Wednesday, October 01, 2008

Black Swans and ideological shifts

Rare and catastrophic events, so called Black Swans, have a way of re-aligning the political landscape. 9/11 turned many a moderate into a conservative, as it did I. But the financial crisis of 2008 threatens to undo my conservative identity, for what alternative I am yet unaware. A case in point is this line of conservative cant in defense of the deregulated financial markets which takes this year's Leonard Cohen award for tone-deafness:
This reaction is a bit like protesting against patching the hole in an ocean liner because doing so will save those who made the crucial navigational errors. Watching the navigator sink beneath the waves might be fun, but one's pleasure will be short and gurgly. So let's get real. While some unjustified enrichment is possible, for the most part, if the financial institutions survive and prosper it will not be because they have been "bailed out" but because the system has been saved. So take a deep breath and say "This is good." In the Midwesternism of my youth, "Don't cut off your nose to spite your face."

Another reason for rational restraint is that there are fewer villains in this tale than the news and the political campaigns would lead one to believe. Three basically good things - the securitization of consumer credit, the extension of credit down the economic ladder, and the invention of derivatives - have combined, and the resulting mix turned out to be explosive. Well, live and learn, and do better next time. But first, ensure there is a next time.


Bringing the world financial system to the point of collapse is not an event that can be shrugged off with a "live and learn" nonchalance. This is not a matter of small miscalculations, but systemic ignorance on the part of the entire financial community, both from the public and private sector. If conservatives and free market libertarians think that political confidence can be restored without any recriminations or blame seeking, they will have ensured a statist political hegemony for the next fifty years. To paraphrase Ricky Ricardo, there is a whole lot of 'splaining to be done.

Nassim Nicholas Taleb has, I think, correctly figured out who the guilty are, and they are not the government regulators.
Statistical and applied probabilistic knowledge is the core of knowledge; statistics is what tells you if something is true, false, or merely anecdotal; it is the "logic of science"; it is the instrument of risk-taking; it is the applied tools of epistemology; you can't be a modern intellectual and not think probabilistically—but... let's not be suckers. The problem is much more complicated than it seems to the casual, mechanistic user who picked it up in graduate school. Statistics can fool you. In fact it is fooling your government right now. It can even bankrupt the system (let's face it: use of probabilistic methods for the estimation of risks did just blow up the banking system).

The current subprime crisis has been doing wonders for the reception of any ideas about probability-driven claims in science, particularly in social science, economics, and "econometrics" (quantitative economics). Clearly, with current International Monetary Fund estimates of the costs of the 2007-2008 subprime crisis, the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks. But it was easy to see from the past that the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools: The same happened in 1983 with money center banks losing cumulatively every penny ever made, and in 1991-1992 when the Savings and Loans industry became history.

It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand. I want this to stop, and stop now—the current patching by the banking establishment worldwide is akin to using the same doctor to cure the patient when the doctor has a track record of systematically killing them. And this is not limited to banking—I generalize to an entire class of random variables that do not have the structure we think they have, in which we can be suckers.

And we are beyond suckers: not only, for socio-economic and other nonlinear, complicated variables, are we are riding in a bus driven by a blindfolded driver, but we refuse to acknowledge it in spite of the evidence, which to me is a pathological problem with academia. After 1998, when a "Nobel-crowned" collection of people (and the crème de la crème of the financial economics establishment) blew up Long Term Capital Management, a hedge fund, because the "scientific" methods they used misestimated the role of the rare event, such methodologies and such claims on understanding risks of rare events should have been discredited. Yet the Fed helped their bailout and exposure to rare events (and model error) patently increased exponentially (as we can see from banks' swelling portfolios of derivatives that we do not understand).

I think the first mistake with deregulation has been to pretend that the financial sector can be treated as private. The financial system is infrastructure, just like roads and bridges. It is an enabler of commerce, a resource that must be in place and must be standardized to allow any economic activity to take place.

The second mistake is to treat financial activity as wealth-producing. When the financial sector leads the economy in profit growth, it is at the expense of real wealth production. Allowing banks to engage in speculative "investment" activity, fueled by leverage, was not only a disaster in the making, but it was a misallocation of capital from truly wealth generating opportunities such as energy and resource production. We have too few oil wells but way too many houses right now because we allowed our financial institutions to play the roulette wheel with leveraged bets backed by the Federal Reserve.

I'm not sure what form future regulations of the financial system should take, but I am in no doubt that the conservative pipe-dream of unregulated financial markets is as dead as Pauly Shore's Oscar ambitions. I only hope that we can direct the bulk of the regulations toward the financial sector and leave the productive sectors of our economy free enough to preserve and enhance our standard of living going forward.

