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# DEAR MR. BUFFETT - New Meltdown Book

Discussion in 'Wall St. News' started by Greg Richards, Jan 28, 2009.

2. ### Greg Richards

http://www.gannononinvesting.com/2009/02/on_buffett_and_derivatives.html

Gannon on Investing wrote a better review than I could (link above), but the information on models below is in the book. Best explanation of what went wrong with the models that I have ever read. It is from Chapter 2. I finally read DEAR MR. BUFFETT: What an Investor Learns 1,269 Miles from Wall Street and I really lliked it.

"A Monte Carlo simulation uses a computer to throw a whole lot of random inputs into a model. It is like shaking a newly made chair to see how stable it is. Financial firms use correlation models to look at what happens when corporations default. The model tries to determine if other companies will behave similarly when one company strengthens or weakens. The models are highly unstable. They are like a chair that collapses beneath you as soon as you sit on it. Small changes to model inputs result in huge changes to the results. "

"If you play with coins or dice, you know exactly what your inputs are and you can model all potential outcomes. You can examine the coins (heads or tails per coin), and you can model all of the possible outcomes. You can examine dice (one to six dots on each face of each cube), and again, a mathematical model can describe all potential outcomes. We do not have to guess at the inputs for dice and cards; they are known in advance and the relationship between the inputs does not change, even though we may use a Monte Carlo model to randomize the inputs (the flips and tosses)."

"The inputs to credit models are a bit of a guess, since we rely on data approximations to come up with the inputs in the first place. Furthermore, the relationships between the inputs can change. Most of the data describing how one corporation behaves in relationship to another is based on market prices such as stock prices or the prices of credit default swaps based on corporate debt. Moreover, there is very little of this already suspect data to work with. The results are guesses about relative price or yield spread movements, which result in a guess about the correlations. When a credit upset occurs in a financial sector, correlations that were previously fractional numbers tend to converge to one. Everything seems to fall apart at once. A model will calculate the wrong answer to nine decimal places, but it cannot tell you it is the wrong answer."

"The biggest problem with the models is that even if they temporarily get the correct answer, they do not tell you what you need to know. Wall Street estimates asset correlations instead of the necessary default correlations. Furthermore, the overwhelming flaw in the methodology is that if you want to make up a default correlation between two companies, you must make the false assumption that default probability does not vary, but of course it does. Even if the models measured the default probability of individual companiesâand they do notâif a company defaults, you still have to guess the recovery rate, the amount left over, if any, after all obligations are paid. You cannot solve for two independent items of information from a single piece of information such as a letter grade or a price. You cannot get both the probability that a company will default and the amount of money you will have left if it does default. "

"The market isnât trying to teach you something when prices rise or fall (or when spreads widen or narrow) relative to where they were historically. You can stuff all of that information into a model (or your head) if you want to, but manipulating market numbersâif that is all you are doingâwill not tell you anything about value. It is up to you to analyze the fundamental value and compare it with the market."

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