Death is Certain ... and Taxes!!

Now, I haven't posted anything in a ages. Life kind of happened. Sorry. Let's move one, shall we?  

To get back into the swing of it I'll post a something of an old trope. But given the shockingly illiterate taxation 'debates' that are being thrown all over the air waves in the run up to the UK general elections this might be topical enough. 

Here's the (probably somewhat apocryphal) allegory of the day:

Suppose that once a week, ten men go out for beer and the bill for all ten comes to £100.
If they paid their bill the way we pay our taxes, it would go something like this:
The first four men (the poorest) would pay nothing.
The fifth would pay £1.
The sixth would pay £3.
The seventh would pay £7.
The eighth would pay £12.
The ninth would pay £18.
And the tenth man (the richest) would pay £59.
So, that’s what they decided to do.
The ten men drank in the bar every week and seemed quite happy with the arrangement until, one day, the owner caused them a little problem. “Since you are all such good customers,” he said, “I’m going to reduce the cost of your weekly beer by £20.”
Drinks for the ten men would now cost just £80.
The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still drink for free but what about the other six men? The paying customers? How could they divide the £20 windfall so that everyone would get his fair share?
They realized that £20 divided by six is £3.33 but if they subtracted that from everybody’s share then not only would the first four men still be drinking for free but the fifth and sixth man would each end up being paid to drink his beer.
So, the bar owner suggested that it would be fairer to reduce each man’s bill by a higher percentage. They decided to follow the principle of the tax system they had been using and he proceeded to work out the amounts he suggested that each should now pay.
And so, the fifth man, like the first four, now paid nothing (a 100% saving).
The sixth man now paid £2 instead of £3 (a 33% saving).
The seventh man now paid £5 instead of £7 (a 28% saving).
The eighth man now paid £9 instead of £12 (a 25% saving).
The ninth man now paid £14 instead of £18 (a 22% saving).
And the tenth man now paid £49 instead of £59 (a 16% saving).
Each of the last six was better off than before with the first four continuing
to drink for free.
But, once outside the bar, the men began to compare their savings. “I only got £1 out of the £20 saving,” declared the sixth man. He pointed to the tenth man, “but he got £10!”
“Yeah, that’s right,” exclaimed the fifth man. “I only saved a £1 too. It’s unfair that he got ten times more benefit than me!”
“That’s true!” shouted the seventh man. “Why should he get £10 back, when I only got £2? The wealthy get all the breaks!”
“Wait a minute,” yelled the first four men in unison, “we didn’t get anything at all. This new tax system exploits the poor!”
The nine men surrounded the tenth and beat him up.
The next week the tenth man didn’t show up for drinks, so the nine sat down and had their beers without him. But when it came time to pay the bill, they discovered something important – they didn’t have enough money between all of them to pay for even half of the bill!
And that, boys and girls, journalists and government ministers, is how our tax system works.
The people who already pay the highest taxes will naturally get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy and they just might not show up anymore. In fact, they might start drinking overseas, where the atmosphere is somewhat friendlier.

I'm going to skip attributing this to anybody in particular, seeing that snopes has about long entry on how all the alleged geniuses that didn't come up with it are not real. I suspect that for those who understand, no accreditation is needed. And that for those who do not understand, no meaningful accreditation is possible.

And before you get your knickers in a twist about the details ("Those bloodsuckers at the top won't leave! We'll call their bluff!"): This is an allegory, not a fully quantified tax revenue analysis. The point is simple: If you beat up on the guys paying the most, even a small change in their behaviour can change the size of the pot by quite a lot. Just ruminate on it for a moment. 

Am wondering where to pick up the next thread and come up with something a touch more creative myself. Social justice nimbysm, basic numeracy (lack thereof!) in high office? Thoughts, anybody? 

Oh and before I forget! This is Rock'n'RollFinance, so here is your dose of awesome to mitigate the mind-numbing: Heino meets Rammstein meets YouTube - fucking deranged:

KISS – Keep it simple, stupid! Or: Derivatives, Models, Academics… and Tazers

Sorry, I’ve been away for a while. Too much to do, not enough sleep, etc. Which is a shame; after all there is an embarrassment of riches or rather topics to bitch about out there! In fact, part of the reason why I have not been more prolific lately is that I just cannot seem to keep up with what going on out there. Too many crises, acts of muppetry or reasons to gawk incredulously to even begin to gather my thoughts before the next one is up on the agenda. It’s stressful! Anyway, enough prevarication let us move on.

