This reflects my personal opinion, not the views of the SEC or its staff.
Sarah Palin's "Being There" ascendancy may strike some as absurd, but it provides a case study for what now counts as news. Today, going viral matters more than the information itself. The object lesson that Palin brings to politics is something we should fear for the financial markets, where going viral can transform information from being the bedrock of market efficiency to a source of irrationality, even crisis.

For example, the most important lesson to come out of robo-signing is not the fiasco itself. The incomplete and flawed documentation for foreclosures has been well known for over a year, as have the practices of “endorsing in blank”, inaccurate reporting of remittances, inflating appraisals and applicant earnings, to name a few. The robo-signing revelation is just one more shoe to drop. The important lesson is that it is a shoe that gained legs, so to speak; that went viral, topping the list for news, blog repackaging, and possible Congressional hearings. As a result, robo-signing is the item that had an impact on financial stocks which could have occurred based on any number of problems that were already known.
More broadly, the lesson from Palin and robo-signing is that we are entering a new age for the way information affects the markets, an age when going viral matters more than the information itself. Information has gone from being illuminating to being a source of risk, and not because of content, but because of the vagaries of what might gain traction.
To put this into perspective, follow the path of the role of information in the markets.
The age of private information. There was a time when information gave an advantage, when there was an edge to getting information ahead of others. Rothschild famously received early news of the British victory at Waterloo; commodities traders hired teams to wander the cocoa fields on Ghana counting pods; equity managers used their influence to get a jump on earnings announcements.
The age of too much information. The push toward transparency eroded this advantage. But the requirements for transparency throw out so much information that it is difficult to find what is relevant. Information can hide in plain sight; if every drug may cause nausea, insomnia and drowsiness, then we get to the point of, “I have to list everything I can think of, but you know the game. Just ignore it and try the stuff out”. The echo chamber of reposting adds noise to any news that is worth repeating, and much that is not.
The age of viral information. Information is moving from being the bedrock of market efficiency to a source of crisis. The risk for the market is not the news itself, but what news gets drilled home through so many channels that people act on it; we cannot anticipate when information might go viral and sweep the markets.. For retail markets – the municipal bond market and money market immediately come to mind – it is easy to envision a “USA Today effect”, to use an anachronistic expression, causing a run on the bank.
The greatest concern lies in information going viral that is inconsequential. For those in the market who are on top of the news and its implications, the question no longer is simply one of when others will finally get around to looking at the information and see that it is important. It is also a question of whether something irrelevant will catch the fancy of the cloud. Look at Sarah Palin and see the logical end to the inane You Tube videos that capture the imagination of the nation, or the ranks of the “famous for being nothing” reality show celebrities that Palin has elected to join.
The new, viral world means more surprises and more volatility; and not because of market shocks precipitated by content, but because of the randomness in what might happen to catch on and reverberate through the internet.

This reflects my personal opinion, not the views of the SEC or its staff.
My last post posited a future world where technology-driven production and consumption lead to a secular drop in demand, and with it a drop in employment, resulting in what I called a consumption trap:
This world creates consumption trap because we are not consuming enough to generate full employment. And such a world comes with a corollary: secular deflation.
We all know that technology is perpetually in deflation mode. On a per unit of consumption basis – whether measured by the cost of processing one instruction or storing one bit of data – the cost of speed and storage is cut in half every year or so. That makes even roaring inflation look like a crawl.
And, it makes life difficult for the Bureau of Labor Statistics folks who have to figure out CPI. This deflation in technology can overwhelm the inflation in other areas of the economy, where a ten or twenty percent rise is something of note. There are two ways the BLS can keep the relentless price deflation in technology from dominating CPI.
One way is to act as if computers do not represent much of consumption. This route is hard to take, given, first of all, that it is obvious that we all spend a reasonable amount on computers and their peripherals, and second, that with prices dropping by orders of magnitude, consumption would have to be suppressed to a rounding error in order to staunch its effect. It would be one thing to understate our consumption of computers, another to act like computers didn’t even exist.
The second way is not to look at the per unit price of computations and data storage, but look at the price of computers without regard to how much they can do. This is the route that the BLS has taken. The BLS defines high, mainstream and low quality computers, and prices each of those. No matter that the low quality computer now is a hundred times better than the high quality one of ten years ago. And, of course, what constitutes these quality levels is up for grabs. Maybe in the bowels of the calculations, the mainstream computer is defined as the one that costs a bit more than the mainstream one of five years ago. Or, maybe I’m being too cynical.
And to be fair, this approach is not totally foreign in other products. Both houses and cars have improved over the past hundred years, and they also are priced based on the standard item at any given time. But a car continues to provide a way for a small group to travel from place A to B, albeit more comfortably and safely, and a house still keeps a roof over the head of one family, even if it does so with fewer drafts and more efficient floor plans. If a car morphed over time into a vehicle that could transport thousands of people simultaneously to their various destinations in fractions of a second, I doubt that anyone would be able to keep it in the “car” column of the CPI calculation with a straight face.
Whatever the mechanism used to corral the inherent deflation in computers, it starts to break at the seams the more the world becomes integrally related to the cost of units of CPU and memory, where CPU and memory permeate what we consume directly, through our experience machines and the like, and indirectly as a principal factor in producing whatever else we need to keep us alive while we stay plugged in. In that world, the trick of using high, medium and low cost computers to hide the inexorable decline in the prices of computations and memory won’t work anymore. If these prices drop by orders of magnitude, we are going to have a negative number for CPI even if health care, housing and food go up by ten or twenty percent.

