Cyrillic Partners

Okay, the latest from the world of informational warfare is only a little off topic for an economics blog. But since encryption underlies every ecommerce transaction and all kinds of protected communications, anything that shakes that foundation is worth knowing about.

John Markoff, an awesome reporter for the NYT, writes about Princeton professor Ed Felton’s latest hack: physically freezing a computer’s DRAM to slow it down and make it spit out the encryption keys that should have only been momentarily stored there.

It’s not the sort of thing that a hacker could exploit from far away, you actually need to pop the computer open and spray the chip with air.

Physical hacks are becoming increasingly popular as computers become more portable. Laptops follow employees home from work or walk out the front door with thieves–often with reams of “private” data.

Now it will be even easier to swipe data from those computers. And unlike software, there’s no easy way to send out a “patch” for this exploit.

[Thanks to iit.edu for the pic]

The Amber Room, a gift from Prussian King Frederick I to Russia’s Peter the Great in 1716 and looted by Germans during WWII may now be found.

The ornately detailed room is believed to have been lost in Königsberg, Germany as the war ended. But German treasure hunters discovered a man-made cavern 20 meters underground in Germany near the Czech Republic, that may contain the looted remains of the Amber Room, they say.

It will take several weeks to dig up, the treasure hunters say. Read the whole story here.

[Image of a reconstructed Amber Room from Wikipedia]

Michael Lewis, an awesomely interesting writer, offered readers of March’s Portfolio Magazine an overly bearish appraisal of the Black-Scholes options pricing model.

This may not, of course, be Lewis’ fault. Portfolio is published by Conde Nast, notorious for yellowing-up its journalism to maximize the shock/sex/scandal factor. How Conde Nast sexed up Wired Magazine to the point of near-unreadability is a sore spot with many readers to this day who say the magazine was “Conde Nastified.”

The story, titled “Inside Wall Street’s Black Hole,” (natch) posits this: The credit crunch ousted bank executives and average Joe Homeowner alike because everybody was mis-pricing their downside protections. Wall Street broker/dealers used Black-Scholes, which provides a framework for pricing options, to justify extending credit to would-be homeowners. But the famous formula doesn’t take into account the possibility of cataclysmic downturns. When the downturn happened, the predictive model didn’t hold up. Therefore, Black-Scholes screwed everybody.

Lewis then goes on to “prove” the point by including quotes from one interview and by paraphrasing much of Nassim Nicholas Taleb’s work (for this feat of journalism he gets paid an ungodly amount per word).

The thesis belies a surprising amount of naivitae. It’s like getting lost on the island of la Grande Jatte and blaming Georges-Pierre Seurat for not giving you an accurate map.

Lewis would do well to remember that a financial theory is just that. It is not a universal law. Newton’s theories of motion start to fall apart when you approach the speed of light, so should anyone be surprised when Black-Scholes starts to break down as the economy fluctuates wildly?

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When the Portfolio cover-line promised me “The Formula that Wrecked Wall Street,” a very different formula immediately jumped to mind: 2 and 20.

That’s the compensation formula used by most hedge funds. It works like this: A hedge fund raises $100 million from private investors, university endowments, large banks and the like. The managers get 2% of that a year, regardless of performance. If they make a profit on their investing operations, say the portfolio gains 10% to $110 million, they get 20% of the profit, or $2 million.

It’s not a bad deal if you can get it: The hedge fund manager walks away with $4 million in income for getting about the market rate of return.

But what’s really deleterious to Wall Street, and general macroeconomic stability, is what happens in year two.

Let’s say the hedge fund manager has a bad year and the portfolio loses 10% of its value (It’s now worth $99 million). The manager still gets $2 million for his “management fee,” but doesn’t take home any bonus pay.

It doesn’t sound like that would have a negative effect, but it does. That compensation structure creates the incentive for the hedge fund manager to take wild risks, literally gamble it all for a shot at a bigger management fee because there’s no downside to poor performance.

If the manager loses all the fund’s money after five years, he or she still walks away with $10 million in fees. And since there’s so little visibility into the performance of hedge funds, there’s little accountability. An unscrupulous hedge fund manager might easily be able to raise another fund. (Which is why public disclosure is important and why journalists serve a role in the new economy.)

So why not risk it all? Go for the one in a hundred chance you’ll get a 100x payoff. It’ll always be preferable to the one in two chance of a x/2 gain.

That’s a formula that’s wrecking Wall Street and probably scares the heck out of Ben Bernanke.

Bernanke and Paulsen went before the Senate Banking Committee today to say that the economy is slowing down but a full-blown recession is unlikely. Big Ben also said he’s not afraid to push the rate-cut button if the economy starts to free-fall.

Perhaps more interesting was what the senators had to say during the meeting, from CNN:

Sen. Charles Schumer, D-N.Y., suggested the problems in credit and financial markets pose a greater threat to the economy than a slowdown in consumer spending.

“Aren’t you underestimating, not giving enough attention to, the severity of the problem in the credit markets?” asked Schumer. He said Wall Street executives he’s talked to “seem much more worried” about credit woes than Paulson and Bernanke.

No question who butters Schumer’s bread. It’s not the first time he’s said nasty things to Bernanke either. He did a chicken little dance back in November (read our coverage). But as Bernanke has pointed out before, the current downturn is hitting financial institutions a lot harder than the rest of the economy. Fed Governor Mishkin already said that Wall Street’s losses weren’t going to be Fed priority numero uno back in November (read our coverage).