Il boit pas, il fume pas, il drague pas, mais il gaffe!
“Si on mettait les cons en orbite, il aurait pas fini de tourner!”

Jean Gabin, presumably upon hearing (from his grave) of the AIG bailout

The title of this piece was shamelessly plagiarized from the 1970 French hit-comedy with the almost identical title, and directed by Michel Audiard. To anyone living in and around Wall Street, the plot should appear remarkably familiar, but please allow me a brief recap for the financial ingénues and rating agency analysts among us. There should be plenty of those, since the demand for rating analysts is now just about equal to that of Maytag repairmen.

It was a major hit in France, good enough to warrant its own 1972 sequel, entitled “elle cause plus, elle flingue!”^[1] In my humble, uninformed opinion, the only thing funnier to come out of France is the fairy tale that Jerome Kerviel actually lost $7 Billion at Société Générale. Mind you, if that were true, there would still be hope for international French finance.

The cast is a who’s who of the French New Wave. Annie Girardot plays a gossip queen/cleaning lady with three different household-clients around Paris. One, Bernard Blier, is a bank teller who has previously murdered his boss (no problem so far) and buried him in his own backyard. This type of home grown solution, so to speak, is typically French. Hollywood-obsessed Claude Chabrol used the same trick as the centerpiece of one of his more famous productions. The second is a priest by day, drag queen by night (so far, this is standard Wall Street fare). That role is played by Sim, a noted French actor with a much longer name, evidently too long for a successful career. The last member of this lovely triptych is a well-known TV anchor, a “former” prostitute now engaged to a famous politician. This is played to perfection by the voluptuous Mireille Darc, Alain Delon’s long-time girlfriend.

The basic plot is simple, as is that of all great films. Through her work at her clients’ homes, Girardot soon learns of their dirty little secret [DLS] and starts to blackmail each one in turn while making sure her name never surfaces. It would be rude to tell you the ending. All I can say is that it’s definitely worth a trip to the video store. Even if you don’t speak French, you’ll understand every word of it. Clearly, were this picture to be shot today, it would no longer be fiction but more like a Ken Burns documentary on the crisis. I saw this movie many years ago, but I never imagined it would turn out to be useful in my work in structured finance. Lo and behold! To my utter surprise and considerable delight, it is the ideal backdrop for my first, bold and risky move into screenwriting.

I propose to take you deep inside the sub-prime crisis. Since this sordid tale will no doubt require more than a single exposé, please allow me to restrict today’s public offering to the banker’s DLS. You won’t be disappointed.

In the meantime, let your imagination run wild regarding the thinly veiled identity of the slutty TV anchor, one quite willing to kick someone off her show, but never off her bed. As far as the holy man-drag queen combo is concerned, I’m not sure exactly what to tell you guys, but if I were you, I would seriously consider looking in the direction of some respected member of the community (a bean-counter perhaps?), a pillar of society who might have already confessed publicly he was doing “God’s work” by day. To be perfectly frank, the character of the priestly drag queen requires a more focused reflection on my part, the kind of thoughtful, top-to-bottom treatment I can ill-afford right now. How do the French say that again: “re-culer pour mieux le sauter!”  But enough speculation! We have a tale to wag!

Believe it or not, you will now be transported back to the adrenaline-laden atmosphere surrounding the aftermath of the legendary collapse of the twin Bear Stearns hedge funds, two wet dreams that, by the way, were neither hedged nor funds. This event is now recognized as heralding the entire subprime crisis. As you will recall, both perpetrators were later found not-guilty by a jury of their peers pursuant to an admittedly botched trial. In the end, I’m not sure what scares me more, that they should have been found guilty or not, because I was really hoping they knew what they were doing. In passing, I’m sure most of us would really like to hire the lawyers who managed to locate an impartial jury consisting of “peers” of the accused. This must have been a competition for the lowest IQ in New York.

Yet, this was but a mere prelude to the “pièce de résistance”, i.e. the Fed’s Bear Stearns bailout, the biggest mistake since Operation Barbarossa. Therefore, let me know replay with attempted Germanic precision what actually transpired in DC on the eve of that momentous breakthrough in facile, short-sighted and naïve financial analysis. In what follows, film aficionados should have no trouble discerning some of their favourite titles.

Presently, Timmy and Ben are discussing the looming national disaster, i.e. that Timmy’s son may never get into Harvard, and how to prevent it. Suddenly, the door swings wide open and an imposing presence is felt:

Hank: Ben!!!

Timmy: It’s too late boss! My son told me so!

Ben: Not for me! You stay here Timmy. Someone has to guard the jelly-bean jar. Besides, you may have the eye for DC-sleaze, but you sure don’t have the stomach.

At that precise moment, Ben storms out of the office in a huff, taking refuge by Hank’s side now on his knees outside the door. Hank knew he had one chance, one last chance to save democracy by demonstrating financial leadership, which he did via swift, Beltway-minded (he never thinks above it) action!

Hank: Ben, I really need you to come through on this one pal! The crime of the century deserves the man of the century: the Princeton man! If I don’t get his money back, Floyd’s going to crucify me. You know that’s what he pays me for!

Ben: Relax old boy! We’ll just say it was stolen at Scores or something!

Hank: I can’t lose Floyd, I can’t! He gave me my own portfolio in the Caymans’, with my own stock written in Sanskrit so nobody knows about it. If I can’t give him his money back, I won’t be able to eat a free lunch in New York for years. You need to get that cash back for me Ben or I’ll be forced to move to Cleveland and never do another deal, ever again!

Ben: This happens all the time Hank! What am I supposed to do, tell the American people we lost a trillion of their savings playing Black Jack in Vegas? Forget it dude!

This was “do or die” for Hank. Luckily, he was a master of deception, of the MI5 double cross, not to mention desperate.

Hank: You gotta help me Ben, you gotta help me! I know I’m a bad man. I know I’ve done very bad things, but you gotta help me! If I lose Bear, I’m, I’m nothing!

Ben: Hank, this could be the start of a beautiful friendship!

And the rest, as they say, is history.

Now, although this was good enough for Bear Stearns, when AIG collapsed, apparently due to a malfunctioning director’s fear of bodily-fluid contamination, Hank knew he had to outdo himself, to take the bull by the tail and face the situation.  Effectively, he had to go ballistic, literally over the top. Dustin Hoffman might be good enough for Bear, but the AIG caper required a more transcendental, virile approach. This time, he knew he had to dig deeper into Hollywood lore, and come up with “The Full Monty.”

And now, exclusively on Quant Net, a sneak preview “Inside the AIG Bailout”:

Ben: Hank, I don’t understand what happened (that’s got to be the biggest understatement since the Pope’s “the Spanish inquisition was a mistake” pronouncement of 20 years ago)? You said letting Lehman go down was the right thing to do, the end of the crisis, and that everything would be fine. Now, it’s worse than ever. Obama is totally bummed out! You need to tell him something man. Otherwise, he may give my job to somebody else!

Hank: Relax about the President Benny. He’s under control, trust me. In fact, this AIG thing is just what Doctor K ordered.

Ben: But I told everybody I didn’t have the authority to save Lehman. What am I going to say now!

Hank: Benny, you said a lot of things last night. You said I had to do the thinking for both of us. Well, I’ve done a lot of it since then, and it amounts to one thing: you’re bailing out AIG.

Ben: What! Again! Unbelievable dude, unbelievable! Alright, alright, but I need to figure this out pronto. …………. Wait! Ah! Ah! I know exactly what to do: you figure it out! You got what you wanted, didn’t you?

Hank: Ben, there are places I’ve got to go you can’t come with me. There are deals I’ve got to do you can’t do (because basically, Ben knows squat about finance).

Ben: But what will I tell the American people Hanky? If I lose this job, I’ll never get another one. I won’t come back. You know that don’t you?

Hank: Oh Benny, I’m not bad at being ignoble, but it doesn’t take much to see that the scams of two weasels like us don’t amount to a hill of swaps in this crazy world! If you don’t bail out AIG, you’ll regret it, maybe not today, maybe not tomorrow, but some day. And hey, we’ll always have Goldman!

This was by far the most mythical, meta-magical moment of Hank’s entire career. In one fell swoop, he had finagled the biggest rip off in history for the benefit of the Firm, and all in the name of truth, justice and the American way.

What lay ahead for Hank? Knighthood, if not sainthood, was definitely in the cards. Meanwhile, he could always go back to fondling snakes.

Disclaimer: All characters and events portrayed in this story are fictitious. Any resemblance to actual persons, events or places is purely coincidental.
^[1] She no longer gossips, she kills!