I just finished reading Robert Reich’s new book, Aftershock. The critical points of the book are well presented in his pre-publication New York Times op-ed piece. I will not be able to do justice to his work in a few sentences, but for those who don’t want to buy the book or click on the link, here goes:

The root of our economic problems is the ever widening income gap. The rich, who are laying claim to a higher and higher percentage of income, don’t spend as much of their income as do those down the income ladder, so demand for goods and services is dropping. The solution is to move income toward those who will spend more of what they earn, namely the workers who are producing all the goods. Put another way, we need to redistribute income so that those who produce can afford to buy what they are producing.

This is one of those “gee, I should have thought of that” sorts of arguments, a reasoned argument for income redistribution based not on some notion of fairness, but on economic results. Rather than the government priming the pump through fiscal measures, which is obviously a short-term solution, he argues that we need to change the structure of the system to shift income toward those who will consume.

But I would like to sketch a path for technology that makes this approach, income redistribution as a Keynesian solution of sorts, unsustainable, indeed a path that leads us to a land where no magic can return us to the economy we have enjoyed in the past. This path is one that takes two of the very problems Reich pinpoints and assumes they deepen. These two problems are, first, that the marginal propensity to consume drops with an increase in income, and second, that the contribution of labor to production declines over time.

Trend 1: Diminishing Consumption
Reich makes the point that someone whose income is hundreds of millions a year is not going to be able to spend more than a small fraction of it on consumption. If that money were instead given to, say, ten thousand middle-income families in chunks of $10,000 each, much more of it would go into the economy, spurring demand for production.

But what if the portion of income that goes toward consumption starts to go lower even as we move down the income ladder. That is, what if those at lower and lower income levels find they don’t need to spend as much of their income on consumption as they have in the past? I think this is what could happen if the current technology-driven trend of how people spend their time continues.

I wrote a post a few months ago, The Accidental Egalitarian, which made the point that with the increased focus on technology – where we spend more and more of our time on our cell phone, doing emails, watching DVDs and generally surfing the web – there is less of a difference between how the super rich and the reasonably well off spend their time hour by hour during their typical days. The point of that post was that in practical term the income gap is not as large as it might seem; that several orders of magnitude differences in income don’t make all that much difference in what these people do with their time. The point here is the corollary: those activities do not require much income.

If this trend continues, a redistribution of income will not spur the increase in spending that Reich suggests.

Trend 2: Diminishing Labor in Production
Let’s also say that the production to feed our demand can be developed with little labor input. This is already happening, not only because of improvements in production efficiency, but also because the sorts of things we want to consume are particularly well suited to capital-intensive production.

Suppose most of what we want to buy ends up being produced in factories run with robots, and maintained and operated by five or six engineers. (That doesn’t really have to be what is going on. It could be that the factory owner just says it is using robots, and is really employing five hundred workers in some third world country each making a few dollars a day. It will still seem to be the same, domestic labor demand will be lower even if we manage to push consumption up).

