Sunday, August 26, 2007

Cat bond risk

Moneyball's Michael Lewis on catastrophe bond trader John Seo (via Chris Masse). A couple of excerpts:
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.”

And after all, how accurate were the models that forecast the likelihood that Enron would collapse? Next to what Wall Street investors tried to predict every day, natural disasters seemed almost stable. “In the financial markets, you have to care what other people think, even if what they think is screwed up,” Seo says. “Crowd dynamics build on each other. But these things — hurricanes, earthquakes — don’t exhibit crowd behavior. There’s a real underlying risk you have to understand. You have to be a value investor.”

In the spring of 2001, to the surprise of his colleagues, Seo left his big Wall Street firm and opened a hedge fund — which, he announced, wouldn’t charge its investors the standard 2 percent of assets and 20 percent of returns but a lower, flat fee. “It was quixotic,” says Paul Puleo, a former executive at Lehman who worked with Seo. “He quits this high-paying job to basically open a business in his garage in a market that doesn’t exist.” Seo named his firm Fermat Capital Management, after one of his intellectual heroes. “I had once read the letters between Pierre de Fermat and Blaise Pascal,” he wrote in a recent e-mail message. “From my father I had learned that most great mathematicians were nasty guys and total jerks (check out Isaac Newton . . . extra nasty guy), but when I read the Fermat-Pascal letters, you could see that Fermat was an exception to the stereotype . . . truly a noble person. I loved his character and found that his way of analyzing profitless games of chance (probability theory) was the key to understanding how to analyze profitable games of chance (investment theory).”

Four years later, Seo’s hedge fund still faced two problems. The smaller one was that investors were occasionally slow to see the appeal of an investment whose first name was catastrophe. As one investor put it, “My boss won’t let me buy bonds that I have to watch the Weather Channel to follow.” That objection doesn’t worry Seo much. “Investors who object to cat-bond investing usually say that it’s just gambling,” he says. “But the more mature guys say: ‘That’s what investing is. But it’s gambling with the odds in your favor.’ ”

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