The Formula That Killed Wall Street 561
We recently discussed the perspective that the harrowing of Wall Street was caused by over-reliance on computer models that produced a single number to characterize risk. Wired has a piece profiling David X. Li, the quant behind the formula that enabled the creation of such simple risk models. "For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. ... [T]he real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust."
the formula that killed wall street: (Score:5, Insightful)
G+R+E+E+D
Nothing wrong with models. (Score:5, Insightful)
But. And it is a big but. You must know the limitations of your model. By definition, a model is a simplification of a complex phenomenon. That does not make it flawed: that makes it a model. Overreliance on the model is your fault, not the fault of the model.
Comment removed (Score:5, Insightful)
Re:Nothing wrong with models. (Score:5, Insightful)
However, there are some models that are just bad. If we take your climate change model example, simply going outside and measuring the temperature, and then comparing it to a temperature you took one the same day three years in a row and then plotting the statistical trend is a very poor model. Using that model, one might assume that we have drastic global cooling going on. It doesn't matter how much you rely on that model, if you rely on it all, you're going to be dead flat wrong.
Or there's my financial formulae (Score:5, Insightful)
- Don't spend the money you don't have
- Don't do credit unless you absolutely have to
I know I know, Wall Street are these big finance hotshots who do complicated things that have nothing to do with personal finances, but what is it they do apart from speculating and playing with money they don't have, or other people's money? They just hide that simple fact under abconce financial constructs, but that's all they do in the end.
Bring back some morals sanity in the credit business and there won't be anymore crisis of this magnitude. No need for math here...
Not Wall Street. Us. (Score:5, Insightful)
It isn't killing Wall Street. Those jokers are getting $billions$ in free money.
It's killing us, the people who work for a living and have to provide all those $billions$ or suffer the inflationary consequences when the Feds just print it.
Re:Nothing wrong with models. (Score:5, Insightful)
It wasn't Li's fault. (Score:3, Insightful)
One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.
There you have it. The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.
Re:the formula that killed wall street: (Score:2, Insightful)
Then we have the same problem in the real world -- everyone is using the same formula. For example, the formula you cite is also:
But since you've gotten the ball rolling on the subject of spitting meaningless venom onto the audience, let me join in with one of my own:
the formula that killed wall street: O+U+T+S+O+U+R+C+I+N+G
Ironic (Score:2, Insightful)
Re:Not Wall Street. Us. (Score:5, Insightful)
It's one reason we don't need to be bailing out bad companies, and instead rewarding or backing up the good ones with incentives and tax cuts so that they can really succeed and push forward.
Re:the formula that killed wall street: (Score:5, Insightful)
actually, greed is good. it's the great motivator. really, it's the only motivator.
It's a good motivator when it's tempered with wisdom. It's a bad motivator when you blinds you to the long term consequences of your actions. I've been saying for years that it seems like our entire economic system has been tailored to next quarters results at the expense of building/investing for the long term. Who cares if this quarter has record profits if you paid for those record profits with the future viability of your enterprise?
Thou shall not calculate behaviour (Score:5, Insightful)
This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.
It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.
Hayek. Nobel Prize Lecture, 1974.
Re:Citation, please (Score:3, Insightful)
Will there be a reprise of the Glass Steagall Act? It was initially passed for very good reasons, which apparently are still valid.
As for the TARP, the biggest reason the banks aren't lending is that they simply don't trust anyone. They know that they inflated the value of their assets, so they (correctly) assume that everyone else has too. Of course, putting the TARP money on the balance sheet is useful "window dressing".
Don't Blame the Equation (Score:5, Insightful)
This seems to be a popular story for the past few weeks, but it is a mistake to blame the statistical method used. The problem wasn't that they were all using the equaton, it is that they were all mis-using the equation. All statistical tools can fail to be sensitive to certain aspects which may be critical to an application.
People in finance applied these statistical tools believing that they would be able to master risk with them. Unfortunately, they made assumptions that certain things would continue to be the same in the future, plugged the information into the equation, and now science was telling them that everything would be alright. If everybody on Wall Street was making decisions based on the Magic 8 Ball would we blame the ball or the foolishness of those misapplying it?