As this trend progresses, income redistribution will have a limited effect on increased employment because there will not be that many more jobs to be had.

In the Year 2025
Take these two trends to their extreme. We are in the year 2025. Because of advances in production technology, much of the path from extracting the required renewable resources through to the production and distribution of most of the items we demand can be accomplished with automated methods overseen by a small cadre of engineers. (At least that is what we are being told. But some blog posts are claiming that all we are doing is exporting wheat to pay for labor-intensive production in Africa. Africa, The New Asia®. It is hard to know who to believe anymore).

The main items we demand, beyond food, clothing and shelter, are the nth generation game systems. Computer games have progressed to the point where they are approaching the level of Nozick’s experience machine. They allow us to be anyone we want in whatever world we want, accompanied by whomever we want, all with full sensory feedback. If you think you used to burn a lot of your free waking hours with your jumping between email, video games, Facebook, and HBO back in 2010….

Speaking of HBO, movie-making software now allows us to make TV shows, even full-length movies at home that rival those that used to require live actors and teams of hundreds. The deflated profitability of journalism and then the music industry earlier in the century has now enveloped all forms of media. The entertainment industry has disappeared; it is all free, operated with the same open-source ethos that spelled doom for most commercial software enterprises over the past decade. Which also means no more advertising. We pretty much know what we want to buy, and depend on those in our FriendWeb™ (version 4.6) to guide us.

If you look hour by hour at what anyone is doing, it is hard to differentiate the super rich from those a few rungs above subsistence level. Given our evolved interests, most of us are spending a fraction of our income on consumption. There just isn’t a lot that we demand. What we do demand is cheap, and doesn’t require much of any labor to produce.

Or, doesn’t require production at all. For those who have the money to burn, demand is moving increasingly toward things that cannot be produced. Land, art, rare wines and Super Bowl tickets are being bid up to unthinkable levels. The major economic pastime that remains to differentiate the rich from the rest of us is picking new stuff to throw into the fray. The latest one is scholar stones from the Sung Dynasty. All that money has to go somewhere. But that only leads to a transfer of income from one well-to-do pocket to another without generating any production. Sadly for those grounded in the middle class, this means more of these things are moving out of reach. But no matter. It all seems silly and abstract to most of us, like the amusing eccentricities of the English upper class a century or two before. Maybe that is because we are no longer taunted by magazine covers and ads (because there are no magazines or ads), maybe it is because the demise of the entertainment industry has also led to the demise of the iconic celebrity, or maybe it is just that we don’t really care what those outside our circle of gamers are doing.

We are a society that basically eats, sleeps, works and then veges out. Not surprising, I guess, given that the tip of the spear of the economy, such as it is, are those same kids who a decade or two earlier were living at home with their parents after college, after graduate school – well, some still are. Though many of us now have our own prefabricated SmallHouse® (McMansions are a thing of the past; no one needs all that space, and, like mink stoles post-Mad Men, social norms regard these as the extravagances of a bygone era). That plus a car, food (the former rarely used, and both produced very inexpensively), our two-hundred dollar experience machine games, and we are happy as a clam.

I don’t know exactly how this economy works, but I can tell you that it is not working well. What are all of Reich’s workers doing for jobs now? Where is the money coming from for even this minimally consumptive society? What levers can we pull to get ourselves out of this stagnant economy, to reduce unemployment? We are approaching our second lost decade, and nothing seems to work. Not that most people care.

There used to be a lot written about the liquidity trap, where monetary policy can no longer function as a spur to economic recovery. Now it is all about the consumption trap creating similar limits on the ability of fiscal measures to push up employment and production.

This represents my personal opinion, not the views of the SEC or its staff.

If all you have is a hammer...

I read a New York Times article a while ago on econophysics – the use of the tools of physics in economics – that featured the application of seismology to solve the problems of market crises. I can see the twists of logic that led to this approach: during an earthquake things shake around and fall, and during a market crisis things shake around and fall. Seismology predicts the former, so why not the latter?

This type of logical leap too far is nothing new. I remember the popularity of Kalman filters and the application of the principles of torque to measure the strength of market turns (I’m not kidding) in the seventies. Later came the emergence of chaos theory to model market dynamics and catastrophe theory to model market breaks, the logic being that markets look chaotic, and that market breaks are, well, breaks.