The following is a hypothetical conversation between Constance “Connie” de Boudinville, the dashing and attractive spokesperson for the US credit rating industry, and Axel Raskolnikov, an eastern European banker on a fact-finding mission in the United States aimed at improving the practice of banking in his native land by emulating the American model. The setting is October 2009 in sunny Miami, Florida, on the last day of the annual ASF securitization conference at which Ms. de Boudinville had just delivered the closing address, a sort of Platonic apologia for the rating agencies.

N.B. This post is dedicated to my former student and current colleague Max Rumyantsev

Axel:                       Madame de Boudinville may I have a few words with you?

Connie:                 Well, you could call me Baroness, but just call me Connie! I’m feeling good today; and after all, this is America!

Axel:                       Well, Connie then, I noted that, in your address, you failed to define what a credit rating really meant. Please excuse my ignorance, for I am new to the term and to the world of finance. Could you define what is meant by a credit rating in words a mortal like me can understand?

Connie:                 Actually, it’s quite simple. May I call you Axel?

Axel:                       Конечно! Of course, I mean.

Connie:                 A credit rating is a measure of the probability with which a corporation or legal entity will fulfill its financial obligations, assuming it has any.

Axel:                      What would happen if a company had no debt at all and wanted a credit rating?

Connie:                Well, if it paid us a fee, it would get a rating of course, but here and now, I can’t tell you what that would be.

Axel:                      But wait, if a company has zero debt, the probability with which it will fulfill its obligations is 100% by definition!  In that case, its credit rating has to be the best there is, right.

Connie:                I can see you’re new at this game Axel! That’s not exactly how the system works, but let’s just say you’re right for now.

Axel:                      So, let’s assume I owe you 100 Rubles, Dollars I mean, and the rating agency estimates that the probability of my paying it back is 90%, my rating will be 0.9 right.

Connie:                Yes, that would be nice Axel but in fact, we are much less precise than that. Instead of using numbers everyone can understand, we use letters of the alphabet, like A, B and C.

Axel:                      You mean like in high school.

Connie:                That’s right Axel, just like in high school!

Axel:                      So, I imagine that the best rating is ‘A’ then.

Connie:               You’re coming along wonderfully well Axel. In fact, the best rating is not A, but triple-A; the second best is double-A, and so on.

Axel:                      But if the ratings are probabilities of repayment, why don’t you just use the numbers themselves? Wouldn’t it be much easier to understand than letters?

Connie:                I know Axel, it’s weird, but most people in America prefer the letter system; it’s much easier to remember than numbers. There are only fifteen or so letter-ratings and most investors have no trouble with that number.

Axel:                      But wait Connie, if I owe you 100 Dollars on Friday and I can only pay you on Monday, that’s not the same as if I paid you on Friday, is it not?

Connie:                Obviously not, because you might need that money on Friday to pay someone else on Friday. Money today is not the same as money tomorrow. No argument there Axel!

Axel:                      So, how can there be only one kind of rating then?

Connie:                I never said that Axel. In fact, there are many kinds of ratings, and each of them means something slightly different. For instance, take where you work, a bank.  Banks have financial strength ratings, short-term ratings and more, and one of them addresses the Friday issue you just mentioned.

Axel:                      Amazing! How does one measure financial strength then?

Connie:                We use ratios of various financial variables, more or less the same ones people use to tell the government about their own accounts, and then decide what that means in terms of a rating.

Axel:                      OK, got it! Speaking of banks, how do you account for corruption inside the bank?  In my country, the absence of corruption is a major sign of “strength”, if not financial, at least moral.

Connie:                Axel, in America corruption is exceedingly rare, and when it happens, we usually find out too late anyway. Besides, we can only go by what other people tell us.  It’s their job to tell us the truth about the company. We are not policemen Axel, only judges.

Axel:                      The truth, ah yes, that ingenious concoction of desirability of appearance.  The truth is that the probability of payment can be any number between zero and one.  Therefore, there could be thousands of credit ratings, not just fifteen. If you use letters to express ratings, some companies will have different payment probabilities and yet have the same letter rating, and unscrupulous people might take advantage of that misinformation to make money. I think they call it “arbitrage” or something, but I wouldn’t pretend to teach you French Connie!

Connie:                Axel, you wanted to know how it works, please leave the truth alone!

Axel:                      I’m sorry Connie; I just get carried away. I won’t do it again, promise! How do we know credit ratings actually work Connie?

Connie:                Finally! It’s quite simple Axel: we have bond defaults studies!

Axel:                      Что это?  What’s that Connie?

Connie:                Well, that’s the proof that credit ratings really do work. Over the last 100 years or so, we have accumulated data on the default of corporations in the United States, so we now know what the ratings mean in terms of default frequency.

Axel:                      Default frequency?  Please explain Connie.

Connie:                OK, here we go Axel. Instead of expressing the rating as a payment probability, we use the non-payment, or default probability, because the numbers are much more manageable that way. You see, default probabilities are very small anyway, so it’s easier to quote them than the corresponding payment probabilities that would all be essentially equal to one. No one would see any difference between all these ratings, and we can’t have that, now can we Axel?

Axel:                      What’s a default Connie?

Connie:                Basically, a default is a bankruptcy, although we also include “mini” bankruptcies and special situations, and call them defaults too.

Axel:                      You mean like what Mother Russia did in 1998?

Connie (laughing):      That was a scandal Axel, not a default. OK, it was a default.

Axel:                      So a hundred years ago, rating agencies did not know what ratings really meant since they did not have any default data. What did people do then?

Connie:                I don’t know Axel, but somehow the Republic survived!

Axel:                      So then, rating agencies only have ratings for the United States right. You said that the default data were for US companies only.

Connie:                Actually Axel, we have ratings for most large countries and most large companies in the world.

Axel:                      But how do you know that the default probabilities associated with those ratings are the same as those for the US companies of the same rating?  Life in Europe is quite different from life in the US Connie; you know that.

Connie:                It does not matter Axel, because we are the worldwide arbiters of credit.  As long as we say it’s OK, it’s OK Axel. See what I mean. One day, we will know what these European ratings really mean, but in the mean time (please excuse the pun) there can only be one referee in any game. Can you imagine a soccer match with two referees?

Axel:                      No, I really can’t. However, I can imagine a biased referee in the game Connie. Many European companies are now competing with US companies and if the default frequencies of two companies are in fact the same it wouldn’t be fair to give the US company a higher rating than the European one, now would it?

Connie:                No it would not, but we are fair, Axel, that’s why we’re in charge.

Axel:                      This is great Connie!  May I trouble you some more?

Connie:                Of course Axel, the rating business is an open book.

Axel:                      I also noted that you spoke of senior secure and senior insecure ratings.  What are these things Connie? Where I come from, everything is insecure.

Connie (laughing):      I said “unsecured”, not “insecure” Axel.  This means that corporations can have securities with different priorities of access to cash should they go bankrupt, and we feel that investors who own the securities with the higher priority will lose less of their investment than those who own those with a lower priority.  We assign a lower rating to the second type of securities to reflect that belief, which belief, I might add, is also verified in practice.

Axel:                      Loss? You never said anything about loss before. I thought credit ratings were about default frequencies, not losses. Even if I lose less than the next guy, the company still defaulted, right Connie?

Connie:                But how then are we going to tell investors that they will lose more money if they invest in unsecured than in secured bonds? We have to make a difference, Axel dear.

Axel:                      Certainly, Connie dear. However, the place to introduce the concept of loss is where it makes sense, i.e. not in the definition of default frequency but rather in your estimate of recovery. You should simply state that unsecured investors would experience higher loss upon default than secured investors, but that the ratings are the same since the default frequencies are obviously the same. Right now, people who price loans using the current system are clearly overpricing since they are double-counting the reduction in recovery.

Connie:                Touché Axel.  I’ll have to bring this up at the next steering committee meeting. Tell me Axel, would you be available to come out and tell our management that they have been wrong for the last hundred years?

Axel:                      Now, now, you wouldn’t want me to subvert the American way of life Connie! Communism is really over, you know!

Connie:                Don’t worry Axel! Americans truly respect honesty, especially in foreigners.

Axel:                      So how does it work Connie? I need a rating, so I go see a rating agency, pay them a fee and get a rating. Is that it?

Connie:                That’s about it. See how simple it is!

Axel:                      What if I don’t like it? Can I pay more and get a better rating?

Connie:                Axel, this is your second warning! One more and you’re on watch! Of course not! If you could do that, everybody would do it. Then, credit ratings would lose their meaning and the country would be in utter chaos.

Axel:                      That’s amazing Connie! In my country, everything has a price. I can see a situation where someone would borrow money from the government to look good for the rating contest and then give the money back afterwards. This way, they would get the rating they want.

Connie:                That would not work Axel, because as soon as they gave that money back to the government, we would lower their rating.

