A subject near and dear to our flinty hearts.
From the New York Times Magazine:
It was Aug. 24, 2005, and New Orleans was
still charming. Tropical Depression 12 was spinning from the Bahamas
toward Florida, but the chances of an American city’s being destroyed by
nature were remote, even for one below sea level. An entire industry of
weather bookies — scientists who calculate the likelihood of various
natural disasters — had in effect set the odds: a storm that destroys
$70 billion of insured property should strike the United States only
once every 100 years. New Orleanians had made an art form of ignoring
threats far more likely than this; indeed, their carelessness was a big
reason they were supposedly more charming than other Americans. And it
was true: New Orleanians found pleasure even in oblivion. But in their
blindness to certain threats, they could not have been more typically
American. From Miami to San Francisco, the nation’s priciest real estate
now faced beaches
and straddled fault lines; its most vibrant cities occupied its most
hazardous land. If, after World War II, you had set out to redistribute
wealth to maximize the sums that might be lost to nature, you couldn’t
have done much better than Americans had done. And virtually no one —
not even the weather bookies — fully understood the true odds.
But there was an exception: an American so improbably prepared for
the havoc Tropical Depression 12 was about to wreak that he might as
well have planned it. His name was John Seo, he was 39 years old and he
ran a hedge fund in Westport, Conn., whose chief purpose was to persuade
investors to think about catastrophe in the same peculiar way that he
did. He had invested nearly a billion dollars of other people’s money in
buying what are known as “cat bonds.” The buyer of a catastrophe bond
is effectively selling catastrophe insurance. He puts down his money and
will lose it all if some specified bad thing happens within a
predetermined number of years: a big hurricane hitting Miami, say, or
some insurance company losing more than $1 billion on any single natural
disaster. In exchange, the cat-bond seller — an insurance company
looking to insure itself against extreme losses — pays the buyer a high
rate of interest.
Whatever image pops to mind when you hear the
phrase “hedge fund manager,” Seo (pronounced so) undermines it. On one
hand, he’s the embodiment of what Wall Street has become: quantitative.
But he’s quirky. Less interested in money and more interested in ideas
than a Wall Street person is meant to be. He inherited not money but
math. At the age of 14, in 1950, his mother fled North Korea on foot,
walked through live combat, reached the United States and proceeded to
become, reportedly, the first Korean woman ever to earn a Ph.D. in
mathematics. His father, a South Korean, also came to the United States
for his Ph.D. in math and became a professor of economic theory. Two of
his three brothers received Ph.D.’s — one in biology, the other in
electrical engineering. John took a physics degree from M.I.T.
and applied to Harvard to study for his Ph.D. As a boy, he says, he
conceived the idea that he would be a biophysicist, even though he
didn’t really know what that meant, because, as he puts it, “I wanted to
solve a big problem about life.” He earned his doctorate in biophysics
from Harvard in three years, a department record.
His parents had
raised him to think, but his thoughts were interrupted once he left
Harvard. His wife was pregnant with their second child, and the health
plan at Brandeis University, where he had accepted a job, declared her
pregnancy a pre-existing condition. He had no money, his parents had no
money, and so to cover the costs of childbirth, he accepted a temp job
with a Chicago trading firm called O’Connor and Associates. O’Connor had
turned a small army of M.I.T. scientists into options traders and made
them rich. Seo didn’t want to be rich; he just wanted health insurance.
To get it, he agreed to spend eight weeks helping O’Connor price
esoteric financial options. When he was done, O’Connor offered him 40
grand and asked him to stay, at a starting salary of $250,000, 27 times
his post-doc teaching salary. “Biophysics was starved for resources,”
Seo says. “Finance was hurling resources at problems. It was almost as
if I was taking it as a price signal. It was society’s way of saying,
Please, will you start solving problems over here?”
His parents,
he suspected, would be appalled. They had sacrificed a lot for his
academic career. In the late 1980s, if you walked into the Daylight
Donuts shop in Dallas, you would have found a sweet-natured Korean woman
in her early 50s cheerfully serving up honey-glazed crullers: John’s
mom. She had abandoned math for motherhood, and then motherhood for
doughnuts, after her most promising son insisted on attending M.I.T.
instead of S.M.U., where his tuition would have been free. She needed
money, and she got it by buying this doughnut shop and changing the
recipe so the glaze didn’t turn soggy. (Revenues tripled.) Whatever
frustration she may have felt, she hid, as she did most of her emotions.
But when John told her that he was leaving the university for Wall
Street, she wept. His father, a hard man to annoy, said, “The devil has
come to you as a prostitute and has asked you to lie down with her.”
