How my IIMB Class explains the 2008 financial crisis

I have a policy of not enforcing attendance in my IIMB class. My view is that it’s better to have a small class of dedicated students rather than a large class of students who don’t want to be there. One of the upsides of this policy is that there has been no in-class sleeping. Almost. I caught one guy sleeping last week, in what was session 16 (out of 20). Considering that my classes are between 8 and 9:30 am on Mondays and Tuesdays, I like to take credit for it.

I also like to take credit for the fact that despite not enforcing attendance, attendance has been healthy. There have usually been between 40 and 50 students in each class (yes, I count, when I’ve bamboozled them with a question and the class has gone all quiet), skewed towards the latter number. Considering that there are 60 students registered for the course, this translates to a pretty healthy percentage. So perhaps I’ve been doing something right.

The interesting thing to note is that where there are about 45 people in each class, it’s never the same set of 45. I don’t think there’s a single student who’s attended all of my classes. However, people appear and disappear in a kind of random uncoordinated fashion, and the class attendance has remained in the forties, until last week that is. This had conditioned me into expecting a rather large class each time I climbed up that long flight of stairs to get into class.

While there were many causes of the 2008 financial crisis, one of the prime reasons shit hit the fan then was that CDOs (collateralised debt obligations) blew up. CDOs were an (at one point in time) innovative way of repackaging receivables (home loans or auto loans or credit card bills) so as to create a set of instruments of varying credit ratings.

To explain it in the simplest way, let’s say I’ve lent money to a 100 people and each owes me a rupee each month. So I expect to get a hundred rupees each month. Now I carve it up into tranches and let’s say I promise Alice the “first 60 rupees” I receive each month. In return she pays me a fee. Bob will get the “next 20 rupees”, again for a fee. Note that if fewer than 60 people pay me this month, Bob gets nothing. Let’s say Eve gets the next 10 rupees, so in case less than 80 people pay up, Eve gets nothing. So this is very risky, and Eve pays much less for her tranche than Bob pays for his which is in turn much less than what Alice pays for hers. The last 10 rupees is so risky that no one will buy it and so I hold it.

Let’s assume that about 85 to 90 people have been paying on their loans each month. Not the same people, but different, like in my class. Both Alice and Bob are getting paid in full each month, and the return is pretty impressive considering the high ratings of the instruments they hold (yes these tranches got rated, and the best tranche (Alice’s) would typically get AAA, or as good as government bonds). So Alice and Bob make a fortune. Until the shit hits the fan that is.

The factor that led to healthy attendance in my IIMB class and what kept Alice and Bob getting supernormal returns was the same – “correlation”. The basic assumption in CDO markets was that home loans were uncorrelated – my default had nothing to do with your default. So both of us defaulting together is unlikely. When between 10 and 15 people are defaulting each month, that 40 (or even 20) people will default together in a given month has very low probability. Which is what kept Alice and Bob happy. It was similar in my IIMB class – the reason I bunk is uncorrelated to the reason you bunk, so lack of correlation in bunking means there is a healthy attendance in my class each day.

The problem in both cases, as you might have guessed, is that correlations started moving from zero to one. On Sunday and Monday night this week, they had “club selections” on IIMB campus. Basically IIMB has this fraud concept called clubs (which do nothing), which recruiters value for reasons I don’t know, and so students take them seriously. And each year’s officebearers are appointed by the previous year’s officebearers, and thus you have interviews. And so these interviews went on till late on Monday morning. People were tired, and some decided to bunk due to that. Suddenly, there was correlation in bunking! And attendance plummeted. Yesterday there were 10 people in class. Today perhaps 12. Having got used to a class of 45, I got a bit psyched out! Not much damage was done, though.

The damage was much greater in the other case. In 2008, the Federal Reserve raised rates, thanks to which banks increased rates on home loans. The worst borrowers defaulted, because of which home prices fell, which is when shit truly hit the fan. The fall in home prices meant that many homes were now worth less than the debt outstanding on them, so it became rational for homeowners to default on their loans. This meant that defaults were now getting correlated! And so rather than 85 people paying in a month, maybe 45 people paid. Bob got wiped out. Alice lost heavily, too.

This was not all. Other people had bet on how much Alice would get paid. And when she didn’t get paid in full, these people lost a lot of money. And then they defaulted. And it set off a cascade. No one was willing to trade with anyone any more. Lehman brothers couldn’t even put a value on the so-called “toxic assets” they held. The whole system collapsed.

It is uncanny how two disparate events such as people bunking my class and the 2008 financial crisis are correlated. And there – correlation rears its ugly head once again!