Axel:                      But wait a minute Connie; are you saying credit ratings can change?

Connie:                But of course Axel; they can change at any point in time.

Axel:                      Do they?

Connie:                Actually, they don’t because most of the time, corporations don’t borrow money from the state, or from anybody else for that matter, just to get a credit rating. If they did, that would be fraud, and that’s illegal. Most of the time, their financial condition is like our method, an open book. Credit ratings are more or less the same all the time. Of course, every now and then, something awful happens and we have to lower the rating. We call it downgrading. Or else, something very good happens and we can raise it; we call that upgrading. Credit rating is quite a sophisticated business Axel, one where angels fear to tread.

Axel:                      But things happen all the time in this world Connie, so ratings should really change quite often. Why don’t they?

Connie:                Well that’s just it Axel! Our clients: investors, corporations and bankers that is, really don’t like it if we downgrade too quickly, or upgrade too quickly for that matter. They say it creates uncertainty because companies borrow money at rates largely determined by their credit rating. Can you imagine if ratings could change every day?  CFO’s would never get any sleep! Unless things are truly bad out there, we leave it alone. Besides, if we had to monitor all the companies we rate our analysts wouldn’t get any sleep either! This way, everybody is happy.

Axel:                      Yes, but if you downgrade only if things get really “bad”, as you say, everyone will be taken by surprise, except of course those that already knew it. How can you say that a default probability has suddenly increased tenfold overnight? Is it not likely that all that bad “stuff” was there all along for everyone to see? If you slowly reduced the rating as things unfolded over time, would this not be a better way to tell investors about it. In fact, would this not avoid having to do the very thing you seek to avoid, i.e. a catastrophic downgrade?

Connie:               Perhaps so Axel, but you have to pick you poison. Either a credit rating is a long-term view of the company, or it is a current view of the same company. It can’t be both Axel. As long as everybody knows what we do, it’s really their fault if they misjudge the rating! Moreover, as I explained to you ten minutes ago, credit ratings really do work. On average, they really express the default probability of obligors. It’s not our fault when some investor out there owns the one corporation that actually defaults.

Axel:                     That’s strange, because in my country, people don’t care if someone else loses money, only if they lose money. Wouldn’t it make more sense to tell people that they are about to lose money rather than telling them that they are just fine on average? To say the least, it seems to be misleading. Could you not provide timely ratings instead of long-term ratings? No one really cares what happens on average, if they are dead now!

Connie:              Axel, this is your last warning! Don’t you remember what the greatest writer of all time, Voltaire, once said: the more things change, the more they stay the same! Well, that’s our policy in credit ratings Axel. That’s all I have to say.

Axel:                    I do remember Voltaire, but the greatest writer of all time was Dostoievsky, not Voltaire! Joking aside, you mentioned something about structured finance ratings in your talk. What is structured finance anyway?

Connie:              Glad we changed the topic Axel! Structured finance is a way for people who can’t get money to get it anyway. You can imagine how popular that might be!

Axel:                    And how does that happen? We’d really like to use it in Russia if possible.

Connie:              It all starts with a special purpose company or an SPC as they say. Then, you sell your assets to the SPC and it borrows money, not you. This way, the people that give you the money don’t really care if you go bankrupt, since they have your assets locked up in the SPC. They get comfortable with the situation and let you have their money.

Axel:                    So, all I need is an SPC and assets for sale?

Connie:             That’s right Axel!  However, make sure you really sell those assets, and not just pretend to sell them. Otherwise, it’s not structured finance but corporate finance.

Axel:                   That should be easy. It must be obvious when you are selling something, is it not?

Connie:             In fact, it’s not Axel; and that’s why we’re on top of things in that department. Darling, don’t you now see how useful rating agencies are?

Axel:                   I have so much to learn Connie. What about structured ratings then?

Connie:             Structured ratings are different from corporate ratings because structured securities are specifically constructed to have a default frequency of zero, so we can’t give them normal ratings now can we.

Axel:                   If they all have the same default frequency, i.e. zero, what do these ratings really mean then?

Connie:             Remember the loss discussion from a few minutes ago? That’s the key.  Structured ratings are loss estimates, not default estimates, and we express that loss in basis points, which is banker-talk for percentage Axel. Unfortunately, some of us in the industry are still not convinced and insist on using default frequency as the measure of structured ratings. I’ll have to talk to them about that some day (sigh).

Axel:                   But how can this be, isn’t everybody looking at the same deals?

Connie:             Yes Axel, but that’s politics. Please don’t tell me you don’t know about that!

Axel:                   Politics is one thing, money quite another. One of these people is clearly wrong. Can’t the other guys talk to him and work out a uniform definition of structured ratings?

Connie:             Actually, it’s more or less already happened. As far as I know, everybody now looks at losses.

Axel:                    Thank God Connie! You scared me for a split second! Come to think of it though, it wouldn’t be so bad after all to have two incompatible definitions. We Russians have lived with a split-brain for centuries and we are doing just fine, right?

Connie:              Yeah, right!

Axel:                    Well, if structured ratings don’t mean the same as corporate ratings, there is no reason why they wouldn’t change all the time right, or is Voltaire making magic here too?

Connie:              Yes, I’m afraid that most illustrious of world scholars is right on again! Structured ratings are different from corporate ratings in their definition, but they are still supposed to remain the same forever.  Just like for corporate ratings, if we find out something nasty is going down, we can downgrade the bonds. In fact, even if we only believe something is going to happen, we can take preemptive action, just like the US army Axel!

Axel:                    But how do you find out what people are up too if you don’t monitor the deals?

Connie:              We do monitor the deals Axel!  However, we are not responsible for other people’s crimes, just our own. If we know what’s going on, we adjust the rating for sure.  Otherwise, our policy is the same as the army’s: don’t ask, don’t tell.

Axel:                    But if structured ratings are loss estimates, isn’t it true that one knows more about losses four or five years after closing than one year after, and so the rating should change to reflect that increased knowledge, should it not? After all, deals can also get better, not just worse. How does it go again? The sun sets, but the sun also rises!

Connie:              I see you read a lot of books. That’s quite unusual for an investment banker. Axel really! Even if we did know more about a deal, and I’m not saying we do, what’s the difference? After all, investors are still in as good a shape as they were four years ago. There’s nothing new in that. Who cares if the rating is really better than before? You can’t lose less than zero right. If the issuer has too much capital in the transaction, big deal! We are an investor-service Axel, not an issuer-service.

Axel:                    You do have a way with words Connie!  If structured ratings are already different in one respect, why can’t they be different in another? Why can’t structured ratings be dynamic instead of static?

Connie:              Because we are already on record as saying they don’t change. Don’t you hate it when people keep changing their mind? I surely do. This way, everything is just fine. Of course, every now and then we make a mistake. To err is human Axel, and to forgive divine, remember that!

Axel:                    I agree with you Connie. Consistency in spite of overwhelming evidence is truly a virtue. What I now see so clearly is that the problems of two people like us don’t amount to a hill of swaps in this crazy world! If they change that rating, they’ll regret it, maybe not today, maybe not tomorrow, but some day! This way, they’ll always have plausible deniability (intense gaze)!

Connie:              Axel, this could be the start of a beautiful friendship (longing look)!

Axel:                     But wait Connie, if rating agencies believe structured ratings are dynamic, then what’s the problem telling investors the truth?

Connie:               It’s not about the truth Axel, it’s about deal flow. At any rate, before one can tell the truth, one has to know it!

Axel:                     Amazing! It’s starting to look more and more like Russia. My boss is going to love this!

Connie:               You’re quite a fast learner dear. Make sure you let me have your resume when we’re done.

Axel:                     Thanks Connie! By the way, I couldn’t help reading about what those horrible people at Enron did! Apparently, they used structured finance to get money they shouldn’t have. However, you said that’s what structured finance is all about Connie. So what did they really do wrong?

Connie:               You put your finger on the problem Axel! What they did was not structured finance at all, but something that was made to look like structured finance.  Investors were all fooled because structured finance is really a good thing. These wretched individuals used the good name of structured finance to get money from unsuspecting investors. That’s what went wrong!

Axel:                     Isn’t there something that could have been done to see what was going on, like following the rules of structured finance for instance?

Connie:              That’s easy to say Axel!  Have you ever tried to find out what is going on inside a small company, let alone a big one? We can do nothing about fraud Axel! We trust that what accountants are telling us is true. If it’s not, we are off the hook anyway, and we simply move on. Of course, there’s a bad apple in every barrel Axel, but we’re still the only game in town. In fact, we are protected by the first amendment to the US constitution because we are only offering our opinion, nothing more. Like ABC News or something! We have no liability for that opinion. If we mess up, we just say buyers beware and that’s it. It’s a very solid business plan.

