate sand pile changes, from building upwards to collapsing, and then rebuilding again.

The pattern replicates what we see with earthquakes: movements in the earth’s tectonic plate occur all the time, and most of the time, each movement just adds to the existing level of tension between those plates. But every now and then, one additional movement occurs, the whole mass shifts, and a major earthquake results. As Per Bak put it, “a big earthquake is a small one that doesn’t stop”.

The pattern of movements you get from such a process can look superficially like a Normal distribution–the famous Bell Curve–but it differs from it in two fundamental ways. Firstly, there are many more movements near the average; secondly, there are also many more movements way, way away from the average–so many more that, in what is known as a pure “Power Law” distribution, the standard deviation is infinite: any scale event can occur, and will occur given enough time.

What does that mean for CDOs and CMOs? Since they presumed a “Normal” distribution (or at best one drawn from the class of statistical distributions where standard deviations are finite), they categorically ruled out the possibility of “large events”–such as, for example, house prices falling 10% in a year.

There is no example of the numbers Osinski’s  programs may have used, but for example if a bond had assumed that house prices move up at 5% a year with a standard deviation of 2% around that trend, then a 5% fall in house prices would only occur once every 3.5 million years. A 10% fall would only occur once every 31 trillion years–it simply couldn’t happen.

Yeah, right.

In fact, in a Power Law process, movements of that scale will occur, and far more frequently than predicted by these standard probability functions.  Osinski shows no awareness of this:

It hurts when people say I caused this mess. I was and am quite proud of the work I did. My software was a delicate, intricate web of logic. They don’t understand, I tell myself. Perhaps it was too complicated. But we live in a world largely of our own device. How to adjust and control these complexities, without stifling innovation, is the problem.

He couldn’t be proud of what he has done, had he known that he had used a fundamentally inappropriate model as the foundation of how risk and return were calculated. As usual, ignorance rules in this folly.

I’ll return to this topic in more detail in next month’s Debtwatch.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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47 Responses to Osinski’s “Manhattan Project”

  1. amishthrasher says:

    Two final thoughts to share as far as social demographics and economic modeling goes: age, and ideology.

    The age of people in a population is important, not only in that it is a factor that (obviously) changes over time, and the forms of economic activity people partake in, but also because it shapes how they – and society – view the world.

    Consider a child born after 1998 or 1999. It is quite possible that a middle class child born after 1998 or 1999 has never lived in a home without the world wide web, pay TV, or a mobile phone. They may not, in many cases, remember a world without broadband internet, Facebook, MySpace, and YouTube. They may have been too young to remember the dot-com bubble and its bursting, or an American President before George W. Bush. They were not alive for any Prime Minister before John Howard, and may not remember a ‘Pre-9/11’ world. A host of what older people consider ‘recent developments’ have defined their world, as they know it. And their knowledge of the world as it existed before these ‘recent developments’ is entirely drawn on second-hand accounts.

    The oldest among them are already about 10 or 11. In the next couple of years, they’ll enter high school. In the next decade, there’ll be Uni lecture halls full of kids who have never known life before Facebook and Myspace; a few years later, they’ll start taking up mortguages, homes, and full time work.

    On the other end of the age spectrum, 10 years ago, an 80 year old was born around 1919. Now it’s 1929. In 10 years time, 1939, and 10 years after that, 1949. And, with life expectancy in the developed world hovering around 80 or so, that year becomes significant because it marks the end of what can realistically be considered living memory. Any events before that is ‘history,’ based on the recollections of people who most likely have passed on.

    What would be interesting to consider, and to model, is a chart breaking down the percentage of the population born in – say – a given year, spread out over time, and chartered against key historical events. It would, if you will, literally be a chart of how things dwindle from living memory – and lifetime experience – over time.

    In a manner similar to lifetime experience, ideology (or perhaps ‘world view’) should be a very important factor in modeling or simulating economic behavior.

    Osinski’s model was bunk. But that – for the best part of a decade – many quants believed it wasn’t. And they interpreted the world accordingly, and acted accordingly.

    Given this, there is perhaps some merit in:
    a) Modeling the rise and fall of political, social, and economic ideologies over time.
    b) Modeling how these shifts in ideology impacted how people understood the world, and
    c) Modeling how shifts in how the world was understood impacted on how people acted in turn.