Re:Nothing wrong with models. (Score:5, Insightful)
You also don't need an MBA to know that there is a limit to the number of balls a juggler can keep in the air at any time before he drops one. And when one ball drops, the whole thing falls apart. As the truism goes, those who don't learn from history are doomed to repeat it...
Yeah right. (Score:4, Insightful)
Complete BS. The Wall Street knew all along the bubble would burst, and cashed in all the time while knowing it. In essence, they kept milking while perfectly well knowing it would come to a disaster.
There's a crisis every 10-15 years. Huge crisis in every 30 years. How can some one be that gullible as to believe the economics would NOT see this coming? Of course they did, but saying and doing something about it would be bad business. It would scare off the suckers... who end up paying the bill.
Re:Or there's my financial formulae (Score:3, Insightful)
Re:Picking up pennies in front of bulldozers (Score:4, Insightful)
Except that the current economic woes don't fit into Taleb's "Black Swan" category. It was obvious that his was going to happen to anyone with one brain cell 5 years ago, and to anyone with two brain cells a decade ago.
I'm pretty sure I heard an interview with Taleb in which he mentioned this. Of course his strategy of investing to break even in the expected conditions and make out like a bandit when a black swan appears would have done very well as risk was repriced.
Re:the formula that killed wall street: (Score:3, Insightful)
i guess what i should have said is that greed is not going anywhere
That's the truth. I would just hope that we can temper our greed with a little bit of wisdom and an outlook on the future. I like your phrase, btw, "short-termism". Seems like short-termism has infected our soceity from the citizen buying a big screen TV they can't afford, all the way up to the Federal Government that tried to wage two wars and expand the social safety net on credit.....
Americans like to have our cake and eat it too apparently.
Happy square root day! (Score:5, Insightful)
The love of money is the square root of all evil.
This formula may have and probably did help crash the world's stock markets (yesterday's Dow Jones was HALF of its worth at its high last June), but the reality is that high energy prices drained everyone's wallets.
When Bush took office, gasoiline here in Springfield was $1 per gallon. At Wall Street's high last summer it was nearly $4.50, over four times as high. We talk about elders living on a "fixed income" but the fact is almost all wage earners' incomes are fixed. We can't demand raises or overtime and have to live within our means. But when that $20 per week gasoline budget quadruples to $80 per week, with heating and electric costs going up as well, that takes money out of other aspects of the economy. Sooner or later people are over their heads and behind on bills, and things spiral out of control.
The result of that and other factors is what you see now.
Happy square root day, everyone.
Re:Picking up pennies in front of bulldozers (Score:2, Insightful)
His main thesis is that the markets are essentially random and are basically impossible to predict in any meaningful way.
If they are random then why do they predict economic change with 100% accuracy? Or do you imply that major economic changes are CAUSED by the markets, and thus our entire economies move completely randomly? Should we do away with markets, then, and solve all our economic woes?
One can argue that the Brownian motion of water molecules is almost completely random, however that doesn't stop them from flowing downstream in the river. Speaking as someone who makes his living on the stock market, if you look at individual price movements over a short period of time then it does seem as if there's absolutely no sense to them. That's why most people lose money - prices don't move the way you expect them to. However if you're able to get a "feel" for the general flow of prices across a sector of the market - not any individual price - then you can be right more often than you are wrong. This must exclude randomness, especially when it remains true over the long term.
If the markets move randomly, then today (or any day) the markets can start heading up again towards the sky. And although I am willing to bet money that today and tomorrow we will probably go up (because we fell so much yesterday - 4%), over the medium term we are more likely to continue to head down. Because it's NOT random - there is no longer a demand for stock. In fact, there are a great deal of people who still want to get RID of their stock. Now if I can predict the general direction of the market through the next weeks (the same or lower than today) - how can you say it's random?
Consumer Credit Report (Score:3, Insightful)
Re:Picking up pennies in front of bulldozers (Score:1, Insightful)
Saw a show on this back in 97-98 (after that bust followed by the 2001 version). They showed traders on the floor using handhelds that did this for them on the floor.
It was like a magic money machine. Put numbers in buy here sell here, or sell here buy here. It works 'decently'. So long as the market is on a 'trend'. Get something out of 'trend' though and the models are useless. These dudes have NO clue what the model does or WHY. The guy they were following around did not know why he was not making tons of money. He did not understand what he was doing. He did not actually understand the models he was playing with. He just knew on average he was doing 'ok'. He is common.