Axel:                    It’s getting better all the time it seems. Coming back to Enron, were the rating agencies not watching these bad people in action Connie? If it was not structured finance, and the rule makers of structured finance, i.e. the rating agencies, were reviewing the deals, then how could they make it look like it was?

Connie:              But Axel, structured finance is complicated nowadays. We are not Gods, although you might think we are. In many cases, our people are simply overwhelmed and just can’t cope with these complex structures.

Axel:                    What do you mean by a structure Connie?

Connie:              A structure can be many things but essentially, it’s a set of rules that determine who gets the cash that comes into the deal. Much like a financial “auto pilot” you might say. It works like Aeroflot, except that these structures don’t crash all the time. Come on Axel, I was just kidding!

Axel:                    That’s great! Because Russians know a lot about rules, in fact, we practically invented the rule business. You know, like chess and all! Wouldn’t it be easier to cope with all these rules by putting them inside a cash flow model and letting the chips fall where they might. That way, you wouldn’t really have to worry about how complicated the interactions between the rules might be, for they would simply come out of the wash naturally. All your analysts would have to do is keep a stable of models for the various types of deals associated with the assets, and voilà! Isn’t this a better way to go?

Connie:              Perhaps it would be in the end Axel, but as surely as I’m standing here today, it would also destroy the romance of the old ways, when a seasoned analyst could simply eyeball a deal and guesstimate the required enhancement at a glance. Everybody’s just talking about the good old days, but at the rating agencies, we are truly living them.  Don’t you feel like our society has lost too much of its charm with all that financial wizardry? Enron is just another example of why we should move backward, not forward.

Axel:                    Yes, technology does dehumanize Connie, but in my opinion, losing money is much worse. On the other hand, I freely admit that romance is hard to give up.

Connie:              Axel dear, don’t you think we’ve talked shop long enough? Why don’t you buy me a drink, and then maybe you can show me your e-bit, da?

Axel:                    Ahhh Constance ma chérie! Détente can be beautiful. Пошли!

Sylvain Raynes is a founding principal of R&R Consulting, a structured credit metrics consultancy founded in 2000. A former analyst at Moody’s, he co-authored “Elements of Structured Finance” with Ann Rutledge. His interview, mentions, and articles written exclusively for Quantnet can be found here.

It will be recalled that Kantian philosophy was mainly a reaction to the liberating, and thus politically dangerous, “new” physics of Isaac Newton. Apparently, and contrary to prevailing opinion, unaided human intelligence had figured out the divine mind underlying all things. Kant replied that, on the contrary, since the way we viewed the universe was essentially related to the very make up of our mind, Newton had in fact figured out his own mind, and nobody else’s. The philosophical issue was that a successful deductive system had been invented, contrary to the inductive, Aristotelian paradigm that held sway at the time. The underlying political issue was of course much more serious. It was a debate between a world of infallible laws (the Republic) on the one hand, and a world of fallible men (the Monarchy) on the other. What does this have to do with credit ratings?

The essential difference between human and purely physical systems is the presence of volition under the guise of feedback. In this case, if there were no cybernetic loop leading from the credit marketplace back to the credit analysis community, credit professionals would have to truly discover the underlying physics associated with credit dynamics to have any chance of being useful in an economic sense, something that would amount to knowledge of the future. In short, it is the inductive, as opposed to deductive, nature of credit ratings that renders moot the question of the exact mathematical relationship between default rates and rating assignments.

It may seem amazing that the many generations of credit analysts that have gone through Moody’s and S&P have collectively and unintentionally given rise to a logarithmic credit scale. As Kant would have said, the fact that this happened is probably related to the way the human mind perceives reality. Thus, the logarithmic form is the only absolute of a credit scale. The larger the database, the more it is self-reinforcing. Companies whose default behavior is different from what the original rating would lead us to conclude are simply downgraded such that they now fit into the appropriate default bucket. In a nutshell, the particular initial numerical correspondence enforced between letter grades and default rates is immaterial. Any logarithmic scale can be used because that scale simply becomes the set point around which the entire process starts to converge.

The use of an objective rating process is however the conditio sine qua non for this coalescence to occur within a reasonable time frame. A rating process left to subjective human intervention will display a much higher noise-level than that associated with the actual statistical behavior of the real world. By contrast, the consistent use of objective scoring models acting as control mechanisms will produce much faster convergence in distribution than any judgmental system.

In the process of adopting the new Basel II proposals, banks will be encouraged to devise internal rating systems under the theory that they know their customer base better than anyone else. Our point is that a reliable correspondence between assigned letter grades and actual default rates will take much more time to converge if a bank adopts as its standard the rating agency method of peer group comparison rather than mathematically rigorous credit scoring methods. This is because, as we have indicated above, any under- or overestimate in the actual default rate of a similarly rated universe of companies will be fed back to the rating system and will cause an immediate correction to the original default rate estimate. This corrective process, when implemented either through the rating scale or via the mapping function between ratings and their associated default rates, will continue until default rates converge in distribution exactly to the assumed rating scale.

In other words, if we had started out assuming that Aaa companies had a 2-year default rate of 0.01%, then at the end of fifteen or twenty years of observing the credit behavior of companies rated Aaa by a bank’s internal rating system, the actual 2-year default rate of such companies would be very close to 0.01% because any discrepancy between the default rate of Aaa rated companies and 0.01% would have generated a corrective signal that would have either lowered or raised the average rating of companies in that segment to bring the default rate in line with our stated target. The combination of a feedback loop and a purely objective rating process thus validates our initial assumption about the rating scale. This is what Kant meant. Without feedback, any assumed default rate behavior underlying the credit scale remains just that, i.e. an ungrounded opinion. As we know, all of them are wrong a priori.

For another example, most economists are deeply impressed by the fact that the Black-Scholes [BS] option pricing formula can predict so accurately the actual price of traded options. For them, this is a proof that the BS formula is the “right” model of option pricing. In truth, this type of statement betrays a very linear, hence adolescent, understanding of economics. What really happens is that market participants are simply using the BS formula to price options. A true comparison between the BS price and empirical evidence is neither attempted nor necessary. Therefore, this coincidence between theory and practice is as amazing as the fact that large rivers somehow always flow next to large cities, or as ludicrous as the well-known CEO opinion to the effect that he or she “doesn’t play politics” at work.

This Kantian epistemological argument simply reinforces the belief that rigorous bank credit rating models are not only desirable to save money, but they are also necessary if economic meaning is ever going to attach to credit ratings in our lifetime.

About the Author:
Sylvain Raynes is a founding principal of R&R Consulting, a structured credit metrics consultancy founded in 2000. A former analyst at Moody’s, he co-authored “Elements of Structured Finance” with Ann Rutledge. His interview, mentions, and articles written exclusively for Quantnet can be found here.

I would like to tell you about the recent Unites States long-term credit rating downgrade by S&P.

Now surely, the Republic will stand regardless of the doom and gloom the S&P minions may see in their crystal ball. Rather than piling in right away with Hegelian negativity on steroids, please allow me to indulge in one of my most cherished childhood memories. Beware, though, for I’m about to tell you a cybernetic story, so if you have better things to do right now, please stop reading. Despite my best literary efforts, what follows is likely to be about as exciting as reading the Wall Street Journal, although Rupert seems, of late, to be doing his best to “raise the bar,” so to speak.

Many years ago, I was addicted to a TV show called Kung Fu. It was a typical 60-minute weekly drama set in the old American West and relating its myths, lies and fantasies. The hero (David Carradine) was presumably a Chinese immigrant whose early childhood had been spent as a pupil at a Buddhist monastery somewhere in China, where he had received extensive training in self-control, martial arts and philosophy. He was kind and merciful and would spend approximately 55 of the 60 episodic minutes preaching peace, understanding, self-abnegation and friendship among men of good will. He would then spend the remaining five minutes beating the living hell out of everybody else on the show. The moral of the story, at least it seemed to me at the time, was that in some cases peace and love just don’t cut it.

The episode I most vividly remember is one during which two young novitiates, one of whom (Cheng) is our hero, the other (Chang), are given cash to travel to a nearby village to buy food for the entire household. On the way, they encounter a nice-looking old man who inquires about their journey. They tell him the truth, as young boys are wont to do, whereupon he proceeds to tells them about a secret shortcut to the village that will save them about half an hour. They thank him and happily take the shortcut. Unfortunately, this was a con job. In the middle of it all, they fall prey to an ambush and lose the cash. They return to the monastery, clearly with their tails between their legs, and are immediately asked to join a woodshed meeting with the Master in residence. It went something like this:

Master: Tell me, Chang, what did you learn from this?
Chang: Not to trust strangers!
Master: Tell me, Cheng, what did you learn from this?
Cheng: To expect the unexpected.
Master: Chang, you will be leaving us soon.