Update: For those who doubt that the current moment represents a potential catastrophe, I refer you to these words from tax law professor Theodore Soto:
In addition, at least $500 billion more of teaser-rate mortgages are scheduled to reset over the next several years. In all likelihood, they too will go into default and become toxic waste. Nothing in Mr. Paulson’s original proposal was intended to do anything about this next $500 billion installment – or, indeed, to prevent lenders from making more teaser-rate mortgages in the future.

Similarly, Mr. Paulson’s proposal was not intended as a general Wall Street bail-out, although to some extent it would have had that effect. Note that the outstanding overhang of credit default swaps alone is estimated to be between $45 and $60 trillion – three to four times the size of our annual gross domestic product. The requested $700 billion, although the single biggest appropriation request in U.S. history, was miniscule when compared with the toxic waste problem as a whole. Mr. Paulson’s proposed solution was to cost just 1% of the size of the problem and was aimed only at a small part of that problem. (It is unnerving to realize that the U.S. government – the “beast” we have been starving for so long – may now lack the borrowing capacity to solve the problem as a whole. We need to get our financial house in order.)

13 Comments:

Blogger Harry Eagar said...

Welcome to the bright side.

October 01, 2008 11:04 AM  
Blogger Bret said...

Duck,

I think I've read every post you've ever written at this blog. Congrats, in my opinion, this is your worst post ever.

The idea of having a riskless financial system is simple: get rid of money and just barter. We could do that, but I don't think you'd like the results.

The world financial system is nowhere near the point of collapse. It is near a point of a moderately severe credit contraction and recession, but that's a bit different from the world financial system collapsing. You're getting taken in by the numerous fear-mongerers including Paulson and Bernanke. So live and learn is a perfectly good response.

Ol' Nassim can throw around statistics buzzwords like there's no tomorrow but apparently doesn't know what they mean. The very first sentence of his that you quote is simply false: statistics does not tell you if "something IS true, false, or merely anecdotal". It only gives you a likelihood of something being true, false, or merely anecdotal, and that likelihood is almost always based on assumptions, which may or may not be true. That's why "Black Swans" will always be with us. No matter how unlikely you make them, if you wait long enough, they'll still show up.

"I think the first mistake with deregulation has been to pretend that the financial sector can be treated as private."

Who on earth (who has any clue what they're talking about) thinks the financial sector is private? It's based on a fiat currency which is, by definition, government controlled and regulated.

"The second mistake is to treat financial activity as wealth-producing."

Here we have to understand how three things relate: wealth production, profit motives, and financial activity. Very few (again, who know anything about money), think that financial activity produces wealth in and of itself. The point is that financial instruments enable more efficient price movements which in turn enables more effective allocation of scarce resources in an economic system, which is a necessary condition to maximize wealth creation. Those that work in the financial sector do, like everyone else, have a profit motive, and in an appropriate regulatory environment will have the correct incentives to provide financial activity that maximizes the efficiency of the price mechanism and thus maximizes the value of the output of the economy.

"We have too few oil wells but way too many houses right now..."

Way too many houses? Are a lot of them sitting empty? Even if so (I haven't actually looked), wouldn't this be at least partially related to numerous programs that have aimed at putting lower income people in their own homes? Wouldn't lack of oil wells be at least partly related to regulations prohibiting drilling those wells in numerous places? Do you not think there are derivatives associated with oil? Have you never heard of light sweet crude oil futures contracts (and options on said contracts)? How about New York Harbor Unleaded futures contracts? Do you think it would help oil and gasoline prices if we got rid of those derivatives?

The idea that derivatives that are used to allocate risk to those more inclined to bear it and explore prices in the future are some kind of evil with no use in the real economy is very, very, very misguided.

Can we live without such things? Sure, but we won't live as well as we otherwise would have.

October 01, 2008 12:40 PM  
Blogger Duck said...

The problem that I have with using derivatives to manage risks is that noone really understands them. It is impossible to trace all of the counterparty interdependencies. And by giving the illusion of managing risks it encourages an unwise use of leverage. Underestimated risk is the worst kind of risk.

Spreading risk across the entire financial system makes as much sense as allowing all of the nations forest land to grow together, thus spreading the fire risk across it all. Better to let each institution to be totally responsible for the risks in its own asset portfolio. Then they would invest more responsibly, and the failure of one institution would not threaten others. That's how it would be if we really had a competitive marketplace.

October 01, 2008 1:35 PM  
Blogger Harry Eagar said...

Yeah, and everything looked fine on Oct. 28, 1929, too.

When it happens, it's like snapping a pencil.

If you could avoid putting stress on the pencil by taking moderate precautions -- of the type that have been thrown to the winds -- why wouldn't you?