  2. Frank says:

    Amishthrasher

    It reminds me of the debate between free-market or strong government intervention. This is analogous to the religious idea of natural and unnatural.

    In my opinion everything is natural, by the mere fact it exists. An atomic powerstation is as natural as a flower. The thing evolved into being and no one person or thing was responsible for it. It is a mistake to think that ‘we’ as humans are some independent agent with mastery over and ability to determine ourselves and the environment. The notion is a relic, a meme, an idea still floating around from the days of Christianity, where ‘we’ were superior to animals, by god-given right, and had nature as our plaything.

    The analogy with free markets is that everything is a free market, and states and state intervention emerges from it – states and state interventions are emergent and their emergence is entirely dependent on the type of people and culture in the society.

    Models should be able to predict the emergence of states (for example), not prescribe whether or not their should be states.

  3. JamesC says:

    This matter of distributions is actually a very complex area and can be counter intuitive, I stumbled across this once looking at ratios of photomultiplier counts (please read on this is actually interesting!). For instance if you had a ‘predictive measure’ that was formed by the division of one Gaussian variable by another Gaussian variable, the resulting distribution would be log-normal, normal or inverse log-normal depending on the relative sizes of the standard error in the two variables. This can result in very weird composite measures that behave as if they are log normal one minute (and thus never go negative), then Gaussian the next with negative values, seemingly impossible in the previous scenario. This type of distribution is known as a ratio population, it has no definable mean or standard deviation, the Cauchy distribution is an example of this problem. It is a common mistake even in fields associated with physics to not spot this ratio measure problem. Finally, what happens if your measure is constructed from a ratio of log-normal or non-Gaussian variables?, I imagine the splice and dice heads down these paths, do you think it might have an even bigger tail?

  4. mahaish says:

    sorry steve sailor,

    if the course of human endeavours were that unpredictable the bookies and criminal profilers of this world would be all out of business.

    i am betting that if the bookies had framed a market for the fight, the cuban would have been the favourite, and they would have been right. they usually are.

    entirely predictable

    in some circles it would have been considered a lay down misere

    same goes for hitler. he might have been deluded by his own interpretation of the so called data that invading russia and fighting a war on 2 fronts was a good idea. clearly many of his generals didnt think so, because their interpretation of the data led them to beleive they were going to be toast.

    the bookies would have rightly had hitler at long oods to achieve his altruistic goal of re unifying europe just like napolean tried to. again entirely predictable.

    i tend to think that the geo political forces that under lie the coarse of human history and the human actors involved are very much predictable and cyclical.

    that goes for sporting events as well.

    actually the vast majority of human behavior can be encapsulated in a david attenborough doco on baboons in the serenghetti

    perhaps i’m being too unkind

    obviously human history doesnt follow the mathematical precision of an elegant equation.
    we can set sail in a particular direction but sometimes the destination may surprise
    there’s no 100% money back gaurantee,
    so in that sense there is unpredictability.

    history rhymes rather than repeats

    however the laws of karma or cause and effect are always in play

    in fact many of our older cultures have dedicated many a treatise on the rules of the game by which the coarse of human endeavours should follow, less you make a miss step.

    these rules were created to prevent mr surprise from knock knocking at ones door.

    quite often the only people who are surprised by the way things turn out, are those deluded individuals such as hitler, and some economists who never let the facts get in the way of a good arguement

  5. mahaish says:

    hi aac

    the problem with useing the entropy analogy when it comes any aspect of human endeavour, is that we may or may not have entropy depending on what the system boundaries are.

    it is entirely possible that entropy can actually decrease depending on the paramaters used and the system boundaries that are defined.

    we can go from less order to more order depending on our frame of reference.

  6. jamesb says:

    Frank,
    I think agent-based models are definitely an interesting way to go. There’s a guy at Brandeis University named Blake LeBaron who makes agent-based models of financial markets with pretty interesting results. Last I saw, they were just toy models–nothing you could apply to any sort of real-world question–but they displayed pretty interesting non-equilibrium dynamics.

  7. riemannzeta says:

    @JamesB

    What’s the alternative? I’m still trying to figure that out, because the same problems apply in modeling the ecological and coupled human-environmental systems I work on.