And the rest, as they say, is history. Why am I telling you this?

For openers, let me tell you why I am not telling you this. Not because I expect you to spend your early years in China learning martial arts and philosophy at a Buddhist monastery, and not because I think violence is an acceptable way to resolve problems, for it obviously is not. On the other hand, even if you did hang out in Chengdu for the next ten years, you would probably not even miss a beat on Wall Street, and would most likely be able to resume right where you left off. Voltaire said, plus ça change, plus c’est pareil: The more things change, the more they stay the same. Can a Frenchman really be totally wrong, especially a self-maid man? But no, I have a more mundane goal in mind today, one I already warned you could only be reached indirectly and painstakingly.

Are you still with me? Please don’t quit now, for the worst is yet to come.

The world of credit ratings does not exactly connote Hollywood-style sex appeal. Historically, the average credit analyst was usually someone with a social profile lying half-way between a misfit and a nerd, very much like me, I’m afraid, going about his business with the naïve certainty that the world is better off because he exists, defending the human rights of widows, orphans, institutional bond-fund managers and other defenseless creatures. When the alternative is something as profoundly rewarding as clearing & settlement or custody, one can easily understand the attractiveness of a job in which recognized business leaders actually return your phone calls and call you by your first name, apparently because deep down, you’re such a pal. If only it were true. The only occupations with more ego-stroking potential are probably journalism, movie stardom and fashion design.

With the advent of structured finance, though, a market solely predicated on the existence of primary market ratings and thus, on the prior possibility of value, credit analysis acquired an exalted, quasi-mythic status, the moral equivalent of the Oracle at Delphi. Ordinary mortals with ordinary jobs had suddenly been made into rock stars. A formerly inconsequential human being was now referred to as a Bodhisattva, while invitations to Louis Vuitton cocktail parties were no longer unthinkable, or infrequent. Credit analysts went from limp losers to Latin lovers in one easy step, and their financial exploits were now recounted in hushed and respectful tones. Their new issue reports got more web-views than Paris Hilton, and seven-figure salaries went from unattainable to lived experience. At Midas Mufflers, you were just a “somebody,” but at S&P, you, erstwhile unacknowledged toiler of the netherworld, had suddenly turned into a big swinging you-know-what, literally a general of the capital markets. Now clearly, every man is a general to his dog, hence the popularity of dogs.

Is this not the quintessential American dream, the faint but still non-zero probability that every US citizen can one day become a hero and marry a fashion model? What’s wrong with a little Yankee self-actualization, with getting that proverbial piece of the action? After all, isn’t it true that no man is an island, in itself entire? Apparently, reciprocity is the key to every lucrative relationship. So, cooperation with Wall Street was obviously the right thing to do.

What’s wrong, of course, is that it was just that, a beautiful dream.

One day, you had to wake up and realize that, when all is said and done, you never understood a thing about finance, that Warren Buffett is not really your high-school buddy, and that the captain of the swim team is still more likely to wed the fashion model you were ogling so fondly just a few moments ago. At some point, it had to dawn on you that you never were the master of your own power; that you commanded without authority, attempting to live your life in reverse. In the end, you were still just who you had always been, only less so because you actually believed the dream. If only investors would forgive your trespasses while punishing those who trespassed against you, all would be well in the quiet countryside, to say nothing of the not-so-quiet Countrywide.

Mea culpa, mea culpa, mea minima culpa!

Dear repentant credit analyst, finance is an analysis of time, of non-linear time that is, i.e., of something apparently beyond your ken. Mind you, the same type of fiasco would have happened had anyone else been in your shoes. Wall Street bankers, self-proclaimed former masters of the universe, are actually glad they have someone else to blame but themselves, for the truth is they would have done exactly the same thing, and most likely worse, given that the average investment banker has as much self-control as Bill Clinton at a Playmate convention. As that famous playwright would surely have said, “The fault, dear trader, lies not in your deals but in yourselves.”

But wait, say you, what about the S&P downgrade? I know what you’re thinking right now. “Can’t this guy say something nice for a change? Can’t he say something righteous, and loving? These are beautiful people!” In the end, isn’t it just easier to shoot the messenger simply because you don’t like the message? Ah yes, the downgrade. What about it? Essentially, S&P said there is too much politics in Washington, and that $2.4 trillion is not enough; it needs more. I’ll bet Monica Lewinski said that too.

First, to say there is too much politics in Washington is like saying there is too much “greed” on Wall Street, too much reckless driving at the Indy 500 or too much sex in a brothel. This shocking news is neither shocking nor news. Second, just a week ago, S&P admitted publicly that it had a bug in its CMBS rating model, most likely for the past 20 years or so, and canceled all future CMBS deal ratings until further notice. Goldman was impressed I’m sure. But that’s not the best part. Just a few months ago, it also admitted not understanding the waterfall-distinction between pro rata and pari passu. I guess S&P can speak neither Latin nor Excel correctly, which may go a long way towards explaining its reluctance to rate Latin American countries AAA. On its face, this downgrade-thing is chutzpah taken to the limit, akin to a priest downgrading God, or a husband telling his wife, “Honey, this time I’m putting my foot down!” Basically, it’s a joke on many fronts.

On the political front, S&P no longer has the moral authority to downgrade an entire country after the fact, when this is precisely what they are accused of having done, no doubt coincidentally by that very same country, just a couple of years ago. If anything, the downgrade is way too late, not to mention way too smug and convenient. In a self-respecting sport like football, late hits will get you a big fine. What will this get S&P? God knows! But that’s the whole point, gentlemen. God is now dead, and S&P is responsible.

A famous Russian proverb says: После боя кулаками не машут. Don’t swing your fists after the fight. When it’s over it’s over, guys.

Perhaps S&P ought to use its credit-rating principles on itself and apply its outrage at the nefarious influence of politics to its own pathetic situation, contemplating the countless lawsuits it is now defending, suits that arose directly as a result of S&P’s mammoth incompetence and inability to know when to downgrade something much less problematic to grasp than Beltway politics. Yes, it is wrong to shoot that oh so Standard, but decidedly not Poor, messenger arbitrarily, but this is someone who’s been walking around for years with a bull’s eye on its forehead.

On the technical front, the thorniest issue is the fact that the US credit rating is the ground, the basis of all other ratings, the equivalent of zero in mathematics. Moving the zero on the scale, apparently without a Plan B, makes as much sense as switching from Fahrenheit to Centigrade in temperature reporting, and then claiming it is “colder” in New York this summer. At this juncture in world history, please tell me who is more creditworthy than Uncle Sam? Do they have nuclear weapons? Do they have cruise missiles? Do they own the Internet? Does their currency also count as international money, in addition to gold? Viewed in the proper context, the S&P downgrade is a meaningless, exculpating, cynical and naïve move that can only result in the immediate focus of the nation’s attention on how badly these people behaved, and continue to behave, despite clear pronouncements to the contrary and innumerable acts of contrition. A savvy US president once remarked that if you’re not part of the solution, you must be part of the problem. Sadly, S&P seems to have crossed that thin red line.

The last bump on the road to righteousness in this S&P saga is likely to be the inconvenient fact of the sovereign ceiling. As you all know, no corporation can have a credit rating higher than that of its sovereign for the simple reason that the sovereign has an implicit, if not explicit call on its country’s assets via taxation and other legal mechanisms. So far, no one has denied this. Therefore, in a few days or so, S&P will have to either downgrade every American AAA-rated corporation, presumably telling them they are sorry, because to such companies a downgrade is not just politics, or else do nothing, thereby covering itself with additional vainglory and demonstrating once again that it is better to remain silent and pass for an idiot than to speak and prove it.

Finally, what about Chang and Cheng from Kung Fu?

You will recall how Chang was fired from the monastery for failing to understand the principle that whatever happens to you should not always be ascribed to others, and that taking responsibility for your own actions and their consequences is the origin of all wisdom, not to mention of all wealth.It is painfully obvious to most observers that S&P needs to take a good look in the rear-view mirror and ask itself, in addition to the army of lawyers now on its payroll, whether it still likes what it sees, or whether, as most of us have already concluded, this sad reality-TV episode wouldn’t be a great excuse to spend some time in a Chinese monastery. From what I know of S&P analysts, I think they might just love it. And who knows, China might begin to love them back!

As many of you know Dr. Dan Stefanica released the second edition of his best seller book, ‘The Primer for the Mathematics of Financial Engineering’. When I heard that Dr. Stefanica would be personally signing every copy of the first set of shipments I went ahead and got myself the book and a copy of the solutions manual. Two weeks later, I see it only fitting that I write a review about it.