The only indicator that I have found for an ending trend is when EVERY talking head on TV starts talking about the 'new economy' and 'how all the rules have changed since time X'. The last few I have told people 'sell'. This time it will be 'buy'.
Re:tinfoil (Score:3, Insightful)
Well, maybe. If we use the Dow Jones Industrial Average [google.com] (zoom out to Max for this discussion) as a measure of the economy (you could definitely do worse), the interesting thing is if we draw the trendline "flat" from about 1995 to today, and base that on the more or less steady trendline from 1985 to 1995, you'll notice that we're actually right where we should be right about now. The DJIA grew wayyyy too fast from about 1996 to 2007 (where the real peak is).
I attribute this skyrocketing economy to a couple of different phenomena: a) The dotcom boom and b) some external factors that I'm uncertain of, but I'm guessing there is some manipulation somewhere. You could be right. I also think it is interesting that current busted economy occurred shortly after the retiring of Alan Greenspan in 2006, who was Fed chairman from 1987 on.
Look at the violent and volatile growth between 1995 and 2000, and again from 2005 to 2007. We were due for crash, for sure.
It's very interesting, because from the 1970s to about 1995, the DJIA grew very steadily. After 1995, it was wild ride.
When I think of Wall Street... (Score:3, Insightful)
They didn't jump, and I have only seen one or two articles mentioning trader or banker suicides.
I can only conclude that those working on Wall Street are so utterly detached from the riskier-than-roulette gambling they were engaged in, that the losses are meaningless to them. It wasn't their money, they had no real stake in any investment being viable in the long-term, and - what's worse - is I see zero effort to move away from the "must profit in the next quarter" philosophy.
I really don't care about any 'magic formula', and I doubt you can squarely lay the blame for the current problems at the foot of any. The issue is the drive to profit right now.
What is perhaps more worrying for the average person is that governments have been sucked into this mindset too - but perhaps not surprising when the only people who can get elected are those who have made the money to campaign from their own short-term investments, or by accepting backing from others who did so in exchange for perpetuating the system.
Re:Citation, please (Score:5, Insightful)
With respect, classical economics and Austrian economics are not quite the same thing
Sorry, I'm not an economist. Therefore if I said something incorrect through ignorance I apologize. I merely wished to emphasize that truly we live in interesting times. I think it's when the world (and especially the consumer intensive US) finds out we've bumped into the limits of our resources on this planet. We can't all have an SUV. We can't all waste electricity. We can't all have a worry free life, and independence, and a nice house, and a big screen tv, and eat in good restaurants, etc. The boom in commodity prices - in part fueled by massive demand from the BRICIT countries that are also expanding their middle classes and trying to adopt an "American" standard of living - has another side to it. Not only was demand increased - but supply is at or near maximum. There IS no more copper, there IS no more gold, platinum WILL run out in 20 years or so, etc.
Therefore commodities (including petroleum) priced themselves right out of the market. This triggered, and is triggering, financial default from everyone who was living "the dream" on credit. And now the cards keep tumbling. Oh, we will reach a new equilibrium some day - but our population keeps expanding, and those resources keep getting more scarce.
Re:Nothing wrong with models. (Score:3, Insightful)
Re:the formula that killed wall street: (Score:2, Insightful)
Totally. This is reason we need sensible regulations. History shows us that when humans are left to their own devices and money is involved, we cannot be trusted. Greed must recognized and factored into our systems of checks and balances, and not just in the finacial industry, but any place money and power are involved.
Re:Nothing wrong with models. (Score:3, Insightful)
The things is are the exception of a model 'normal' vs 'abnormal'?
Benoit Mandelbrot and other think that the economy is 'wildly random', see this 2006 paper:
http://www.ft.com/cms/s/2/5372968a-ba82-11da-980d-0000779e2340,dwp_uuid=77a9a0e8-b442-11da-bd61-0000779e2340.html [ft.com]
Current crisis is one more proof that economy is 'wildly random' and that a stock market is even less reliable than a casino (where the randomness here is just 'normal'), so stock markets are like adding oil in a fire, they make crisis worse..