The first thing I have to do is to make sure that you understand that I DO NOT regularly (or even occasionally) read The Guardian. I strictly limit myself to articles and columns recommended to me by concerned friends. Thus I was confronted with a piece on the pitfalls of mathematical modeling in finance that was on the face of it actually reasonably well thought out. Please find aforementioned piece here. Shame, however, that in the end the author managed to not only conflate about three or four different problems that plague the world of finance but also missed out a number of glaring problems with the thrust of his argument and then finally came up with the weirdest and most hackneyed remedy to the mess we are in that only a dyed-in-the-wool materialist dialectic type Marxist who sadly doesn’t really understand Marx (or possibly did not read him to the end).

Right, so what are my points of contention?

Number one: Black-Scholes is not the all there is to financial modeling – Despite the somewhat excessive use of big names, a historical narrative that goes back to the beginning of the 20^th century mathematics and features super numerate Frenchmen and cryptic terms such as “Brownian motion” the Black-Scholes model is not really all there is to quantitative finance. In fact, it’s used for a very specific purpose, namely valuing options. And granted, therein lies a challenge. And it is open to abuse. And it can, if misused, bring about all manner of financial ruin. However, it didn’t really bring about the credit crunch all by itself (granted the author indemnifies himself a bit by phrasing the thrust of his argument in such a manner as to avoid stating that B-S [yes, funny(ish) acronym] is directly responsible for the credit crunch and merely “opened” the field, but the implication is pretty blunt). For that one needs all manner of other mathematical chimeras that defy easy comprehension: Gaussian cupolas, mean reversion theorems, VAR, Monte Carlo simulations, the list goes on and on. Just burrowing into the history of one particular type of financial modeling technique doesn’t really make for a comprehensive argument about the use of mathematical models in finance. Especially if that history is bereft of it’s proper context and leaves out a cautionary tale that is known industry wide. Which leads me to my next point.

Number two: Long Term Capital Management … Kaboom! Rather gamely, the author informs us, that the brains that developed the B-S formula (or rather the surviving part, seeing that Mr. Black passed away a before it could come to pass) were awarded the Nobel prize for economics in 1997. What he fails to mention is that Myron Scholes and Robert Merton (who didn’t author the model but refined it) basically lost their shirts when the investment company they co-founded – not overly prophetically named Long Term Capital Management – demonstrated the limits of the usefulness of their theoretical acumen by imploding. The fact that LCTM peaked and then died in 1998, the year following the award of the Nobel prize, does actually make me think that whoever is in charge of the universe does have a wicked sense of irony. At any rate, that story has been and remains a constant reminder for any option trader to not rely on B-S derived option valuations too much. I bet you; even the most illiterate option desk in the city has a copy of this book lying around somewhere.

John Meriwhether, Robert C. Merton and Myron Scholes as seen by themselves.

John Meriwhether, Robert C. Merton and Myron Scholes as seen by the financial industry.

Number three: Derivatives are not simply bets on bets – Another thing that really annoys me about that article is the obtuseness with which derivatives are simply described as “investments in investments, bets about bets”. I’d expect that kind of definition from a dreadlocked tramp at the Occupy camp outside St Paul’s, not from a Emeritus Professor of Mathematics at Warwick University and a Fellow of the Royal Society who has written over 80 books, and has won three gold medals for his work on the public understanding of science. With this standard of work, I do wonder who awarded those gold medals? Derivatives do cover a humongous range of different financial products, which across all different types do share one – and only one – characteristic: Their value is determined not intrinsically, but through observation of another, underlying asset. It is derived; hence the name derivative. And yes, they can be bets upon bets. But they are not necessarily so. To say so is a bit like asserting that hammers are instruments of murder. They certainly can be, but I’m not so sure that really comprehensively captures the essence of what a derivative is. To be fair, derivatives are a bit more complex than hammers. They also can wreak havoc on a larger scale. But the analogy does work. Oh, and please spare me the Warren Buffet comment.

Number four: More models are NOT the answer!!! – The single most mind-boggling thing about the whole article really is the conclusion. Namely, that the answer to the travails of the world of modern finance lies in an increase in the reliance on mathematical models. I’m not quite clear how the factually somewhat compromised but still largely coherent rant about the inadequacy and misuse of mathematical models in the world of derivatives finance leads to the conclusion that more rather than less emphasis needs to be put on developing ever more complex models. I mean, he does get one thing right: model abuse is at the heart of a rotten system. How that model abuse is remedied by use of more intricate (and by implication less well understood) models is beyond me. I daresay trying to make it more academic is not the answer. But then again, Emeritus Professor of Mathematics at Warwick University tactfully failed to mention that his esteemed and academically minded colleagues’ venture into the world of finance did end with a bang and not a chest beating roar of triumph. Personally I think finance should be run more like Tazerball:

And I think next I’ll try and write something about pirates!

