The Danger of the Real Finanical World

There is a great commentary by Nassim Nicholas Taleb in today's Financial Times (and the whole thing seems to be available, at least I write this, by non-subscribers, so I'd urge you to go quickly and see if it's still up).

Taleb, author of The Black Swan: The Impact of the Highly Improbable is a former trader and risk manager of 20 years experience. In his day, he say many improbably events, culminating in the crash of 1987 (and from what I heard on NPR yesterday, an equivalent sudden drop in market value would be 3000 points on the Dow). His argument is that everyone going through the ranks at business schools is learning modern portfolio theory, an approach to handling risk and investment in which a person or entity handles a mix of investments with varying risk. The concept is that you can plan and diversify your way into financial goals and out of danger. Each asset is a variable, and then you weight the assets, so the value of the portfolio is the combination of those weighted assets. There are expected values of these variables, and expected variances. In theory, you come up with a function that expresses the value of the variable, calculate the variances - how far the value of the variable can be expected to swing - and you can predict the portfolio value.

It's great in theory. However, Taleb points out that this can lead to useless results. Variance depends on historic information, which is fine so long as you recognize the limitation that can impose. (I'd also wonder whether the proponents end up smoothing out data - tossing the scary out-lying values - because it becomes very difficult if not impossible to make calculations with them.) He points to work of mathematician Benoit Mandelbrot, father of fractals, who has tried applying fractal mathematics to the stock market to try and understand the wide swings that happen in short periods, but that probably shouldn't if you use the typical coin toss price goes up/price goes down underpinnings of most stock market prediction. (Here's a Forbes piece on the topic.)

As Taleb writes:

MPT produces measures such as “sigmas”, “betas”, “Sharpe ratios”, “correlation”, “value at risk”, “optimal portfolios” and “capital asset pricing model” that are incompatible with the possibility of those consequential rare events I call “black swans” (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

Certainly I've seen the 1987 market crash, the dot com meltdown, and more than one major hedge fund collapses (including Amaranth and LTCM, the latter having two Nobel prize winners on its board of directors). Maybe there's something to be said for assuming that the impossible always happens and that current financial models just don't cut it when then meet reality.

Business Using Sub-Prime as an Excuse

There have been many news accounts of how the meltdown in the sub-prime credit markets have become like a contagion, affecting a growing amount of all business. The reasoning, as I understand it, goes something like this:

1. Housing prices kept escalating, so people had burgeoning amounts of equity, at least on paper.



2. Sub-prime lenders kept taking on more risk because high demand for homes and rising housing prices made it seem relative safe.



3. Lenders bundled together derivative securities that held the mortgages.



4. By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.



5. Prices topped and dropped, and a growing number of people were defaulting - not just on first mortgages, but on secondary ones, including equity-backed lines of credit.



6. Someone had to start paying out money, which meant credit insurers and mortgage lenders alike had to start pouring out cash, which meant reducing liquidity.



7. Those with lots of cash didn't want to lose it, so they stopped underwriting so much of the business being done.



8. As a result, some groups are losing money on deals because they couldn't get the terms they needed, and some hedge funds started to close because they were effectively undertaking high stakes gambling and finding that the house eventually wins.



9. Private equity firms, which had been indirectly fueling the rise in stock prices (not some quick miracle of economic conditions), are backing away from deals because they can't get the terms and returns that drive their business models. (Friday's Wall Street Journal had an article called "Leveraged Buyout Remorse?" with the following first line: "Having spent years racing to put deals together, some private-equity firms are puzzling over whether they should take them apart.")



10. The stock market is likely to see an increasing pinch as people and institutions aren't rushing to make a killing on the next takeover prospect.

So it's all the fault of the sub-prime markets, we hear. But I don't buy it. Yes, that is a mechanism, but it's not the finger pulling the trigger. That honor belongs to greed unchecked by business sense.

In the face of economic history, expecting that prices relative to other demands of life could rise forever, and even planning on that happening, is idiotic. That has never happened and isn't about to start. What we are seeing is the same as the tulip market mania of the 16th century. It's multi-level marketing on a grand scale. It's a ponzi scheme. At each point, furthering of the business "model" depends on someone having the expectation that no matter what the inflated price, he or she will shortly see the same type of return. If a business or investor wants to take some risk for high returns, that's fine, but it's called risk for a reason. There is a measurable chance, sometimes large, that you will lose part or all of the money you've invested.

To put virtually all of your eggs into this one basket is insane. Yet that's what the markets have done. All manners of companies have been betting on consumer spending to continue. But the spending wasn't itself fueled by increases in wages. No, because that would lead to inflation and corporations having higher labor expenses, and smaller returns. Instead, everyone more or less turned their heads, opened the credit taps, and let the money flow because, well, those increased housing prices would make everything fine in the end. One could always refinance, pay off the one lender at risk by transferring the risk to another, and take a little extra money out at the same time.

It's over. People are increasingly stuck in houses they couldn't afford and that, with dropping prices, they can't afford to sell, because they would remain in debt as the sales price wouldn't cover the mortgage. The markets are experiencing (I'm not sure they realize quite what is actually happening) a cold turkey economic abuse program. Now governments are involved, making cash available to keep enough money in the system to leave it afloat. Although you won't see it called such, this is the world's largest economic bailout masked as maintaining market liquidity. The sums that are going in and will probably continue to pour in will dwarf the savings and load debacle this country experienced. I wouldn't be surprised if it ultimately overtook the real spending during the Great Depression. We are in a pile of doo-doo, and all the finger-pointing and rationalization won't change the fact that it is of our own making.