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Blog : Penny Stocks, AIG and the Felling of Wall Street
by John Whitefoot on March 20th, 2009
Poor Edward M. Liddy. CEO’s just don’t get the respect they deserve. Not only are we overlooking the fact that he’s taking home an annual salary of just $1, but he’s also being emotionally abused by Congress for legally awarding $165 million in executive bonuses to the AIG Corporate Cabal.
Sure the $165 million is funded by the taxpayer, and yes, the contracts were in place before Liddy took over…and of course Liddy finds the bonuses “distasteful” and takes offence to the bonus blame.
Don’t believe me? In the immortal words of the man himself - “Six months ago I came out of retirement to help my country,” said Mr. Liddy. He may be questioning the sanity of that decision.
Especially for just $1 a year! Fear not – Liddy will get by. In 2005, when he was CEO of Allstate Insurance, he received $26.7 million in compensation. Still, he’ll probably cash the $1 check.
To be fair, Liddy isn’t in a very favorable position. After all, he inherited the compensation contracts providing for retention bonuses to certain AIG derivative traders, some of whom have left the company.
On the other hand, he is the CEO…it’s not like he can pick and choose what he takes the blame or credit for. Not that I’ve ever met a CEO that won’t take credit for work he or she may…or may not have had anything to do with.
But what is he to do? Make CEO like decisions that show he isn’t flushing tax payer dollars down the drain? Nonsense. He’s a deer in the headlights. And I think Henry Paulson might just be driving the car.
Things could be worse. He could be the one being blamed for single handedly taking down Wall Street…and by extension…the global economy. That distinction falls on the shoulders of statistician David X. Li.
In a story line that may just get used in an upcoming episode of Numb3rs, former University of Waterloo statistician David X. Li has surfaced as a scapegoat for the global meltdown. Yup…one lowly mathematician…all on his own.
Recently, Wired magazine ran an article on Li's work subtitled, "The Formula That Killed Wall Street." The formula in question is the so-called Gaussian copula function. On the most basic level, the formula allows statisticians to model the behavior of several correlated risks at once.
In a scholarly paper published in 2000, Li proposed the theorem be applied to credit risks, encompassing everything from bonds to mortgages. While the theorem itself wasn’t new, the financial application Li proposed for it was.
Wall Street investment bankers seized the formula like a magical numeric elixir. Throwing pearls to swine, Li’s application was just simple enough for untrained financial analysts to use, but too complex for them to properly understand it.
In a nutshell, the formula appeared to allow analysts to definitively determine risk, effectively eliminating it. It didn’t.
As Li himself pointed out in a rare interview in 2005 with The Wall Street Journal, “very few people understand the essence of the model.” He was right.
Through the lens of Li's theorem, even the shakiest investments suddenly looked viable. Money poured into CDSs (credit default swaps), a financial device that acts as an insurance policy against defaults. By the end of 2007, the total investment in credit default swaps had swelled to $62 trillion (U.S.), a 6,700% increase in only six years.
A little knowledge can go a long way. Usually in the wrong direction. The more you know as penny stock investors, the smarter your decision making process will be. You can’t take a sliver of knowledge and extrapolate it to marry ideas that simply do not correlate.
And in the world of penny stocks, I find most companies make asinine promises and ask investors to take ludicrous leaps of faith. Just because the gold or oil penny stock you’re looking at is in the same vicinity as a major player…does not mean they’re sitting on a bonanza. Correlation is not causation.
If calculus deprived MBA’s can erroneously use a statistical model to over-extend the global economy, and CEO’s can wax glazed eloquence about their innocence, it’s not a stretch to think that as penny stock investors we can gloss over corporate earnings - cherry picking hollow truths that could drive our portfolios off a cliff.
If the recent events on Wall Street have taught us anything…it’s that nothing is safe and sound. And greed cannot be the foundation upon which you build your penny stock portfolio.
A little knowledge can go a long way…a lot of understanding goes further. There is no simple formula for picking penny stocks. I don’t care what the tele-broker preaches at 3a.m. on your local cable station.
To losely quote Francis Bacon, “knowledge is power”. And when it comes to my penny stock portfolio…I’m not willing to give that power over to anybody. Wall Street has already shown the world what it can do in the so-called best of times. Now that it’s merrily led us to the worst of times, we can use our brains to take back…what we blithely gave away.