As many readers of the first edition will notice the book has gone through a bit of an overhaul. There is a significant amount of material added. The size of the book is bigger and the font is smaller. Dr. Dan Stefanica has found a way to literally combine a whole introductory course in Financial Engineering in a 324 page book. As I have mentioned before, this book is a MUST HAVE for ANY financial engineering student. If you have an admission for MFE, pick up this book right away. You will not regret it. The book is not only a great preparation for MFE programs but also an excellent primer for quant interviews.

As the book states some of the new things added in the second edition are Dollar duration, dollar convexity, DV01, Lagrange multipliers (extensive), maximal return portfolios, numerical precision of finite difference approximations of Greeks, parallel shifts in yield curve and more. The book also has been reorganised to give a better streamlined movement as the user goes through the book. Some proofs and basics have been moved to the appendix for readers to have a look at and the main part of the book is now only filled with relevant practical and theoretical information. The book covers several important topics: Put-Call parity, interest rates, bonds, Black-Scholes formula, implied volatility, portfolio optimization and many more quant finance topics. As I have mentioned before it truly is a unique PRIMER in financial engineering.  Adding the new topics has helped to give students a deeper understanding about the fields thereby giving them a head-start basically for the courses in their first semester. I had some criticism of the book last time which had been mentioned by other readers as well. Dan has mostly met everyone demands which is also truly amazing to see. You don’t usually see writers listen to their readers in such detail. The one thing I would still have liked is to have a Bootstrapping code, but I guess that is one of the things the readers will have to figure out for themselves. Many program curriculums that I have seen have parts of this book as a course. Some universities that offer Pre-MFE programs have also made this book a required text book. And I am not surprised as it should be.

The book is also great for interviews. All interview books do a general Q&A format. This book first explains all the concepts in great depth and then puts forwards the question that can be asked in interviews. And trust me, the majority of the questions are typical quant interview questions, from the first round general questions, to 2-3^rd round deeper analytical questions. The solutions manual provides mostly thoroughly explained answers to the questions giving the reader a better grasp of the material. Dr. Stefanica always says that the biggest compliment he has got for his book is the fact that during interview season he finds the book in the hands of all his students in the Quant Lounge at Baruch College. And this is very true. We all in the Baruch MFE program can be seen going through Dr. Stefanica’s book before any quant interview. I used it on many occasions whether it was for a trading interview (lots of questions about options/put call partiy/Greeks) or for a desk quant internship (finite difference, Newton’s methods, algebra, etc).

But why listen to just me?

Here are some more reviews from student and a recent graduate..

Dr. Dan Stefanicas’s refresher is an excellent overview of the introduction to the math involved in pricing financial instruments. From basic bond arithmetic, and a thorough treatment of the Black Scholes Framework, this book makes for a great introduction into the mathematics of Finance to both future students studying in math, and those who would want to attain careers related to finance.  This book is also very solid on the basic knowledge required to do well in junior level positions and I find myself browsing through it to review any concepts that might have slipped my mind since the last time I cracked it open. Well worth the money. – MFE student

It is a pleasure for me to write this review in favour of Dr. Dan Stefanica’s primer book. I had bought the first edition when I started my program and have recently ordered the second edition to the book. I recently went through the recruiting process for quant analyst positions at banks and this book aided me greatly. Many of the questions asked in the book were basically right off the interviewer’s questionnaire. The thing I like the most about the book are the pseudocodes. It helped me a lot during my first semester as some of our profs did not go into much detail. In the new book I like the addition of Dollar duration convexity and DV01. Every student in MFE or MSCF or MSFM program should know these concepts.Every financial engineering students should get this book! – Recent MSFM Graduate

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It has been a little while since my last post. I have been very busy with interviews and the recruiting season. It has been quite a ride. I have interviewed with several firms as I had mentioned in my last post. I have narrowed down my offers to the firm I will be doing my internship at. It is a large European BB. I will get out more details later.

The purpose of this post is to give out as many tips as I can as to how I believe a person can secure their dream internship. I am relatively new in finance but I worked VERY hard the last few months to attain my internship. I was lucky enough to have the option of having a couple offers to choose from.

So here are my tips…

1. Location – This is probably the most important thing. If you go to a school where there are strong placements you literally have to do absolutely nothing but show up to the interviews since your career services takes care of the rest. But if you don’t goto a target school then you have to be in New York. There are many that will say Chicago is a good alternative but your choices are basically restricted to prop firms. There is very few BB trading happening in Chicago. It literally comes down to New York or nothing. The proximity to New York is the most important. So pick a school in New York City or in the tri-state area. If you get into Harvard or Yale or any of the target schools then it doesn’t matter where you are, but if you don’t, be as close to NYC as possible. I have found this to be VERY effective.During my first four months in New York I went to almost every finance conference I could find. Many conferences will let you in as students. But more about this in next tip..
2. Networking – This has been my strongest suite. I have networked networked networked like a maniac over the last 8 months. As I mentioned during my first four months in New York I went to as many conferences as I could find and talked to everyone I could. I tried to get as many business cards as I could get and tell as many people my name. I made my own custom business cards and basically gave them to everyone I could meet. I tried to speak to everyone, big or small. I spoke to John Hull, I spoke to a tech analyst at a small hedge fund. I did not leave anyone out. My motif was to get my name across to as many people I can in finance. I had built up a good database of emails after a while that I used later on for internship requests.  I made a lot of good friends during this period too. I would say the friendships and the mentors I have built during this period are the most valuable to me. I am able to call Managing directors of large banks (CS,JPM,GS) hedge fund traders, private equity portfolio managers and quants my friends.

   People might say, “I don’t have the money to go to all these conferences.” I have taken significant loans to pay for my schooling. Even though I go to Baruch where tuition is low, I live in midtown Manhattan and my cost of living is high. I chose to live in manhattan since I wanted to be in the middle of it all. I did not have money to goto conferences. My loan was just about enough to pay for tuition, food and rent. I literally was eating less so that I could save money to goto conferences. I was emailing the conference organisers and pressuring them into giving me significant student discounts so that I could attend. You have to make sacrifices. I did, and it was all worth it now. Be pro-active.

3. Applying – Many people say applying online does not result in much. This is not true. It does have a very low probability of working out into an interview but there is a chance that you might get called for an interview. My friends have got interview calls from Goldman, UBS and JPM by just applying online. I myself have got interviews at two large hedge funds and a big bank by just applying online and having no connections inside. So, take the time and work on your applications and apply to AS MANY companies as you can. You apply to 100 firms and maybe one of them will hit, so apply to as many as you can.

   Quantnet maintains a list of firms with quant internship positions.

4. Be Flexible – Everyone wants to be a trader and become rich overnight. That is most likely not going to happen. Even if you want to be a trader it won’t happen for a very long time. But there are possibilities that it might. Be flexible in terms of what you want to do. Risk management is an area of big growth right now. It will be a lot easier to get full-time offers if you do internships in risk management compared to Sales and Trading. If you are so fixated on money, trust me you can make a good living in risk management. One of my friends is working at a large bank in their risk management group and is a fresh graduate of an MFE program and has been working for almost a year now and his total compensation for this year was around 120K. I think that is pretty awesome. So be flexible, and look into risk management, technology and analytics and don’t just be fixated on getting trader jobs.
5. Knowledge – No one is going to ask you to code a finite differencing scheme during your interview or to solve stochastic differential equations. Here are some basic things you MUST know before going to ANY interview. These are things you should know in GENERAL even if you don’t go to an interview as it could come up during a conversation at a conference or event.
   • Black-Scholes – You must know black-scholes like the back of your hand. It has come up in EVERY interview I have had. You should be able to derive the BS equation by ATLEAST one method. Wilmott’s FAQ book has 12 methods.
   • Greeks – You should be able to say exactly what happens to the Greeks when variables in Black-scholes are manipulated.
   • Bond – Know how duration and convexity work and how they are used in portfolios. You must know absolutely how yields work.
   • You must know these values:
     S&P Index
     Dow Jones Index
     VIX
     EUR/USD
     CAD/USD
     Stock of the company
     Market Cap of the company
     Fed Funds rate
     6 month, 10 year US Treasury Yields
     10 year Bund Yield
     WTI Oil
     Copper
     Latest Employment Data
   • Always be ready to pitch a stock. This is VERY common in Sales and Trading interviews. Be ready to pitch a stock with accurate price target and reasoning behind it.
   • Read the WSJ or FT as often as you can. Know what Bernanke has said the day before.
   • Product knowledge – In internships you are not expected to have a significant amount of product knowledge. You should the following products:CDS , IR swaps, Vanilla Options(European and American), Asian options, Barrier options, Corporate Bonds, MBS, CDO, Index’s , Equity, Futures, Forwards

At the end of the day, what I have noticed is that most of the decisions made for finance positions are purely based on fit. If you answer every answer wrong, but show strong enthusiasm and personality, you will probably get the job. It is all about communication.