None of these work, and as I will get to in a bit, there is a reason they don’t work. But the use of physics in finance and economics persists, thus the fledgling discipline of econophysics. The reason it persists is first of all, there are not many jobs for physicist in physics, and most of finance is child’s play once you have gone through the rigors of a physics degree, so a lot of physicists end up in finance. Another reason is that most of those in finance really do have physics envy. They want to have the solid structure, the clean answers, and the sexy mathematical models of physics.
So if you are a physicist by training, what is more natural than to take to your new home with your physics hammer, especially if everyone wants you to look at everything as if it is a nail.

Boards don’t hit back
Andrew Lo and Mark Meuller have has a recent paper that addresses the issue of physics envy. They focus on the applicability of the tools of physics as the type of uncertainty becomes more profound, pointing out that while physics can generate useful models if there is well-parameterized uncertainty, where we know the distribution of the randomness, it becomes less useful if the uncertainty is fuzzy and ill-defined, what is called Knightian uncertainty.

I think it is useful to go one step further, and ask where this fuzzy, ill-defined uncertainty comes from. It is not all inevitable, it is not just that this is the way the world works. It is also the creation of those in the market, created because that is how those in the market make their money. That is, the markets are difficult to model, whether with the methods of physics or anything else, because those in the market make their money by having it difficult to model, or, more generally, difficult for others to anticipate and do as well.

In the Bruce Lee movie, Enter the Dragon, Lee faces his arch enemy in a fight. To intimidate Lee, his opponent holds up a board, and splits it in two with his fist. Lee watches passively and says, “Boards don’t hit back”. That gets to the reason physics does not work in finance: markets do hit back.
The markets are not physical systems guided by timeless and universal laws. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space without well structured rules or defined possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

For example, I have seen this issue repeatedly in risk management, and it is one reason any risk management model will not cover all the risks. Once the risk model is specified, the traders will try to find a way around it. Are you measuring DV01 risk? Well, fine, then I will do DV01-neutral yield curve trades. Now are you measuring yield curve risk? Fine, then I will do DV01 and yield curve neutral butterfly trades. One of the problems with VaR – and for that matter with any complex model – is that it opens up all the more dimensions for such gaming, and for gaming in a way that is harder to detect. Maybe this can be put into a model, but if it can, it won’t look like how things are modeled in physics.

So it is not by chance that there are so many people trying to add complexity to the markets. Whatever rules are put in place, whatever metrics are devised, traders will try to find ways around them. In an engineering system, if you find a poorly designed valve in a nuclear power plant and replace it with a new and better deigned one, the new valve doesn’t try to figure out ways to make you think it is closed when it is really open. But traders will do that.

Lo and Mueller conclude their paper by considering that “the study of economics may be closer to disciplines such as evolutionary biology, ecology, and meteorology”. And indeed, an increasingly popular alternative to borrowing from the tools of physics is to push finance into a biological model. The argument is that in the biological sphere, there is the interaction and feedback that physics lacks. Evolution is the result of this dynamic, of one species changing over time to best another species, just as one trader will change strategies to best another trader. But this model also does not fit. Evolution is not a conscious process. It is a winnowing out of the poorly designed and emergence of the better designed on the basis of the process of natural selection. In contrast, in finance the process is conscious and intelligent.

A better analogy than physics or biology is a military one. The point is that there is a strategy of intelligent reaction to any action, an arms race to leapfrog one another in information gathering and technology, to know what others are doing, and to react in a way that they will not anticipate. This is the point where I could pull out quotes from The Art War about seeing into the mind of the enemy, attacking when your opponent believes you will retreat, and the like. That is not physics.

There has been some comment on my recent post related to ways to make soccer less boring, and it appears some readers do not fully understand the direction I am trying to go.

For example, with regard to the idea of a Goal Tunnel: The point is that most of the time, as it is currently structured, soccer is stadium pinball. The proposal I made for a Goal Tunnel is intended to play off of that feature of the game. But the Goal Tunnel, the use of two balls, and these other approaches are only suggestions. It might be enough simply to allow free substitution, or increase the goal size.