The Final Countdown; or The dumbness of number quoting and the end of the occident

Europe - BEFORE the crisis!

Just a quick illustration of the general dumbness of the number quoting that is rather rampant in all manner of media items these days: One of the most popular number quoted to illustrate that the end of western civilisation is nigh, is the fact that in the last 18 months no less than five elected governments in Europe have been swept aside. The common assertion being that this indicates that popular unrest is rampant across the continent and that the political elites which have hitherto driven the EU project seemingly no longer can keep a lid on their long suffering, disenfranchised and alienated populations. Now, that may well be the case. Nevertheless, those five governments tapping out really don't conclusively support the argument that this is the height of crisis. For the record: I totally agree, that the situation in Europe is a little dicey. But to be brutally honest, if one takes the 17 Euro countries with electoral cycles that typically are around 4-5 years then 5 changes of government are pretty much exactly the number I would expect to take place over an 18 month period. More, if you are widening your sample size to take in all (27) EU member states. Not saying that there isn't any turmoil and the causes for those government changes were not linked to the whole Euro/debt mess. But the numbers don't actually tell us that. Numbers don't automatically proof a point! Never mind...details...why would anybody care...

The Eye of the Beholder - RnRF-Reviews: Lulu

No, it doesn't get less depressing.

First: No, it's not Master of Puppets part two. If you are one of those dyed-in-the-wool-total-bonehead-let-it-be-1986-again die-hards who just cannot cope with Metallica not trying to record the same album for the 17th time, then this record is not for you. Stop reading this and go back to trying to fit into your black stretch jeans. Second: I'm not liable to give you a truly unbiased account of this. I love Metallica. I even managed to find something (very little) vaguely redeemable in the mess that was Garage Inc. So don't expect me to go all high-brow and read a yard of Brecht before I go and comment on the somewhat anxiously awaited collaboration between Metallica, the royalty of all things metal, and Lou Reed, erstwhile frontman of cutting edge art-rock wonder Velvet Underground and by now probably one of the gnarliest and moodiest bully-brains on stage.
Talking of anxiety: I had been anticipating the arrival of 'Lulu' with a barely contained sense of dread since from when I first learned about the collaboration effort between the (by now slightly ageing) gods of thunder and the (yet even older) undisputed king of sexually inspired misery poetry. What good could possibly come of that? I wasn't heartened after the first bunch of reviews. At best there seemed to be a sense of confusion and incredulity mounting in the open minded. Outright disbelief and scorn from traditionalists on both side of the marriage. And howls of incomprehension from the rest. Not exactly a good sign.

All in all, somewhat unexpected.

Strangely enough, however, I kind of like this album. Don't get me wrong, it's not exactly the kind of aural energy drink equivalent you listen to on the way to the office to get pumped up before a particularly beastly client meeting. It's more of a soundtrack to an evening with a bottle of wine, a gripe about political incompetence in the Eurozone or the inversion a CDS curve and the time to turn it into a blog post. It's not an entirely sane affair. It does name-check both Boris Karloff and Klaus Kinski in the first song. And it kind of relegates one of the world's most dominant and charismatic rockbands to a supporting ensemble to an expert in bitterness. Except that that supporting ensemble occasionally coalesces into a menacing snarl that reminds you that it  _is_ Metallica that is hanging back in the wings. What it does have is tension and latent violence that sometimes comes close to the surface. Like a fanged octopus-monster rising to the surface of a muddy lagoon...while some demented shaman is howling it's name in some Lovecraftian un-language. And a palpable sense of disappointment that is what the music is about. Not what it is!
So would this discerning critic recommend it to you? Not if you are looking to stuff something entertaining onto your iPod. To be honest, this is probably best listened to at home, on your own, when you are sufficiently misanthropic to start with. And bear in mind that I actually wanted to like this. I'm sure you can find plenty of reasons to find this underwhelming. But if you are ready to accept that jaded millionaire rockstars can sometime actually strike gold in their (often misguided) search for a new experience, rather than turn into Iron Maiden / a circus act, then this might actually work for you. Just don't expect to feel chipper afterwards.