As for the amount of risk, allow me to quote from the excellent blog, Restating the Obvious, about the risk managers:

'How stupid are these guys? Well, as we used to say in Tennessee, they need to take off their socks to count the big numbers.

'I want to refer back to something that zipped by almost unnoticed in the pellmell rush. Less than one paulson before the first $700B plan was pushed out the door without his shoelaces tied, there was an international plan announced that was supposed to backstop not just the U.S. markets, but all of the world's shaky banks -- which, as we know better today than we did then, are a lot of banks.

'Since this came from the finance ministers of the G8 countries, it is safe to say that the proposal represents not just the best estimate by the world's assembled geniuses about the solution, but also their best guess as to the magnitude of the problem. After all, they get the reports, don't they?

'And how big was that rescue package? Seventy billion dollars.

'That's right. They were off by (at least) an order of magnitude.'

If you haven't been reading Restating, a paulson is a convenient measure of time -- the time a business manager can rely on a government policy. It is equivalent to 48 hours.

October 01, 2008 2:19 PM  
Blogger Bret said...

duck wrote: "The problem that I have with using derivatives to manage risks is that noone really understands them."

I'm certain the statement that noone understands derivatives is wrong. For example, commodities futures such corn futures are derivatives. Many people have a complete understanding of corn futures, including farmers, banks that lend to farmers, users of corn, and speculators. The farmers and the bankers use the futures contracts to ensure a certain price per bushel for their crops before they take loans out to plant and tend their crops. By doing so they reduce their risk because they can guarantee that they can sell their crop profitably before they plant. I personally have traded corn futures and I can assure you that I understand them deeply.

But here's the thing. As well as corn futures are understood, and as well as they work at keeping the prices of corn lower over the long haul, in the "Black Swan" case they do probably increase risk a bit.

For example, let's say a new pest, maybe some sort of locust thing, appears out of nowhere and consumes the entire corn crop and all the stored corn and all the wheat, etc.

The farmers would go bankrupt whether or not they hedged their position with futures. After all, they applied significant resources to plant and tend their crops and will have nothing to show for it and no way to pay back their loans.

The banks that lent money to the farmers will also go bankrupt (or be in big trouble) because the farmers can't pay them back. Again, this is true whether or not the farmers used the futures derivatives to hedge their position.

So far, using futures hasn't made a differences in the Black Swan event. However, in an extreme case, the bankrupt farmers may not be able to cover their futures positions and the exchanges may not be able to force the liquidation of those positions fast enough such that other financial institutions are significantly adversely affected. So the systemic risk in the truly catastrophic scenario is probably increased.

In the current crisis, the crop is mortgages and the derivative is credit default swaps. They are well understood (especially now). In normal times they reduce the cost of mortgages. In the case of widespread failure, they somewhat exacerbate the risk.

But don't think that the credit system would be fine and dandy if the derivatives weren't traded. The fact is that widespread defaults were going to put a great deal of pressure on the financial system anyway. It's probably worse with the derivatives, but not necessarily all that much worse.

The question then becomes: if derivatives allow for cheaper products (corn or mortgages) year in, year out, except once in a great while exacerbate a catastrophic situation, should we use them or not? Should we pay 30% more for corn forever to avoid massive crop failure rippling a bit further into the financial system? Should we all pay another half percent on our mortgages forever to avoid an occasional bailout?

My answer is definitely not. That cure is far worse than the disease.

duck also wrote: "It is impossible to trace all of the counterparty interdependencies."

Yeah, but so what? When you buy a candy bar at the store, do you think anybody can trace where that bit of cash is going to go with all the counterparty interdependencies?

duck wrote: "And by giving the illusion of managing risks it encourages an unwise use of leverage. Underestimated risk is the worst kind of risk."

No, they really do manage risk in the vast majority of circumstances. One more example. Surely you don't think that fire insurance for houses is a bad thing. However, if a whole city burns, the insurers and reinsurers will all be dragged down and the government will have to jump in. The risks wouldn't have been underestimated. It's just that everybody accepts (if they think about it), in the Black Swan case, the system simply won't cope.

In the case of the current financial situation, the risk may well have been underestimated in this case. Now everybody knows better and will no doubt set up a better regulatory framework in order to help reduce the risk. No big deal.

duck also wrote: "Spreading risk across the entire financial system makes as much sense as allowing all of the nations forest land to grow together, thus spreading the fire risk across it all."

Not a great metaphor since there's no advantage to having one continuous forest, while there's a lot of advantage to letting those players who specialize in absorbing risk and who are set up to absorb risk take risk off the hands of others (for a fee).


duck also wrote: "Better to let each institution to be totally responsible for the risks in its own asset portfolio."

Again, we can do this, it will just make corn, mortgages, etc. much, much more expensive on average.

duck also wrote: "Then they would invest more responsibly, and the failure of one institution would not threaten others. That's how it would be if we really had a competitive marketplace."