Among the changes I proposed, free substitution should be non-controversial. When there is no substitution, the players cannot be as aggressive, because they know that they will still have to be out there even if they become fatigued. So you have a game that is slowed down and conservative. Most every team sport other than soccer allows substitution. Hockey, football, basketball, and lacrosse all have free substitution. Baseball is an exception, but fatigue is hardly an issue for anyone but the pitcher. And there, substitution is allowed.

But in this post, let me focus on another of these changes, an increase in the size of the goal, and show how this can not only increase the amount of scoring, but also make soccer a more interesting game. This illustration will also help with another important point: one change might require other, supporting changes.

Suppose we increase the size of the goal to span the entire goal line. Then it will be impossible for the goalie to cover the goal area, so he may as well move into the field, which means there will be eleven people in the field rather than ten. With so large a goal, it will be trivial to kick the ball past the goal line. So to overcome this problem, require players to carry the ball across the goal rather than simply kick it across. Which, of course, means the players finally get to use their hands, a long overdue improvement. Because the ball can be carried, it should be made smaller and shaped so that it can be tucked under the arm.

The Goal Tunnel can go, but the basic concept behind it, that of tackling, should still be allowed, at least tackling the person carrying the ball. And allow a pause in play whenever the ball carrier is down so that both teams can do any substitution, regroup and reassess their strategy.

A last problem that comes up with the enlarged goal is how to allow the other team to gain possession. If the ball is small and easily held, it will be hard for the other team to jar it loose. So perhaps if the team with the ball cannot advance it sufficiently after a number of “downs”, the other team should be awarded possession.

This is only one example of an improvement in soccer, derived from the simple first step of increasing the size of the goal. But I believe these changes could turn soccer into a much more engaging sport.

Now that the U.S. team has been eliminated, and with it the thrill of having an emotional attachment to the World Cup, I can go back to reflecting on why soccer is so boring. The basic reason is not so hard to come by: there is not enough scoring. Because there is not enough scoring, the bulk of the playing time passes with no concrete result, and the outcome is unnecessarily random. Even when a great team is matched up against a mediocre team, if you were to replay just a few critical seconds out of the hour and a half of action, the outcome might be different. Yawn at the wrong moment and miss the meat of the game.

There is an analytical basis for determining the amount of scoring a sport should have, and soccer is well below the ideal.

First, the greater the number of scores, the lower the chance for a lucky win by a team that is inferior. The number of scores required to move this random component to an acceptable level depends on the nature of the game. For example, if I were up against a professional basketball player in a game that involved each of us taking shots from the foul line, there is a reasonable chance I would win if the game consisted of only one shot each. If we each took ten shots, I would almost never win. On the other hand, if I were up against a world-class sprinter, one race – one score – would be enough. Absent a hamstring pull, he would win a hundred times out of a hundred.

Countervailing the benefit of having the outcome determined by more scores is the negative effect of having too much scoring. Up to a point, the more scores, the more interest and engagement for the spectators. But there is a turning point. Create a game with too many scores and the individual scores become inconsequential.

So in designing the ideal scoring for a sport, you want enough scores to reduce the chance of one team wining by dumb luck. The more randomness in any one score, the more scores you will want, so that a clearly superior team will win most all the time. But you don’t want to overdo it with the scoring. I think that soccer and hockey have too few scores, basketball and tennis have too many, while baseball and American football are somewhere near the sweet spot. This sweet spot can be determined empirically. A sport has enough scoring if a team that, in a large sample of games, tends to lose to most everyone rarely beats a team that tends to beat everyone.

This is all preamble to a way to improve soccer: have more scoring. It will reduce the random component, and lead to more minute-by-minute excitement. Change the game so that a dominating team wins by 10 to 5 rather than 2 to 1.

Here are a few changes I might propose in soccer to increase its entertainment value and reduce the randomness of the outcomes.

1. Free substitution. Allow fresh players into the game. This will make for more aggressive and faster play, which should lead to more scoring. Free substitution will also allow better strategic use of players with special skills.
2. Shorten the field. The ball will then spend more time within striking distance of the goal.
3. Increase the size of the goal. The most direct way to increase scoring.
4. Slope the field. Have the field slope toward the nets, both from the sides of the field and the center of the field. This will keep the ball closer to the goal area. Furthermore, this change will lead to a host of new scoring strategies. If a team can be distracted from the game -- by, say, a staged fight or a naked fan running across the field -- the ball will just roll into the goal.
5. Use two balls. Having two balls in play will increase the number of shots, and spread out the defense. The balls can be color coded, with one ball being worth two points and the other ball one point.
6. Add a goal tunnel. Have a corrugated metal tube that runs into the goal from beyond the goalie area. If someone can kick the ball into the tube, it is an automatic goal, since the goalie cannot defend it. New and entertaining strategies can be added with this feature. For example, players can be "tunneled" by being slammed against the sharp metal edges of the tube, thereby increasing the physical component, and with it, the entertainment value of the sport.