    I don’t disagree with your observation here, but I don’t think that it is fair then to conclude that no mathematical models are helpful. Physicists have models for systems that are far from equilibrium, and some of them work pretty well at capturing what otherwise seem like random patterns.

    For example, the dynamics of atoms or molecules in a laser cavity can be modeled as an ensemble of coupled parametric osillators. The models can’t be solved exactly, but they give quite a bit of insight into how the molecular-level dynamics produce the macroscopically observable effects of coherence, &c. See here.

  8. Frank says:

    JamesB

    Thanks for that. I’ll take a look.

    I wish I had more time to work on my own stuff. In fact I wish I’d taken some kind of academic career path. Problem is most people I think don’t realise they have academia in their blood until some spouse and/or employer has got them nailed down for good.

  9. jimbo says:

    From the article, it looks like this Osinski guy was just a software mechanic – he took other people’s formulas and did the grunt work of putting them in an application that was usable by traders. He probably never really thought through any of the theoretical implications of gaussian curves and power laws, instead thinking about “Should that button be blue or purple?”

  10. Steve Keen says:

    I agree with you here Frank. One of my problems with Austrian thinkers–and this was noted by my friend Chris Sciabarra’s excellent book Marx, Hayek and Utopia–is that Austrians treat the state as something that was simply imposed on an otherwise evolutionary system. Of course, as you observe, the state’s role evolved out of society, as did the market’s.

  11. Bullturnedbear says:

    I have a few thoughts that may warrant further discussion. Maybe we have already had the discussions under another guise. I will present the two ideas as two separate posts.

    Paul Keating keeps coming to my mind. While Mr Keating was far from perfect, he is remembered by me as a straight shooter. Sometimes to straight. His famous line “The recession we had to have”. Is very interesting. I claim that government decisions are lead by the herd and that governments want to please the herd to avoid being kicked out of office. Whilst the 1991 recession was very painful. It was a necessary circuit breaker. If a few more politicians had backbone and vision, this current bubble may have been no where near as large as it is.

    But then I guess the herd got what they wanted. They just were not aware of the consequences.

  12. Bullturnedbear says:

    The second discussion relates to the solvency of the large US banks and how “they are the problem that needs to be fixed”.

    I keep hearing two opposing arguments:
    1. The US Administration says – The large banks are too big to fail. We must pump in as much money as possible to save them or our system will crumble. This new money will also re-capitalise the banks so they can start the credit flow again, which will allow growth to restart. Yeh!!!
    2. The opposing view – The 5 large US banks are the problem. We must nationalise, liquidate and start again. If we do this, the banks will be clean and we can start lending again. Thus get credit flowing again. Yeh!!!

    Both arguments are based on a false premise. That consumers and businesses have an appetite and ability to service new credit. And further that there is any real societal benefit from new speculative credit anyway. Both arguments are treating the symptom and not the cause. That is, too much debt.

    While ever the focus remains on only two solutions the system grows weaker and weaker by the day.

    I don’t understand why the politicians can’t focus on the cause. Some say because of conspiratorial greed, some say bad economic theory, some say political survival and some say plain old ignorance.

    Whatever the cause. We are all heading for a total systematic collapse because everybody (and I mean everybody) is looking in the wrong place at the wrong time. Get ready for the biggest crash, systematic change and societal breakdown in 100 years. Why, because no-one truly believes it is coming, everyone believes that some existing ace or new ace in the hole will fix the broken system. Everyone is living in hope. Hope that is based on ignorance.

  13. MACCA says:

    BTB,

    I began getting interested in the US economic situation in 2006. I was coming towards making some major decisions with my super and decided I better get myself up to speed, rather than just accept the Financial Planner type pap. I am so glad I did. Even back then it was clear to me what was coming.

    After having followed all these developments since that time, I believe that that essentially the US Administration is entirely corrupted by the influence of the Big Banks- primarily GS. There are many many instances supporting this belief but the events of this year with AIG really is the smoking gun. If GM was a counterparty to GS for billions in derivative swaps, it would never be allowed to go under. No way. The relationships that GS has within the Fed , US Banks , US regulators and all US Administrations since the early 90’s in Clinton’s Presidency is insidious and extremely powerful. GS has infiltrated and I believe has now a controlling interest throughout the US financial system and US political system. The US has taken extraordinary steps to amend common sense mark to market accounting rules (FAS157) in order to continue playing in their make-believe world of dodgy Ponzi finance.