 

The Peer Pressure of Finishing An Exam Early

Today is the final exam of my course at IIMB. It’s a two part exam – students have been given the problems today and they have to describe on paper how they are going to approach the problem. Tomorrow I’ll send them relevant data and then they need to build an Excel model and solve the problem.

The point of this blog post, however, is to do with the peer pressure of finishing an exam early. Today’s exam is taking place in two rooms, with the students having been divided equally between the rooms. I’m writing this two and a half hours into a four hour exam, and so far about a dozen students have handed in their papers. The interesting thing is that eleven of these are from one room, and one from the other.

This makes me wonder if there is some kind of “peer pressure” in terms of finishing an exam. When you hand in your paper early, you signal one of two things – either that you have really aced the exam or that you really have no clue. By looking at the people who have walked out so far and their academic reputations, it is possible for the remaining students to know whether the people who have left have aced the exam or given up.

So the question is if there is some kind of gamesmanship involved in finishing an exam early. Let’s say a stud walks out of a 4-hour exam in an hour. Does he walk out early in part to let his peers know that it was a bloody easy exam and that they should be doing better than they already are? And does this in part put pressure on the other studs to “preserve their reputations” in some manner by also finishing early? And does this imply that they might hurry up and not do a good enough job of the exam, leading to suboptimal performance and better grades (let’s assume a relative grading system) for the person who originally walked out?

Or do you think walkouts are independent? That two students walking out i close succession to each other were independent events that I’m reading into too much? I wish I had actually tabulated the timings at which papers had been handed in, and maybe perhaps correlated them with the actual performance in an exam (to analyse how early finishing affects performance). As it stands, though,I should work on the data available.

I’m writing this blog post siting in room 1 (posting later since Wi-Fi has been switched off here for purpose of the exam). After I started writing, one of the studs sitting in room 1 walked out. Almost in quick succession one other stud in this room followed him. This is the room where one guy had walked out really early, and he’s also one of the studs of the class.

This suggests that there is some kind of correlation. A sort of relationship. That one person walking out puts pressure on others to also walk out. And can result in some good “relative grading”!

I’ll end with an anecdote from my days as a student here, almost exactly 9 years back. It was an objective final exam, with multiple choice questions only. And in that series of exams it had been some sort of a competition as to who would walk out early.

So it was the last exam, and this one guy decided to “show off” by walking out within five minutes. Unfortunately one other guy had decided to turn up late for the exam. The institute rules state that nobody is allowed into an exam after at least one student has walked out. So the second guy was not allowed to take the exam.

As it turned out, he got a better grade than the guy who had walked out within five minutes!

Finance is boring, once again

So IIMB goes to placements this week. Two months back, though, in the first class I taught there, in an attempt to “understand the class”, I asked my students to tell me their “most preferred employer”. The intention was to tailor the course in a way that would be more suitable for their prospective careers.

Thinking back at that class, there is one thing that hits me – very few want to do finance (again that’s no indication of how many of them will end up in finance jobs this week). I initially thought it was a biased sample – there was a course of the same name offered to the same batch in an earlier term, and those that had taken the course then were not eligible to take the course now. Given the primacy of spreadsheets in finance, I thought students more inclined towards finance would have taken the course in the earlier offering. But then thinking about it (without data to back me), that so few want to do finance doesn’t surprise me at all.

When I tried putting myself in the shoes of my students and thought of what jobs I wanted to take, I realised that there weren’t any finance jobs that I could think of. With the derivatives world having undergone several downturns in the last decade, no one recruits for derivative sales and trading from IIMs any more (if my information sources are right – they could be wrong). And if you were to take out derivatives sales and trading, there is very little that excites about the other finance jobs that recruit MBAs.

There is investment banking (M&A, Equity/Debt Capital Markets) of course, but the job is insanely fighter, and while it is ultimately a finance job, finance forms a small portion of your day-to-day activities there (secondhand information again). Venture capital and private equity are again ostensibly finance but again there is very little finance you use in decision-making there – other “softer” stuff (such as evaluating “quality of founding team”, etc.) dominate.

Then there is commercial banking, which is finance only in name, for most jobs for which they recruit MBAs (data from a decade back) are in the realm of sales or business development. There is the odd treasury or risk management job, but those jobs are small in number compared to the others. And corporate finance jobs see excitement very rarely (when there is M&A or related activity). You have asset management and research roles, but they are again not the kind that you would call as “exciting”.

