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October 14, 2008

Comments

fresno dan

I agree. It has made me re-evaluate my whole philosophy. As an amateur economics fan, I would ask one question: After all these bubbles, is it still possible to believe that most, or even a significant portion, are rational agents?

I lied, one more question: How many people here believe Paulson knows what he is doing, and knew what he was doing when he ran Goldman?

John

So the failure of the economics profession, yet again, to predict a crash is not their fault, but because people are so stupid.

Unimpressive.

Chris E

It's only 'troubling' and 'suprising' if you cling to some variant of the 'all markets are efficient/all actors are rational' trope.

The same psychology lies behind both bubbles (momentum investing) and the way bankers took on risk.

Bob B

"I was browsing through The Black Swan in a bookshop the other day, and have come to the same conclusions of other people -- it's a glossy rendition that doesn't have anything new to say."

Any comments about this on Mandelbrot in 2004?

"In the sixties Mandelbrot already showed that extreme price swings are more likely than some of us think or incorporate in our models. . . "
http://lstat.kuleuven.be/research/reports/2004/report2004_08.pdf

But then as Hegel observed long ago:

"What experience and history teach is this – that people and governments never have learned anything from history, or acted on principles deduced from it." [Philosophy of History]

Unsympathetic

The issue of executive pay HAS been addressed. Buffett's executive team does not receive one penny for work this year until 5 years in the future - and the true results of their actions can be revealed. This results in the execs realizing that their bonus is not tied to creating the "under-the-rug" risk monster.

The issue of risk managers having no pull in any politics anywhere is quite admirably (albeit stultifyingly hard to read) addressed in Bookstaber's A Demon of Our Own Design.

FYI about Paulson: He was the chief aide to Nixon's Ehrlichman - of Watergate fame. Lying, cheating, anything to get ahead - he had a great mentor!

Of course bankers are that stupid - their pay depends on them being short-term greedy. The key is this: Bank risk managers never stopped being skilled. They were simply fired or down-sized or ignored during the RE boom, however, because of the ridiculous short-term profits to be paid immediately. Let the good times roll!

Until they stop.

Alex Kristofcak

hey there.. great post.. see my thoughts triggered by your post here:

http://eatreadplay.blogspot.com/2008/10/read-lessons.html

cheers-
alex

Blissex

«They entered into a valid contract with their employees. It is their problem if they were insufficiently clever to design the proper ownership and incentive structures to get the results they wanted.»

BAHAHAHAHAH. Except that:

* There is the little matter of "fiduciary" duty.

* The contract was usually for compensation based on profits, not on illusory profits because insufficient reserves and provisions against losses were made.

* Most of the ownership and compensation structures have been design by the employees.

* If public money is to be used to bail out banks "ex post facto", there is a public interest in reducing the cost/frequency of that.

Blissex

«"I was browsing through The Black Swan in a bookshop the other day, and have come to the same conclusions of other people -- it's a glossy rendition that doesn't have anything new to say."
Any comments about this on Mandelbrot in 2004?»

I have both Taleb's excellent (and not at all arrogant) book "Fooled by randomness" and the similar one by Mandelbrot "The misbehaviour of markets" and I find them both very nice.

Anyhow most of that stuff is, as Mandelbrot and Taleb acknowledge, quite old; chaos was prefigured in biology and in market studies, and a lot of their conclusions were fairly common knowledge in Europe (despite some vigorous opposition by wingnuts of the time) and especially in Italy.

I have studied with some economists who have enjoyed a great USA and European academic career by carefully recycling the least subversive bits of Political Economics as taught in Italy by Sylos Labini, and others. E.g.:

http://www.e-elgar.co.uk/bookentry_main.lasso?id=1028litical_economy/v032/32.4barucci.html

ad

I tend to agree with reason: "A prudent banker is imprudent in the same way as everybody else."

The banks are safest if they all make the same mistakes as each other. The only banks allowed to go bust are those that make unusual mistakes.

Blissex

«They entered into a valid contract with their employees. It is their problem if they were insufficiently clever to design the proper ownership and incentive structures to get the results they wanted.»

BAHAHAHAHAH. Except that:

* There is the little matter of "fiduciary" duty.

* The contract was usually for compensation based on profits, not on illusory profits because insufficient reserves and provisions against losses were made.

* Most of the ownership and compensation structures have been design by the employees.

* If public money is to be used to bail out banks "ex postfacto", there is a public interest in reducing the cost/frequency of that.

Mayson Lancaster

There are some bankers who didn't go short term rational/long term insane.

Banco Santander is one of the world's top 10 banks. It made 6.5 billion dollars in the first half of 2008. It recently took over Bradford & Bingley's 197 branches for about $1.1 billion, and is buying 75 percent of Penn.-based Sovereign Bancorp. Sovereign has 750 branches and is the largest surviving U.S. savings and loan. Santander already owned a quarter of Sovereign's stock.

From a speech by Santander's chairman, Emilio Botin, a fourth-generation banker with a reputation as an extremely shrewd investor, explaining how Santander has avoided the sub-prime mess:

"If you don't fully understand an instrument, don't buy it, if you will not buy for yourself a specific product, don't try to sell it. If you don't know very well your customers, don't lend them any money. If you do all these three things, you will be a better banker, my son."

michael e sullivan

You're missing the critical combination of leverage with bankruptcy law and limited liability.