My Childish Pleasure: Milestones, Satan and big(ish) numbers!

Woe to you Oh Earth and Sea
for the Devil sends the beast with wrath
because he knows the time is short

Let him who have understanding

reckon the number of the beast

for it is a human number
its number is six hundred and sixty six.

A pretty pathetic reader count...but it still made my day!

Raining Blood - Greece, Mercs, Merkel and the EFSF

Raining blood

From a lacerated sky

Bleeding its horror

Feeding my structure

Now I shall reign in blood!

- Raining Blood by Slayer - 

"One more referendum and I will fuck him up."

Today something vaguely frightening/flattering happened: the inimitable, esteemed and often unflappable blogger and keen observer to the human condition RogerofSicily dared me to explain or - even worse - make sense of the Kabuki theater that is the European effort to bail out Greece. It’s not exactly like he’s asking me to unify quantum physics and Einstein’s view of the world but it still made me kind of gulp with trepidation. But then again, this is Rock’n’RollFinance! So there, here we go: Challenge accepted! ...Don’t blame me if this gets boring half way through!

Rather than go straight to the “why bother?” part of the bail-out question, it might be worthwhile to start with the “how did we end up in this mess?” end. To brighten things up I’ll be channeling a bit of Teutonic working class heroism in an effort to bring us closer to comprehension. I’ll be drawing heavily on the efforts of Superfritz. Hope you don’t mind, but do consider yourself referenced!

So let’s step away from the global super-macro perspective and have a look at the German micro perspective to understand why this is (politically) not exactly straightforward. The story goes as follows:

German worker goes to work and builds a great Mercedes.

German worker gets paid 2,500 Euros, pays 1,000 Euros taxes/social security and saves 250 Euros on his savings account at stupid German bank, because he wants to buy a great Mercedes sometime in the future.

Stupid German bank takes the 250 Euros and buys some funny paper from a stupid US bank for 100 Euros and some more funny papers from US government for 100 Euros, converted into 100 Dollars. For good measure it also buys some 50 Euros of funny paper from the Greek government.

The stupid US bank is happy. It found someone even more stupid to buy its mortgage risks.

US government is happy. It has a handful of wars to run and taxes to break. Wars and tax breaks are expensive.

Greek government is happy. It has a legion of civil service unions to buy off and needs to keep up with the neighbours in the “buying-Bundeswehr-surplus-tanks” competition. Doesn’t have to bother with tax collection either now!

Stupid US bank pays huge bonus to banker who sold funny paper. Stupid German bank pays huge bonus to banker who bought funny paper.

Stupid US bank takes the 100 Euros and grants another mortgage to US IT consultant.

US IT consultant takes out mortgage, uses the money (incl. the 100 Euros saved by the German worker) to buy himself a great Mercedes for 100,000 Euros. Why wait and save to buy it? That's so 1950s! US IT consultant is happy. His house has turned him into millionaire. He drives a great Mercedes.

Mercedes is happy. It now has money to pay 2,500 Euro to the German worker, 10,000 to the German government and 87,500 Euros to its shareholders in Kuwait.

Kuwait shareholders are happy.

German government takes 10,000 Euros, pays 5,000 to pensioners and unemployed, 1,000 to Eastern Germany, 3,000 for "other expenses" and 1,000 Euros for non-existent olive trees in Greece and great Spanish Autobahns.

Greek farmer is happy. Considers buying a Mercedes. Spanish construction worker is happy. Considers buying a Mercedes. German worker doesn't really understand what's going on. Goes to work to build Mercedes.

Scene at the Eurozone bail-out summit

Restart at top. Repeat 10 times. 

= Trade imbalance.

Turns out, US IT consultants house is worth half his mortgage. US IT consultant gives house and car keys back to bank. Pity. But what a great time he had with his great Mercedes!

Stupid US bank goes bankrupt.

Stupid German bank reads the funny paper it bought from stupid US bank for the first time (500 pages in English, hello?) and finds out it's bankrupt, too.

German government uses taxes of German worker to bail out stupid German bank's shareholders. German worker's kids Kindergarten is not refurbished. No money left. But German worker still has savings of 250 Euros at state owned stupid German bank. Phew!

Stupid US bank is bailed out by US state, using the 100 Euros saved by German worker given to it by stupid German bank.

US government is broke. Invents new term for inflating debt away. "Quantitative easing”, sounds funny. German worker doesn't get it. 