    One simple logic which I am unable to dismiss is that if the Banks are too big to fail, then why are they allowed to be so big ? The US Govt has broken up empires before because of this very issue of being too big. Yet they allow this monster which has caused immeasurable human suffering to continue, and in fact support it.

    So, don’t expect the Fed or Treasury to change their ways on propping up US banks.

    Incidentally, I agree that we are heading for a systemic collapse but I am now thinking it will be in slow motion and show up much worse in some places than others. Eg, southern Europe and the UK are financial basket cases- Africa will fall into real chaos quickly. The Asian export economic model is over- to be replaced by what? Financial systems and institutions will crumble and atrophy over time as financial and social chaos grows. The Mexico situation bears watching as it could easily be a “model” of the future for many countries.

    That slow decline scenario will be to the advantage of the elites because it allows them to maintain their power and ability to continue milking/gaming the taxpayer and the economy. This will make any investment strategy a significant challenge going forward.

  14. MACCA says:

    By the way………

    One main reason why I believe the financial system collapse will not be a sudden event is that Govt’s worldwide intend to squeeze every drop of wealth (now and future) they can from their citizens, by spending theirs tax dollars frivolously, in order to keep this debt based economy game going. While that is a dead ended plan, it will take time to reach it’s ultimate death, and keep the masses sufficiently docile in the meantime.

    It is all (only?) about playing for time now.

  15. Bullturnedbear says:

    Hi Macca,

    I agree the fall out is taking a lot longer to surface than I expected. I disagree about the slow process though.

    When the point of realisation is reached. The markets will already be 1/2 way to being destroyed. That final half will happen very very quickly.

    During this massive sell-off phase (I expect this to happen later this year) the policy announcements and government directional changes will be unprecedented and unpredictable.

    I predict that the “change” will occur so fast that anyone who is not ready (that’s all of us) will be both caught by surprise and major financial loss at the same time.

  16. The Outback Oracle says:

    Just thinking out loud…..

    I believe the end game will be quick. Whether it will be soon is a moot point.
    Later this year…maybe June…the Govt, finding they don’t actually have unlimited money and far less than they now have, will have to choose between say…the First home Buyers grant and pensions, or health care etc
    If they drop the FHBG it’s game over…property falls…Banks are bankrupt… end of story.
    If they get past June, it will be some other month or some other cause like a crisis in the external account which busts funding. This economy is built on the false perception that everything is fundamentally strong. The pricking of that perception, which must happen sooner or later, will result in a deterioration at a speed even those of us here can’t really visualise.

  17. MACCA says:

    Hi BTB and Outback Oracle;

    Thanks and very good points all. What you outline is no doubt very plausible. Those were my thoughts as well, up until I saw the way in which Geithner outflanked the US legislative process with his latest PPIP scam and his setup of the AIG money laundering operation. Those were game changers for me in terms of delaying tactics, with the clear intent of exercising unassailable power to benefit the chosen few.

    I think also BTB you have more confidence than I that the public will “get it”. Certainly, in Australia it will take a good deal more pain for people here to really ask the truly searching questions of their institutions, themselves and their belief systems. It will take a very long time for the public to accept and understand that things will not be going back to the way they were anytime soon for the lucky country.

    Whilst I may not entirely agree with your view on timing for the moment, I have preparations for either scenario. The end is the same and no disagreement on that.

  18. Jim says:

    Hi Bullturnedbear,
    Very good post! To answer your question the cause is falling property prices triggered by excess debt. The authorities have turned into crisis managers, who put out fires one fire at a time starting with biggest fire. That’s why they are focusing on the banks. I was really impressed when the Obama administration started giving some attention to foreclosures in their latest stimulus package. The penny must have finally dropped! After the announcement, Mortgage rates actually dropped a little, which will help home owners. This is not an all out rescue, but at least it is reassuring to know they are now moving in the right direction. Having stated all the above it is probably too little too late! Just look at the latest house price data just released:-

    http://www.marketwatch.com/news/story/Home-values-sink-record-pace/story.aspx?guid=%7B2AEA804A%2D2895%2D440A%2D828B%2DD6C60A8553B6%7D