Baruch MFE classmates, myself in the Quantlab

It’s been a while since my last post.  It has been quite the semester. I am currently visiting my parents and girlfriend in Canada during our winter holidays. I figured I would take the time to talk about my first semester in the Baruch Financial Engineering program.

The first semester included taking 4 graduate level courses. These were Stochastic Processes in Finance, Numerical methods in Finance, Object Oriented programming in Finance and Pricing of Financial Instruments. All the courses were heavy on the quantitative side. The Pricing course included a strong exposure to lots of financial products which was a good relief from the heavy math in the other courses. Every course included lots of programming (C++ especially) except Stochastic Processes class.

The most challenging class definitely had to be Stochastic Processes. There is a big focus on Measure Theory and Real Analysis in this course. The second part of this course will be next semester which is supposed to include a significant amount of Stochastic Calculus and finance exposure. After going through this course, martingales, sigma-algebra, LDCT, MCT and Brownian motion have been embedded into my brains pretty deeply.

One of my favorite classes had to be the Pricing class. We had an amazing professor who had a lot of deep industry knowledge about various products. I definitely got exposure to a huge range of financial products in this course and how to price them. I can now effectively price several exotic options, vanilla options, FRA, FRN, CDS, Interest Rate Swaps, FX Swaps, etc. The course also gave me a lot of exposure to various risk management parameters like Delta, Gamma, Vega, Theta, etc. The course included a lot of coding in Excel/VBA.

The highest amount of programming in the course was done in two courses: Numerical Methods in Finance and Object Oriented Programming. Numerical Methods mostly included lots of Monte Carlo simulation and Finite Difference methods to price options. The course went through several finite difference methods which included Forward and Backward Euler, Crank Nicholson and many more. We priced vanilla options with dividends, without dividends, with discrete dividends, with continuous dividends, exotic options, and many more products. This course included a significant amount of algebra, differential equations and programming. All the programming was done in C++.  Our final basically included pricing a Barrier option and an American option.

The last, but not the least, was Object Oriented programming in finance. This course included teaching us the intricacies of C++ at a much technical level. It included us learning about classes, pointers, polymorphism, STL, factories, etc and implementing various pricing procedures using optimized code. The course was taught by a programmer who works on the prop desk at Bank of America.

Well enough about courses. I have been applying for summer internships and full-time positions extensively. I also have been networking a lot by going to several conferences in the area. The fruits of networking and applying have already been paying off. I recently had the pleasure of interviewing with a large British bank for an internship, a private equity firm for a full time position, 2 hedge funds for an internship, a large Japanese bank for a full time position, a full time position at a large American BB, a full time position at a prop firm and a few other positions. I have a few offers now from the interviews. I cannot give out any more details for obvious reasons right now. Once it is all confirmed and set I will be sure to let you guys know.

For job seekers out there I will give you some information in how I secured these interviews. Mostly what I did was have an effective resume and just applied on websites and job boards. I also sent out several emails that I have collected over the last few months. These emails are mostly of people I met at conferences and events around New York. In addition, I contacted people who were part of the fraternity I am a member off from Wisconsin that are in finance, especially in New York. I think one of the biggest help in me getting interviews was probably the Resume Book that my professor sent to firms for internship positions. Other than that, I am sure some luck helped me too. I just stayed positive and highly pro-active and made sure I applied everywhere I could think off.

These two articles helped me quite a bit:

• How to get quant jobs -advice from Wall street executives
• List of firms that offer quant internships and jobs

I think I have a decent enough resume to get to the first round. Beyond that I believe the strong first semester at Baruch and general inter-personal skills aided me a lot in converting interviews to offers.

The social life at Baruch is absolutely great. My classmates and professors usually get together for drinks once a week. We even went to several famous spots on school field trips in New York which included the Metropolitan Opera, Museum of Natural History, Central park, etc.

I feel very blessed past few months. I have had the chance to make some great friends in the program, got to meet some great people in the industry, and learn a lot. I am looking forward to next semester. I will be taking Stochastic Calculus 2, Numerical Methods 2, Risk Management, and am still debating between Market Microstructure and Structured Finance. I would love to learn more about the role that exchanges play in trading. At the same time being an engineer, I love the notion of “creating” new products. Right now Structured Finance seems absolutely dead, but I do see a strong come-back in the near future. It is a hard decision. Let me know if you guys have any tips?

Until next time…

Right at home…

One of the reasons I chose New York over Chicago was the high number of conferences and events in the city, and the possibility to network effectively. Most of the practitioner researchers in the field are in New York. I have attended several conferences over the last few months and a few have stood out over the rest.

One of the best events I have been to was right at home at Baruch College. It was not a conference or a seminar. It was the reception of Dr. Jim Gatheral on him becoming a full tenured professor at Baruch College in the Masters in Financial Engineering program. All current students and alumni were invited to attend Jim’s reception. In addition to that, Jim and our program director invited many of their own friends and colleagues.

The guests at the reception were definitely a “who’s who” of the top researchers and industry professionals in the area of volatility, options trading and financial engineering. I had the great pleasure of meeting Bruno Dupire (local volatility model) and discuss with him one of my projects related to energy spot price modelling. I had a great conversation with Andrew Lesniewski (SABR Model) and was glad to see him again as it had been quite a while since our previous meeting. I also had a short conversation with Paul Glasserman (Monte Carlo book). It was great to see and talk to Attilio Meucci again. The room also included Managing Directors from Merril Lynch, Bank of America, Citadel, Prudential, to name a few. There were several executives from Goldman Sachs,Bloomberg and other banks and investment firms in the area too.

It was truly amazing to be in the company of such ‘giants’ and have the ability to talk to them and have my queries solved and also ask for advice academic and career wise.

As usual Dr. Dan Stefanica out-did himself by ordering fantastic food, out of which the mini-burgers were my favourite, and Andrew’s too. Over-all it was definitely a great experience. The true out-reach of the Baruch MFE program and our new Volatility Surface professor was definitely visualised at the reception.

Welcome, Dr. Jim Gatheral.

Not too far from home…  THE BUTTONWOOD GATHERING

The buttonwood gathering definitely was the BEST conference/event I have ever been to. In a matter of two days, I got to meet and have great conversations with people that I most probably would never have had the chance to meet or even see in person. The event took place at City University of New York – Graduate Center, one of the campus’s of CUNY like Baruch College.

Twenty-four prominent brokers and merchants gather on Wall Street to sign the Buttonwood Agreement, agreeing to trade securities on a commission basis. The New York Stock Exchange traces its beginning to this historic pact

The conference was definitely a great time. I had the great opportunity to talk to some really great minds. Among political figures, I had an incredible conversation with Bob Rubin (former treasury secretary). Bob was part of a “simulation” of the process and conversation held when a “state” defaults, or is on the brink of bankruptcy. It was quite an informative and entertaining simulation.

Nassim Taleb was also present and gave quite an interesting speech. Some of his key points included:

1. People are just greedy, and there is nothing we can do about it.
2. Basel III and any other regulation is basically useless.
3. The financial crisis was caused by regulations made in Basel II (VaR)
4. Bonus packages and compensation should be re-strucured as they lead to very risky ventures.
5. There is a chronic underestimation of risk
6. Capitalism should be symmetric.

At least, those are the ones I remember. Here is a video on CNBC where you can spot me in the background talking to Nassim Taleb. (Around 4:54 mins is where I come in)

Vikram Pandit had an interesting speech in which he mostly focused on the new global banking rules. He asserted that the new Basel accords would hurt the system rather than fix the financial system. He said that the new minimum capital requirements for banks could hurt the credit creation and fuel risk into the system as they “squeeze” consumer credit in bad times and encourage more lending in good times. In addition, separate countries are adding their own capital requirement on top of the ones agreed to under the Basel accords, Pandit said. And by providing a false sense of stability, the new accords “lack a sense of urgency,” he said. Under the Basel III accords, banks must hold a capital ratio of 4.5% by 2015 and of 7% by 2019. Pandit had some bones to pick with the U.S.-specific bank reforms, saying that the Dodd-Frank legislation and CARD Act may have the unintended consequence of clamping down on loan availability for the lower income brackets, if not leading to an outright abandonment of low-income and rural communities where banks can’t make enough money.

Here is his complete speech./p>

Mervin King…. Here is an article about his speech : http://www.economist.com/node/17363435?story_id=17363435&fsrc=rss

Some other great people I got to hear speak included Robert Shiller, Joseph Stiglitz, Raghuram Rajan, Ed Clark (CEO of TD Bank), Gordon Nixon (CEO of RBC), Arriana Huffington, Mohammed El-Erian(CEO of PIMCO), Neal Wolin (Deputy Secretary – Treasury), Laura Tyson, Clifford Asness, Emmanuel Roman, Jeffrey Sachs and some. Talk about walking among the greatest. The ‘giants’ were definitely roaming free.