US government returns 100 USD to stupid German bank. Bank converts 100 USD into 10 EUR. Ooops, 90 Euros gone. Stupid German bank is bankrupt again.

German government uses German workers taxes to bail out stupid German bank again. German worker's street is not repaired. No money left. But German worker still has savings of 250 Euros at state owned stupid German bank. Phew!

German bank now no longer keen on buying funny Greek government paper. Stops that non-sense. 

Greek government figures out it is broke too. Didn’t bother with tax collection. Why bother when stupid German bank gives you money? 

Enter ECB.

ECB council decides that sticking to rules is for stupid Germans. Easier without rules. Much more fun. Cranky Germans don't get the joke. Typical. ECB buys lots of Italian and Greek debt at knock-down price.

THE FUTURE:

ECB decides that 2% inflation is too ambitious. The rules are only paper, after all. ECB decides 10% inflation is better for majority of countries in ECB council. Cranky German still doesn't get the joke. Ah, these Germans...

German worker goes to bank. Wants to buy Mercedes with money saved. Bank gives him 250 EUR back. Plus interest. German worker is happy.

German worker goes to buy Mercedes. Turns out, Mercedes now costs 123,890,571,238,457 Euros, instead of 100,000 Euros. German worker uses savings to buy himself a glass of Schnaps instead. German worker is a bit cranky. Now understands what "Quantitative Easing" means. Doesn't get the joke. Lack of humour, presumably.

US banker: got huge bonus
German banker: got huge bonus
US IT Consultant: got Mercedes and huge house (for a while)
Mercedes shareholder: got dividend
Greek farmer: got subsidies
Spanish construction worker: got subsidies
Bond holders: got bailed out.
German worker: got bill.

German worker feels so 1950s. Needs to catch up with rest of world. Should have borrowed money years ago to buy Mercedes. Honest work and sticking to rules makes no sense. Quantitative Easing makes alles kaputt. 

Greek and British papers tell German workers it's all his fault because his granddad invaded Poland.

Merkel after the post summit press-conference

Not sure this explains what's going on but then again I'm not sure any of this _really_ makes sense.

I'm not even going to try explain how the EFSF is supposed to work in all this. I'll need to drink a lot more to try that. 

1%ers - Public Enemy Number One! Or maybe just your doctor.

1%ers - Strangely not including dope smoking bikers

I'm rather brazenly stealing somebody else's research for this (we call it "leveraging" work), but it's just too succinct for me to not put it up (at any rate, here is the link to the original article). Our fellow citizens from the "Occupy thisthatortheother" movement seem to rather hastily assume that their much vaunted target (among other things the greedy 1 pct of income earners) are all somehow to be found in the financial sector. Or maybe that all finance workers are actually in the top 1 pct of income earners. It probably doesn't matter which way round. It would also appear that facts won't get in the way of a good bit of demagoguery. Unfortunately, however, if you did take about 10 minutes to think about who the richest / most income earning 1 percent are it might become apparent that you are tarring an awfully diverse group of people with a somewhat broad brush when equating them with SATANIC BANKERS. Just have a quick look at the attached graph and the presumption that 1 percenters are the root of all evil might just look a little less convincing than when it was spray painted on some banner. I for one would rather want medical professionals to be paid well. Or lawyers for that matter. Well, at least the one that is representing me. I kind of believe in the notion of incentivising people for excel by offering larger rewards for superior performance. But I suspect that I won't be able to convince somebody who decides that the best time to demonstrate against capitalist greed is the weekend. WTF? And yes, I know this is a US based statistic, it's based on income tax not income etcetc...but it probably is a decent proxy for what I'm trying to say.
Mind you, maybe these upstanding folks with the ethnically diverse musical tastes and questionable hairstyles are not just objecting to finance professionals to be in the top one percent of the money making fraternity, maybe they object to the very notion that anybody should be in the one percent bracket. Last I checked, however, getting rid of the top one percent of any distribution only really works if you flatten the whole thing out more or less completely. Last anybody tried that everybody ended up wearing rather dreary boiler suits and would've made George Orwell both proud and distinctly uneasy. Oh, and they gave it up when they figures it didn't really solve their issues. Go figure, China. Anyway, looks like ideologues have all the answers and as such they don't need to care too much about arguments. Or as Billy boy was putting it: they don't need to care about how the opposition is doing. Almost makes me wonder why I am. Before I leave you to meditate on it all, just remember, true 1%ers do not wear pinstripes. They look a bit like this:

Grade A Banker