  19. onimod says:

    I’m not sure that the final crash will happen…this time.
    I know we deserve it, but I expect full scale obfuscation and statistical manipulation (as if it hasn’t been going on for quite some time) to really move into hyperdrive.
    Change of this scale is essentially generational, and until the current ruling generation (and probably their underlings too) has been removed, both physically and intellectually, I can’t see radical change coming from the top down.
    I think you have to be pretty informed, even in these times of unlimited information, to be actually intellectually outraged. Sure, there’s plenty of envy outrage at present in the masses, but it doesn’t even scratch the surface as far as understanding of the underlying cause(s).
    I think all of that tends to suggest that most people will continue to take the spin they are being fed.
    Long term I can’t see how things won’t unwind, but then I see a lot of things that defy my (twisted?) logic everyday. Australian property prices would be close to the top of that list.
    I’ve seen in the last few days more spruiking from the RBA suggesting that our property won’t slump like the rest of the world. I haven’t heard a single person (publicly) ask whether that is in fact a good thing for our future.
    Also,why on earth is the RBA getting in to the business of predicting the future? How many mistaken predictions does it take to evaporate your credibility?

  20. Zulu says:

    I think there is a very good chance there will be a crash this year.

    I remember reading somewhere that WD Gann predicted the big collapse (end of the super cycle) in 2014 (I think it was), though I can’t say I believe in his theories exactly. Now, assuming he’s right, have the governments past interference (& lack of regulation) brought this forward or will their new stimulus packages etc actually mean we survive until then . . . .

  21. Tel says:

    You can argue over the details of the probability (and FWIW I agree with the central point that by ignoring correlation, Osinski was guaranteed to get utterly bogus results) but there’s a bigger fish lurking a little deeper that Osinski remains happy to ignore.

    Why didn’t anyone spend a little time with a computer model checking those results? Why not run them against some arbitrary historic data? Was there not a single man or woman in these large financial organisations who could not have put up a hand and asked whether correlation had been considered?

    Of course, the answer is that it is unthinkable that they really believed they were turning lead into gold. But they were gambling with someone else’s money so it didn’t really matter. There was absolutely no incentive to create a working model for the CDO calculator, and that is the real reason why their bell curve was considered good enough. Good enough to fool the fools and create a haze of confusion around fraud.

    I’m excited by the intellectual exercise of understanding correlation in a market economy, but to fix the banking industry the only answer is to ensure that the people making the bets are betting strictly with their own money, and they are the ones who lose when the problem strikes. Any other situation and the result will be looting just like happened this time, and many times before.

  22. heterodox says:

    Tel,

    actually many of the banks internal models, whether they be specifically pricing CDOs, broader VaR or wider yet Economic Capital models are often based on historic calibration. But there in lies the problem…..and surprise, surprise, past price behavior does not necessarily reflect future price movements.

    So although say in the case of CDOs, historic volatility and correlation assumptions may be used…..this does not necessarily provide any meaningful risk signals about what may occur.

    But there are two important points that can be drawn from this in the case of real estate modelling ;
    (1) Historic price behavior – US post w/war II period, at least prior to 2007, nominal property prices did not see any period of systematic nationwide falls. Of course there were localised examples (eg- California etc), but not nationwide at the same time. Perhaps a broader view of history may have helped, as Shiller has demonstrated with the Dutch example going back to 17th century. Anyway “mainstream thinking” only observed the post WWII experience, hence a mistaken belief that property prices cant fall, which was then reflected in the models…

    (2) Systemic feedback loops – Most pricing models do not take account of how likeminded thinking (ie- pricing of these products) can in fact change the system. Soros refers to this as reflexivity. So although historic prices did not display material price falls, the widespread adoption of originate and distribute business model changed the inherent systemic risk – and therefore created the possibility that property prices can fall…..and fall materially, since prices were able to be bid up to unrealistic / unsustainable levels.

    I guess in a convoluted way i agree with you – but the simple truth is that looking at history is not always sufficient either. As Steve might say “Stability is destabilising” and the comfort taken from 50years or so of a lack of falls in real estate values, has proven to be destabilising….

    That said – What is

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