This Washington Post article discusses the push in the SEC to add more market expertise. It features my colleague Gregg Berman -- who ran the risk management part of RiskMetrics -- and me.

A member of Congress asked me to provide my personal thoughts on the OTC derivatives portion of the Senate bill, S. 3217. Here are portions of my letter. The views here are my own, and do not necessarily reflect those of the SEC, its commissioners or staff.

Now that S. 3217 has passed the Senate, I am writing this letter in response to your request. I will focus primarily on the potential for that legislation to allow regulatory arbitrage and reduce transparency to the regulators.

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

As far as I was concerned, I owned the stock: I treated the swap transaction in my trading and risk management systems as if I held the stock, and my portfolio return was the same as if I held the stock.

If regulation allows equity index swaps to be under the CFTC’s regime and the stocks to be under the SEC regime, there will be the same potential for regulatory arbitrage. I can already envision a thriving new market developing for what might be called Index Spread Total Return Swaps. A fund that wants to hold a long equity position in IBM and P&G, but wants to do it under the CFTC regime, will have a broker give them a total return swap that pays the difference between a position in an index that holds the S&P 500 and another index that holds all the stocks in the S&P 500 except for IBM and P&G. This is a swap on indexes, and so will be under the aegis of the CFTC. Whatever equity positions the fund wants to hold, a swap can be created to fulfill its needs. With the push of a button, voila, the fund is effectively trading stocks – securities – under the CFTC rather than SEC umbrella.

This is a simple example of a broader point: a financial engineer could just as easily construct a position drawn from the equity market that behaves like a commodity, or create a currency swap that looks like a bond. In other words, under the proposed OTC derivatives regime, traders will be permitted to choose their regulators. In my view, these provisions should seek to eliminate regulatory arbitrage, not create it.

Another weakness of the bill is what it affords regulators in terms of transparency. As I stated in my 2007 testimony before your subcommittee, I believe that regulators should know the positions, leverage and web of counterparty connections across firms. I do not think regulators can fulfill their mission of protecting investors, the market or the economy at large without this information. The bill enhances the transparency of OTC derivatives both by improving price discovery and by pushing for greater simplicity and standardization, a critical step. However, the division of OTC derivatives oversight between the SEC and the CFTC moves us away from this objective. There is no ready mechanism envisioned within the bill to allow unfettered sharing of these data. This not only will create routes to hide abuse, but also, because what is essentially the same asset will end up in different buckets based on how it is constructed, neither agency will be able to readily amass this position and exposure information.

One last thought, based on my experience in risk management. Risk managers have the unfortunate tendency of fighting last year’s war, of developing tools and reports to prevent the crises that just occurred from happening again. Of course, the next crisis almost always comes from a different direction. To some extent, the financial legislation has a similar tendency. For example, much thought has been given to credit default swaps. It is likely, however, that the next major issue will spring from a new financial innovation. The nature of the markets is to exploit weaknesses and to find ways to work around regulation and other constraints. Because legislation can only address what has happened in the past and what is currently expected to occur in the future, the legislation must give the regulators the flexibility to address the unanticipated.

All happy families are alike. Each unhappy family is unhappy in its own way. – Leo Tolstoy.

All days in a normal market seem the same, but when a crisis occurs, it seems as if we have never seen the likes of it before. Each crisis brings evocations of Black Swans with twenty standard deviation tails swimming in the waters of a hundred year flood. But of course, we have seen it many times before, or at least some aspects of it. The cause might be different, the initial market from which it propagates might take us by surprise. But the path a crisis takes, at least in broad strokes, hardly differs from one case to the other.