In short, finance has become boring, again. Most jobs on offer to fresh MBAs nowadays are for roles that are fairly routine and “boring” for the most part, and while finance still pays well, there are no adrenaline-pumping jobs on offer there as there used to be a decade ago. And from the macro point of view, that is a good thing.

Because finance is fundamentally a boring job, and is supposed to be a boring job. If finance had become “exciting”, it was because finance people were doing stuff that they were not supposed to be doing! Like taking highly levered bets for example, or concocting derivatives so complicated that nobody – not even most traders – would be able to understand it.

I had written recently that people have stopped considering coding “cool”, and that we should do something about it. A similar thing is happening to finance, where MBA students are not finding it “cool” any more (but people will take up the profession since it pays well). However, this is not a problem, and nothing needs to be done about it. This is how things ought to be. Finance is supposed to be boring!

Anyway, this might be biased opinion since if I could roll back nine years and were asked to pick a job, I couldn’t see myself working at ANY of the companies that had come to recruit from IIMB back when I graduated! So perhaps my hypothesis about finance jobs being boring now is a result of all typical post-MBA jobs being boring! Perhaps that explains why I’m doing what I’m doing now – a “job” so atypical it takes a lot of effort to explain to people what I’m doing.

Oh, and coming back to finance, I’m four weeks though with my Asset Pricing MOOC, and have been totally enjoying it so far!

Teaching at IIMB: Mid-term review

IIMB has a strange policy. They are not allowed to have classes tomorrow on account of it being a national holiday so they shifted tomorrow’s concept to today, indicating a complete lack of appreciation of the concept of the long weekend. Anyway, since I didn’t have any other plans for the day or the weekend I decided to not request for a slot change and went anyways. This was my eleventh class out of twenty.

I expected the attendance to be rather thin today, but the class surprised me with more than three-fourths of the registered students turning up (on par with most sessions so far). And despite the class being at 8 am in the morning, none of them slept (at least I didn’t notice anyone sleeping). That is again on par with the course so far – more than halfway though the course and I’m yet to catch a single person sleeping in class! Maybe I should take some credit for that.

The class before today’s was about ten days back (long gap due to mid-term exams), and that day I had a minor scare. I had formulated a case that involved solving the Newsboy Problem (now politically corrected to “Newsvendor model“) as a sub-step in the solution to the case. Having worked out the sketches of the case solution the previous night I went to sleep hoping to work out the full case before I went to class. And my brain froze.

So it was 6:30 on the morning of an 8am class and I wasn’t getting the head or tail of the newsboy problem despite having known it fairly well. Decided to have cereal at home rather than go to SN to give myself more time to read up and understand the model. And my brain refused to open up. Yet I made my way to class, hoping I could “wing it”.

I didn’t have to, for the class exceeded expectations and solved the case for me. One guy popped up with “newsvendor model”. Another guy said that we could consider a certain thing as a “spot price”, thus eliminating the need to make any assumptions on costs. Then we started working out the model on Excel (remember that this is a “spreadsheet modelling” course). And the time came to implement the newsvendor model. And my brain froze in anticipation. “How do we do this?”, I asked, trying to not give away my brain freeze.

“We calculate the critical ratio”, came the chorus (sometimes I dispense with the politeness and order of people raising their hands and speaking in order). “And what is that here?”, I asked. “B6/(B5+B6)” came back the chorus. And then when I asked them how to impute the ordering level based on this, the chorus had figured out the exact way in which we should use NormInv to determine this. The troubling bit of the newsvendor problem having been thus solved, I took control and went forward with the rest of the case. And my respect for the class went up significantly that day.

Later in the day I was relating the incident to the wife, who I might have mentioned is an MBA student at IESE Business School in Barcelona. “Oh my god, your class is so quant”, she exclaimed. This is a topic for another day but perhaps due to the nature of the admissions procedure, students at IIMs are definitely much much more quantitatively oriented than students at B-schools elsewhere. Yet, IIMs don’t seem to be doing much in terms of harnessing this quant potential which should be giving their students a global competitive advantage.

And coming back to my class, they’ll be sitting for placements starting the 9th of February. If my class is a representative sample (it is most likely not, since I’m teaching an elective and these people expressed interest in learning what I’m teaching, so there is a definite bias), this seems like a great batch at IIMB. So I encourage you to go and recruit!

 

Deranging groups

Ok so this is a mathematical problem. I plan to give three group assignments to my IIMB class. Let’s assume that there are 60 kids and for each assignment I want them to form groups of four members each. For the first assignment I’ve let them form the groups themselves.