That would be a highly regulated marketplace since the players would be greatly limited in bringing competitive products to market. Again, we can do it, it will just be very expensive on average.

October 01, 2008 10:29 PM  
Blogger Duck said...

Bret,

You make many valid points, but I'm not arguing against all derivative contracts for all players. I'm concerned primarily with MBS and ABS securities and credit default swaps, and primarily for banks and financial institutions that our economy relies on to extend credit and to enable commerce. I couldn't care less if General Motors went belly up because of leveraged bets in the mortgage market. Its productive assets would just be sold to other companies, and its stockholders would take a bath.

The fact is that widespread defaults were going to put a great deal of pressure on the financial system anyway. It's probably worse with the derivatives, but not necessarily all that much worse.

The analogy to a crop failure fails in one aspect - futures contracts didn't enable the crop failure, it was an act of God. But the current financial crisis was largely enabled by stupidity based on an illusion of risk mitigation. The mortgage market failed because too many risky mortgages were originated, and too many risky mortgages were originated because everyone thought that they had diversified their risk away. It's a "tragedy of the commons" scenario. No one was incented to look out for the quality of the total aggregate mortgage pool. Because everyone bore the risk, no one was responsible for the risk. If every bank had to account for the full risk of all of its assets, then the number of risky assets would never have grown so high.

In the case of the current financial situation, the risk may well have been underestimated in this case. Now everybody knows better and will no doubt set up a better regulatory framework in order to help reduce the risk. No big deal.

But there is no excuse for any of the players to have misunderstood the risk. Many, many observers foresaw the current outcome. It didn't take advanced quantitative analysis to see the structure for the house of cards that it was. It took such advanced skills to mistake it for something other than a house of cards.

And it is a big deal. It's a very big deal. It will decide the political and business climate in this country for a generation, at least.

October 02, 2008 6:33 AM  
Blogger Bret said...

duck wrote: "..too many risky mortgages were originated because everyone thought that they had diversified their risk away..."

Many other than you are claiming this, but I find myself very far from convinced. Fanny and Freddie would've ended up buying half or more of the bad mortgages anyway and that would've still been quite the credit squeeze.

The metaphor with corn actually works pretty well. Because of the risk mitigation from futures, more farmers plant corn (that's why it's cheaper on average). Therefore, in the Black Swan case, the problem is made worse. Same in the mortgage sector.

duck wrote: "It will decide the political and business climate in this country for a generation, at least."

Sure, because the politicians are using a minor crisis as an excuse to ram more legislation down our throats. But there's no need to do anything much more than let the Fed do its job. We don't need the bailout (I think it's probably a bad idea, especially in its current form). We do need to set up institutions to handle the derivatives (for example, an exchange for them to be traded on). But the whole thing is way, way overblown in my opinion.

October 02, 2008 8:23 AM  
Blogger Harry Eagar said...

'Now everybody knows better and will no doubt set up a better regulatory framework in order to help reduce the risk.'

That's a joke, right?

Your discussion of hedging assumes, Bret, a fact not in evidence, which is that it's OK to be dead for a little while, because you can come back to life.

My old biz law prof began every lecture by saying, 'Remember, we are working on the basis that we are operating a going concern.'

I was, in those days of my naivete, puzzled why he repeated that over and over. But today I know why.

October 02, 2008 10:30 AM  
Blogger Bret said...

harry,

The mortgage related derivatives have been traded thus far over-the-counter. They should be traded on a regulated exchange, or as an alternative, should be considered insurance products and regulated as such.

I think that it would be foolish to prohibit such mechanisms. Assuming they don't do that, I'm confident that one of the other alternatives will happen. In any case, it will almost certainly be a different regulatory framework.

October 02, 2008 12:15 PM  
Blogger Hey Skipper said...

Bret wins the thread.

October 03, 2008 12:59 PM  
Blogger Duck said...

Skipper,

You know the rules - no voting without 'splaining.

October 03, 2008 1:36 PM  
Blogger David said...

I seem to be doing most of my blogging about this at Thought Mesh and have no desire to repeat everything I said there (except that there's an interesting and important question here about why the markets were systematically underestimating risk that we're not going to answer because we're busy scoring points).

But it's worth noting that Bret is exactly right about Taleb. Statistics can't prove anything and no one who knows anything about statistics would say that it can. It's a mistake on the order of 2+2=5. So everything else he says can be ignored.

October 04, 2008 7:02 AM  
Blogger Hey Skipper said...

Duck:


Sorry, my time for posting is down to a few minutes in a Starbucks.

David, at ThoughtMesh, and Bret here win the thread for clear, coherent, factually sound posts.

October 04, 2008 12:28 PM  

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