We all know the limitations of standard risk management methods in dealing with times of market crisis. And we are starting to get a sense of what is needed beyond these methods in order to see a market crisis coming, things like understanding who is under pressure, what sorts of positions they hold (and thus might be forced to liquidate) and who else is holding those positions (and thus who might get caught up in the propagation of the forced selling).

Common Sense about Market Crisis
Unfortunately, although we can hope that this sort of information will end up with those regulating the markets, it is beyond the realm of anyone in the private sector. But here are a few common sense things we know about the way markets behave during a crisis:

• Equities drop
• Volatility goes up
• Credit spreads widen
• Correlations rise
• Areas of low liquidity decline more than similar areas with high liquidity
• The yield curve flattens

Volatility goes up because everyone is jumpy, so any new piece of information leads to a big reaction, and also because there are fewer people willing to step up as liquidity providers, so prices have to move more to elicit the other side of the trade.

Correlations rise because people don’t care much about the subtle characteristics of one instrument versus another. Everything is either high risk or low risk, high liquidity or low liquidity. I think of the market during a crisis like in high energy physics, where matter melds into a homogeneous plasma when the heat gets turned up.

Because liquidity becomes critical, the less liquid markets – emerging markets, low cap stocks and the like – take it on the chin more than their more liquid cousins.

(Oh, and what about gold? Sometimes it responds, sometimes it doesn't. There is nothing intrinsic about gold that makes it part of the crisis/no-crisis equation. If it is a flavor-of-the-month market, it will respond positively, otherwise, it will simply act like a commodity, responding to economics).

Knowing this, it is not hard to take steps to protect against a crisis. Just move away from equities, avoid being short volatility, stay away from credit-laden debt, focus on the liquid markets, and watch those carry trades. Also, don’t trust diversification, because those low correlations you are depending on will not be there when it matters.

Or, if you want to be more sophisticated about it, create a variance-covariance matrix predicated on these sorts of relationships, and be sure to add a constraint to your portfolio optimization so that you will not breach a specified risk level under this crisis-based matrix. For example, if your usual risk constraint is to keep your portfolio volatility below twelve percent, perhaps you also make sure it won’t be higher than thirty percent in the case of crisis. Or, because we know the direction of these market effects, to make life simpler you can add a simple scenario test, and not allow the portfolio to lose more than, say, ten percent in that scenario. Doing this will guard against the tendency to over-rely on diversification, over-lever or put too much exposure into the markets that are particularly sensitive to a crisis.

The problem with this advice is that it is exactly the opposite of what will make sense when the crisis has yet to emerge. More to the point, it is exactly the opposite of what makes money as the market is building into a crisis.

Before a crisis (I won’t say “during a bubble”):

• Equities are rising
• Volatility is low
• Credit spreads are narrow
• Correlations are low
• The opportunities are in the hinterland markets of low liquidity
• The yield curve is steep

Volatility is low because everything is so rosy. Any new piece of information is No Big Deal, and liquidity is swarming around the market, so prices barely have to move to get an order filled.

Correlations are low because, in an attempt to find value in when every portfolio manager, trader and dentist is spending his time combing the hills for value, the slightest difference between otherwise similar instruments is worth mining. And with the languid pace set by the low volatility and money sloshing over the sides, people have the luxury of spending time in fine-tuning.

With so much money flooding into the market (and so much money means so much leverage), people start to scan the landscape for the less known – and less liquid – markets to find value.

Regime-switching models of market crisis
It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days. But they are not. It is following a different dynamic, a dynamic that we have seen enough to become familiar with. People sometimes look at periods of market crisis in the context of a regime switching model, and this gets more to the point. There are the normal times and then there are the crisis times. But what I am suggesting above is that there are (at least) three regimes. There are the crisis times, the normal times, and the pre-crisis times. The transition generally is not from normal to crisis, but rather from pre-crisis to crisis. And the move from the pre-crisis to the crisis regime is more gut-wrenching because in almost every dimension things are moving from one extreme to another.

The killer is that what protects you in a crisis is also what leaves money on the table pre-crisis. The best trades and market positions in the pre-crisis regime are the ones that cause the greatest losses in the crisis. The result is that those who take defensive actions will under-perform. So the the only way to stay in the game is to be as bold in the face of the crisis risk as others. As a result, in a variant of Gresham's Law, imprudence will drive out prudence.

This represents my personal opinion, not the views of the SEC or its staff.