A
willingness to upset one’s mother is usually a promising first step to a
conventional Wall Street career. But Seo soon turned Wall Street into
his own private science lab, and his continued interest in deep
questions mollified even his father. “Before he got into it, I strongly
objected,” Tae Kun Seo says. “But now I think he’s not just grabbing
money.” He has watched his son quit one firm to go to work for another,
but never for a simple promotion; instead, John has moved to learn
something new. Still, everywhere he goes, he has been drawn to a similar
thorny problem: the right price to charge to insure against potential
losses from extremely unlikely financial events. “Tail risk,” as it is
known to quantitative traders, for where it falls in a bell-shaped
probability curve. Tail risk, broadly speaking, is whatever financial
cataclysm is believed by markets to have a 1 percent chance or less of
happening. In the foreign-exchange market, the tail event might be the
dollar falling by one-third in a year; in the bond market, it might be
interest rates moving 3 percent in six months; in the stock market, it
might be a 30 percent crash. “If there’s been a theme to John’s life,”
says his brother Nelson, “it’s pricing tail.”
(Page 2 of 10)
And if
there has been a theme of modern Wall Street, it’s that young men with
Ph.D.’s who approach money as science can cause more trouble than a
hurricane. John Seo is oddly sympathetic to the complaint. He thinks
that much of the academic literature about finance is nonsense, for
instance. “These academics couldn’t understand the fact that they
couldn’t beat the markets,” he says. “So they just said it was
efficient. And, ‘Oh, by the way, here’s a ton of math you don’t
understand.’ ” He notes that smart risk-takers with no gift for theory
often end up with smart solutions to taking extreme financial risk —
answers that often violate the academic theories. (“The markets are
usually way ahead of the math.”) He prides himself on his ability to
square book smarts with horse sense. As one of his former bosses puts
it, “John was known as the man who could price anything, and his pricing
felt right to people who didn’t understand his math.”
In the mid-1990s, when Wall Street first noticed money to be made covering the financial risks associated with hurricanes
and earthquakes, it was inevitable that someone would call John Seo to
ask him if he could figure out how to make sense of it. Until then, he
had specialized in financial, not natural, disasters. But there was a
connection between financial catastrophe and natural catastrophe. Both
were extreme, both were improbable and both needed to be insured
against. The firm that called him was Lehman Brothers, whose offer
enticed Seo to quit his job and spend his first year at Lehman learning
all he could about the old-fashioned insurance industry.
Right
away, he could see the problem with natural catastrophe. An insurance
company could function only if it was able to control its exposure to
loss. Geico sells auto insurance to more than seven million Americans.
No individual car accident can be foreseen, obviously, but the total
number of accidents over a large population is amazingly predictable.
The company knows from past experience what percentage of the drivers it
insures will file claims and how much those claims will cost. The logic
of catastrophe is very different: either no one is affected or vast
numbers of people are. After an earthquake flattens Tokyo, a Japanese
earthquake insurer is in deep trouble: millions of customers file
claims. If there were a great number of rich cities scattered across the
planet that might plausibly be destroyed by an earthquake, the insurer
could spread its exposure to the losses by selling earthquake insurance
to all of them. The losses it suffered in Tokyo would be offset by the
gains it made from the cities not destroyed by an earthquake. But the
financial risk from earthquakes — and hurricanes — is highly
concentrated in a few places.
There were insurance problems that
were beyond the insurance industry’s means. Yet insurers continued to
cover them, sometimes unenthusiastically, sometimes recklessly. Why
didn’t insurance companies see this? Seo wondered, and then found the
answer: They hadn’t listened closely enough to Karen Clark.
Thirteen
years before what would become Tropical Storm Katrina churned toward
Florida — on Monday, Aug. 24, 1992 — Karen Clark walked from her Boston
office to a nearby Au Bon Pain. Several hours earlier, Hurricane Andrew
had struck Florida, and she knew immediately that the event could define
her career. Back in 1985, while working for an insurance company, Clark
wrote a paper with the unpromising title “A Formal Approach to
Catastrophe Risk Assessment in Management.” In it, she made the simple
point that insurance companies had no idea how much money they might
lose in a single storm. For decades Americans had been lurching toward
catastrophe. The 1970s and ’80s were unusually free of major storms. At
the same time, Americans were cramming themselves and their wealth onto
the beach. The insurance industry had been oblivious to the trends and
continued to price catastrophic risk just as it always had, by the seat
of its pants. The big insurance companies ran up and down the Gulf Coast
selling as many policies as they could. No one — not even the supposed
experts at Lloyd’s of London — had any idea of the scope of new
development and the exposure that the insurance industry now had.....MUCH MORE
This piece was originally published on August 26, 2007 i.e. three weeks after the "
Quant Quake" (NYFed 77 page PDF) and over a year ahead of that glorious September of '08.
HT: to an unrepentant quant, World Beta's Mebane Faber:
Cat Bonds
You'll note that his list of natural catastrophes shows lower estimated normalized
losses than those in
our earlier post
"What was the Most Expensive Hurricane Ever to Hit the United States?".
Nothing against his source, AIR Worldwide but use the figures in the latter, they came from Professor Pielke Jr. who literally wrote the book on such things.
![[image]](http://si.wsj.net/public/resources/images/EI-BW883_ECONOM_G_20121030174333.jpg)
911 OPERATOR
911 OPERATOR
Posts