I also had the chance to talk to some of the above mentioned people personally. Clifford Asness was definitely one of my favourite speakers. He is quite an entertaining individual. I had the chance to talk to him personally and discuss a few hedge fund related topics.

The whole event was taped. I am told that there will be videos of the various speakers online soon. I will make a post about it when I get an email regarding it. Feel free to follow me on my twitter too.

Well, back to studying for now. Until next time…

Throughout the years, we have grown from a small forum to a comprehensive resource where it is the only place online where you can read candid student reviews of MFE programs, monitor application process to the top MFE programs, participate on monthly online chats with a growing number of MFE programs, among other things. The fact that anyone can get all the information about an MFE program while interacting with current students, program faculty and staff, recruiters and executives alike on our community makes this site one of the most interesting places to be.

This month marks our 7th anniversary so we dug deep into our history and pulled together some of the most entertaining facts about our community that we could find. Here are 10 that you might not know.

1. Quantnet was Originally Hosted on a Small Bedroom Computer

Very few people knew that when Quantnet was first set up in 2003 as a private discussion board for students studying Financial Engineering, it had no domain name and ran from a computer in the bedroom of Phat Loc, the first administrator of the site.

Members would access the site to discuss homeworks, coding projects using an address setup by Phat with the help of Dynamic DNS service. With only a simple DSL line, whenever there was a problem with this tiny computer, we can only imagine the disruption it caused to members who grew dependent on the site.

Being a technical savvy person, Phat built and maintained the site using many open source software such as Mambo and phpBB.

Phat Loc (Baruch MFE’03) is now a successful trader at an investment bank. Whenever we meet him and talk about Quantnet, his bedroom computer story is one that got mentioned often and usually results in few chuckles and good laughs.

Pic 1. Phat Loc’s first post on Quantnet in Oct 2003

2. Quantnet.org was Our Main Address until 2009

Fast forward to 2005 and it was decided that a little bedroom computer was no longer a good way to run a website, a search for a domain was put in place. Since we had called it Quantnet from the beginning, it only made sense to use the same name on our domain. Unfortunately, the .com domain was taken leading to us taking .org, the next best available extension. According to Whois, quantnet.org was officially registered in Feb, 2005

Domain ID:D105747652-LROR
Domain Name:QUANTNET.ORG
Created On:17-Feb-2005 16:56:24 UTC
Last Updated On:07-Dec-2009 21:18:21 UTC
Sponsoring Registrar:eNom, Inc. (R39-LROR)

For many of our earliest members, Quantnet.org has been an integral part of their lives and long after we began using the .com domain, they still type .org out of old habit.

3. We obtained Quantnet.com in 2009

Pic 2.A screenshot of quantnet.com front page in 1998

Pic 3.A screenshot of Quantnet.com in 2002

When we reached out to Anton Fokin who was listed as the last known owner of Quantnet.com in 2003 and who also owns several similar domains at the time, he told us that “we were running QuantNet Limited company in UK with my partners. Someone forgot to pay for the site when we dropped the company. This is our story of quantnet.com“.

This explains why the domain became a place holder for several years until we purchased it in 2009.

If you read this interesting piece, it’s clear the obstacles some would go through to obtain a domain name that somebody else owns. Even if the owner outright abandons it, chances are you will pay a dear price to get it. So you can imagine the delights we had when we discovered the missing piece of our domain was available for a price. We paid quite a bit of money for the domain but you can’t put a price tag on having the chance to finally get the prized .com domain for your business. It’s fortunate and a bit of luck for us to be able to obtain the domain when we are able to do so.

Smarting up from the lesson, we currently own all important extensions (org, net, info, us, etc) and have them redirecting to quantnet.com.

4. The Origin and Meaning behind Quantnet Logo

The logo was designed by Luka Pensa, an artist from Croatia who owns a design studio called Mis i Pile. Quantnet first approached him in April 2007 but the design was not commissioned until late 2009 when it took two months, several drafts, concepts, and numerous email exchanges to complete.

If you go to Mis i Pile website, you would see our logo was #346 among the hundred logos done by Luka.

We got asked a few times what does the logo mean? And what kind of animal is it in our logo?

The final logo of a young bull is symbolic of the members who make up the Quantnet community. It represents a demographic of young, educated professionals who are determined to begin their journey into the world of quantitative finance. They are here to stay and will be the forces behind many more future bull markets.

5. Quantnet Wiki began as a NYU-Baruch Collaborative Project

Unbeknown to most students, there are ongoing discussions among MFE programs at the director level to collaborate on educational projects. That’s specially true among programs based in New York City due to its close proximity. One of those discussions was in 2007 between Peter Carr, then Director of NYU Courant Mathematical Finance program and Dan Stefanica, Director of Baruch MFE program. The talk arose from a need to have a centralized place to host information for the NYC-based quant finance programs. When we got wind of the idea, we offered to create a wiki for a handful of the local programs. As they say, the rest is history.

Now three years after we first set up, the wiki contains two dozen entries for MFE programs from around the country. Many of these entries are edited by the programs’ director and their staff. We hope to promote the use of this wiki feature to our members and expand the programs it covers. If you don’t see your program listed there, please feel free to create one.

6. Origin of Quantnet Program Reviews

Many of the ideas we have around here came directly from our members in respond to a specific need. It would then come as no surprise that one of the best features we have here was also idea of one of our members.

At the end of 2009, Chris Dolan, then a recent graduate of the NYU-Courant Mathematical Finance program suggested to us that it would benefit our members if we organize a series of student reviews of MFE programs. Chris offered to start it off and until today, his very first review of the NYU MathFin program was one of the most comprehensive and well-written submissions we ever received.

Today, our Review section contains close to 100 entries for over two dozen MFE programs, from UCB MFE, Baruch MFE, Chicago MSFM to as far as Cape Town Math Finance program.

These reviews provide a unique opportunity for prospective students to get uncanny comments from current or recent graduates who do not hold back in their criticism as well as praise. When criticism goes unscripted, the resulting responses can be very telling. Just ask the graduates who wrote a unfavorable review of UCB MFE, IIT MS Finance, Chicago MSFM, among others.

7. Quantnet Serves Over 50,000 Visitors a Month

We currently server over 50,000 unique visitors and our memberships grows by 600 per month. How do these numbers compare with other sites in the same niche? According to Google, the venerable Wilmott site servers 76K unique visitors a month. You can view our stats on Google here. Our numbers via Quantcast is available here.

Like everything we do here on Quantnet, transparency is one of our guiding principles and we make all of our traffic data available through tracking services like Google Analytics and Quantcast. Parties interested in advertising with us can independently verify the traffic stats there.

Pic 4. A snapshot of Quantnet traffic growth on Quantcast website

8. Tim Grant was the First Quantnet Interviewee

We owe it to the man who started it all. His name is Tim Grant, a former Managing Director of UBS. I met him during an information visit to UBS Stamford trading facility in Aug 2007 and was impressed enough with his enthusiasm for quant students to follow up with him for a formal interview.

It took until Dec of 2007 for him to clear with UBS corp comm to agree to proceed with Quantnet interview. The whole process took two months and we published his interview in Feb 2008. The resulting interview proved to be such a smashing success that we keep it a permanent feature on our site.

Tim is no longer with UBS but we still keep in touch with him and look forward to his contribution in the near future.

Pic 5. A picture of the Tim Grant interview

9. First Quantnet Chats were held via IRC

For members of this Facebook, Twitter generation, IRC is a term they may not have heard about. In fact, it was one of the oldest text messaging protocols used since the early ’90s. According to this Wikipedia article, IRC stands for Internet Relay Chat and was used to report on the 1991 Soviet coup and during the Gulf War.

In a less dramatic fashion, we used IRC for many admission and informational chats during our early years. Getting on with the time, we now use the same modern platform that serves big news organizations such as BBC, Yahoo, ESPN.

Take a look at the new monthly chat service we use today.

10. Highest Ranking Official to Comment on our Article

One of those tips came in March 2010 that the director of the Chicago Mathematical Finance program got fired. Weeks of following up with numerous past and recent graduates of the program as well as representatives of the university and department results in our biggest article to date, Seeking changes, Chicago MSFM fired founding director.

The responses were immediate from many people associated with the program. We got emails from the head of Public Relationship of the university. Dean Robert Fefferman even commented publicly on the article. To date, he is the highest profile university official that ever responded to our articles.

To set another record, the article itself receives 68 comments as of today, the most ever on Quantnet.