This creates a tragedy of the commons. Every single actor has a financial incentive to take risks that they shouldn't, and the reason is because there is no difference to them between a long run -N result and a -100N result (N being their investment in the enterprise).

So, there is much incentive to play martingale like strategies with speculative markets. In a martingale, you take some bet that is 50-50, run it. If you win, great. If not, you just do it again for double. If you and the house both have an infinite ability to up the bet without bound, you never lose in the long run.

When that is not the case (i.e. always), the strategy can't turn a zero or minus EV bet into a winner, but it can change the payoff structure. Instead of -N, +N at roughly 50-50, an iteration of the whole sequence ends up giving a very high probability of a small win, and a very low probability of enormous loss.

But if you will let me start a martingale corporation where I put up a few thousand dollars and then leverage it 10-100 times with other people's money, I can do really well for a long time, until my day of reckoning comes when my corporation simply declares bankruptcy "oops, black swan.... my bad."

All those people getting their debts cancelled basically just paid for my downside risk. Over time (divedends, paychecks, etc.) I got my share of the win, but did not have to pay my share of the loss.

This is exactly what happened in the financial markets.

And it is exactly why those risk managers were, in fact, perfectly rational to ignore these extreme tail risks. At least when it comes to dollar maximization -- how they could sleep at night is another question.

Gavin Hinks

Have a read of what UBS said about its own risk controls after writing down $18bn. It's weirdly confessional.
http://www.ubs.com/1/e/media_overview/media_global/search1/search10?newsId=140329

Jay

It's not just financial risk that gets treated this way.

I'm a chemist. At one lab I worked for, one of the safety guys retired. He was a nice guy, got a few thousand for minor projects, smiled and signed the papers. The new girl took her job much more seriously, citing labs for violations and enforcing rules that had been overlooked for years. Eventually management reassigned her and got the old guy to come back as a contractor (for more money).

nate

Sorry don't buy the people are rational, it's all about the incentives argument. Don't buy principal/agent theory either, too simplistic and explanation. The way the principal wins is to force the agents to compete with each other rather than gaming the principal, and Wall Street is one of the most competitive environments on the planet.

Why do I think so? Simple, most of the people involved, especially those involved in decision-making, lost a massive amount of their net-worth. Head of Lehman, billions down the drain. Goldman -- most of the employees had their portfolio tied in with company stock.

Instead, I think really what we are seeing is the undermining of the people are always rational dogma that is epidemic in economic circles.

Check out schemas. Check out fallacies. Look up the things that the Greeks knew back from historical times -- that certain arguments, whether from a speaker or in our modern age from incomplete data, lead us astray.

So my explanation for why Wall Street is stupid, simple. They choose youth over wisdom. Short term, this works out pretty well. Less paid out for healthcare, younger folks haven't been on the hedonistic treadmill long enough to demand more, they work longer hours, etc. Long term, it causes the below problem:

1) Young guy gets hired, swings for the fences (over-leveraging) because he can always find another job (he's young) but may have only one shot at getting rich. Convinces everyone that the theories he learned in MBA program (Sharpe, modern portfolio theory, derivatives-pricing, etc.) will make the company a ton of money. Bosses, not wanted to appear stupid or below the 8 ball in a youth driven enterprise give young guy the green light.

2) During positive business cycles, young guy gets a few years under his belt and tons of money. Arrogantly, young guy based on limited experience assumes that he's figured the game and doubles down. Cautious players get shown the door or are effectively neutered by management.

3) Multiply over time.

4) Crash

Or, in other words to steal from Taleb, they were fooled by randomness. Is it any surprise that booms and busts used to happen every 20-30 years? (around a time a generation cycles out of the workforce) Is it any surprise that as old folks are more and more knocked out of the game, the boom-bust cycle is becoming compressed?

Maybe the most "rational" thing the bankers could do is put any trader that survived Wall Street past 50 into a risk management position (and limit exposure to flawed risk management models churned out by academics). At least the 50+ trader will have a decent idea what a bubble looks like.

John Roth

William's comment (the first post) is only half the answer. The other half is that people have natural biases that affect their decision making. The upshot is that --any-- form of incentive is going to produce behavior that tends to maximize the likelihood of getting the reward and minimize the recognition of the risks involved in doing so. It's also not all that likely to maximize the results that the incentive is supposed to produce.

John Roth

Maxine Udall

It doesn't just happen in financial marekts: http://history.nasa.gov/rogersrep/v2appf.htm

Hugh

Stupid as in too confident of their own knowledge. NNT says in the 'Black Swan' that it takes far less effort and time to assign a cause and effect to explain events rather than to accept that your assumptions are wrong when information refutes it. What bankers and economists have done is take their knowledge too seriously, lacking the humility to be proven wrong by random events. Remember LTCM

John Cowan

It's the same logic that leads people to build on flood plains (sometimes over and over) and on the fertile slopes of active volcanoes, or for that matter to set alarm clocks and then hit Snooze when the alarm goes off: hyperbolic discounting.

Sometimes I think we ought to adopt the economy of the ancient Gauls, in which the buyer had the right to choose between paying the seller's price now, or paying ten times the seller's price in the afterlife. It could hardly be more irrational.

FX

Why be safe and prudent when there is money to be made. Everybody else was doing it, why shouldn't we? After all, we have to get our bonuses too.

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