For the second assignment, though, I want to create a “derangement” of these groups – in the sense that I want to form a different set of 15 groups of 4 members each such that no pair of students who are in the same group for assignment 1 will be in the same group for assignment 2. And I’m looking for an algorithm to thus “derange” my students. And whether it is possible at all to derange students thus.

My inclination is that this might have a solution in graph theory – in terms of graph colouring or something? Take the students from the first group and join every pair of students that are in the same group with an edge. Then colour the nodes of the graph. Pick nodes of the same colour (these are students that haven’t been in groups together) and randomly assign them to new groups. Repeat for all colours.

Question is how many colours we need to colour the graph. If it’s planar, we’ll need only 4 colours! And considering that the first assignment has 4 students per group, the maximum degree of a node is 3. If the maximum degree of an edge is 3, does that say anything about the planarity of the graph? If I derange the students once for assignment 2, can I do it again for assignment 3 (now each node has a degree of 6!) ? How do I think about this mathematically? Can you help?

Dressing up in residential schools

As  I was getting ready this morning to go deliver my lecture at IIMB, the wife expressed surprise at how casually I was dressed (I wore jeans, a (collared, “formal”) t-shirt and a hoodie). “In my business school all professors wear suits”, she said. My mind went back to the time when I was a student at IIMB, trying to remember what professors wore. While they were generally dressed more formally than I was today, no one wore suits – the only one who wore a blazer every day was easily the worst professor who taught me at IIMB!

I was thinking about why I don’t feel like dressing formally while going to IIM. And then I thought of the students, and realised that with the odd exception, I’m easily much more formally dressed than most of my students. When students turn up to class in track pants, professors have no incentive to wear anything close to a suit!

And this is not a new phenomenon. Back in my time too, close to ten years ago, people would wear track pants and other articles of clothing you might describe as “home wear” to class (Not me, though. I don’t wear track pants. As a rule. But I remember making it a point to wear shorts to all my final term examinations). So I started thinking about what it is about IIMB that makes people wear “home wear” to class. And I realised it has to do with the proximity.

IIM Bangalore is a wholly residential campus, and the student accommodation is a short walk away from most of the classrooms. In the second year, thanks to electives time tables are such that there is a good chance of having long breaks between classes, so you go to the academic part of the institute for only one class.

When you are going to a classroom that is only a short walk away from where you live, and when you go there only for one or two classes, it doesn’t feel like you’re “going somewhere”, so you don’t see any point in dressing up. Moreover, most of the people you meet in class are people you share a hostel with – these people would have seen you in your pyjamas anyway, and seen you get sloshed all over L^2 during one of those parties which I’m told are not so common nowadays! So there is no good reason for you to dress up! And you come to the class in pyjamas!

The wife’s B-school is not residential, and people live a few kilometres away. Very few pairs of people would have seen each other in their pyjamas, and the distance means people are “going somewhere” when going to a school. And so people dress up (and by that I mean they really dress up!). And when students are well-dressed, the professor wants to show off his superior social standing, and thus wears as formal clothes as he can – which usually means a suit!

Again I’m talking from small number of data points – I’ve lived in another residential institution (IIT Madras) – and that too was famous for its rather muted/horrible dressing sense. It’s a pity/mercy (depending on the way you look at it) that us IIMB people manage to well cover up our generally bad dressing by wearing suits at interviews and PPTs and other public events!

Missing data in IIMB Alumni Directory

Recently, I got a mail from the IIMB Alumni association asking me to contact batchmates who are not part of the association mailing list. The objective of the mail was to ensure that every alumnus is registered with the association and can be reached for whatever purpose. Among other things (including exhorting us to mail our class mailing lists, etc.) the mail contained statistics of the number of students in each graduating batch and the number of students who are not part of the alumni mailing list.

The pattern in the proportion of people not on the mailing list was quite interesting so I thought I’ll share it here:

IIMBAlumni

For the earlier graduating batches, you can see that the proportion not on the mailing list is very high. And then there are two deep drops, one in the mid-nineties and one around the turn of the millennium. The latter I would associate with all students having a valid email ID at the time of graduation which would have allowed them to be reachable and be part of the alumni association. The former also would be associated with penetration of email.

What is also interesting is the bump around 2010 – while the enrolment rate up to the batch of 2009 seems to be pretty good, something seems to have gone wrong after that. The enrolment rate for the batch of 2010 is as bad as that for 2002, which is quite bizarre! Wonder if the alumni association messed up, or if there were some technical glitches around then or if for some particular reason that batch hated IIMB so much that they didn’t register!

All in all, though, a very interesting dataset.