So the question is: is-it possible to have capitalism without a stock market or with a very regulated one?
I think that this is possible, but that it will take many crisis as the current one before the strict regulations start to kick in..
This Is Their Bullshit Cover Story (Score:5, Insightful)
Yeah, "complex mathematical model". Tell it to the judge.
They did indeed use this model, and the work of many other PhD mathematicians, physicists, and other geniuses. But any of the bankers could have looked at this whole class of derivatives from mortgages and seen the basics that make the model a joke. They sold millions of mortgages and other loans to people using artificially low initial interest, to get people to take the loans, but which ballooned to rates they couldn't afford, so they'd have to default. Inevitably, a large percentage would certainly default. A losing bet overall for banks holding those loans. Meanwhile, each bad loan was "good" because the banks could sell many times the number of derivatives on it. Which was "good" because they got paid for the derivatives they sold, but was much more "bad" because the derivatives would cost the issuing bank many times more when it came due. The derivatives came due when the mortgages defaulted. Which was inevitable.
So whatever "gaussian copula" model they use to convince each other it was good, basic business sense would have insisted that the business was bad, horribly bad. These bankers don't get paid for discovering new math, they get paid for their years of experience and business sense. So they should have laughed this model out of the boardroom, even if they didn't understand why it was wrong. They should have known it was wrong, as the past few years proved beyond any doubt. But they embraced it instead, and centuries old banks like Lehman Brothers have gone down, taking us with them (and no end in sight).
Because ultimately, the model was a way to delay the costs of a business that paid some fat revenue up front. Since bankers are paid in huge bonuses for the initial year of revenue, and then leave before the bills come due , they got paid to make those bad deals, because they paid off up front, before costing many times more their benefit a few years later. By which time the bankers are gone with their early bonuses. Which have a lot more buying power when the economy collapses, and everyone else is holding merely the debt they created.
Nice work, if you can get it. Since they ruined the banking system and everything else, no one can get any work at all.
These people are holding the money. Their bonuses often equal the losses that destroy their bank. The government should take back that money to pay for fixing and repairing some of the mess they made. "Fiduciary responsibility" is a requirement of bank execs, and these violated that by the $TRILLIONS. Make them pay for what they did. That's a simple model anyone can understand. Not just a complex conjob to hide behind.
Greed (Score:5, Insightful)
Blaming greed for a financial crisis is like blaming gravity in a plane crash.
Re:Nothing wrong with models. (Score:4, Insightful)
Considering how much impact human emotion and irrationality has on the markets I would tend to agree. Is today's bubble burst any more significant because of their use of models? Not really. The simple fact is they used a tool incorrectly and in their job, instead of sawing a finger off, they lose billions. But what drove this? Human emotions. Perhaps one day we can accurately model this, but I'm not so sure.
Re:the formula that killed wall street: (Score:3, Insightful)
yes, i completely agree with you. the focus on quarterly earnings is representative of "short-termism" everywhere, which is usually detrimental to long term value preservation.
i guess what i should have said is that greed is not going anywhere. harness it when you can and don't be surprised when it causes people to do things that harm others.
If you want your company to focus on long term profits, then you'll likely find that it is a family or employ owned business that doesn't offer any public stock. They don't want you telling them in any form or fashion how to run their business. Here is a question for slashdot. Those that work at companies that are entirely family or employ owned, do you feel that your company is in better shape than those public stock corporations?
Re:Nothing wrong with models. (Score:5, Insightful)
I disagree. A model defines a static or pseduo-static system. It takes the non-linearities out of a system to make them as close to a linear, 1st order or 2nd order system as much as possible, such that you can produce matrices of inputs to outputs. All models also are accompanied by regions of legitimacy.. Namely the non-linear (or super non-linear) components press close to zero in these regions. Outside the regions, those non-linearities become too much 'error' for the model to be valid. Ideally, you can use separate models for different regions, and you have a nice continuum. But for that, you need to be able to first measure a region parameter.
The problem here is that you're talking about a model for an investment strategy that is inherently non-deterministic, non-linear and more importantly recursively adaptive. The region you're operating in, is part of the outcome variables.
Consider 3 investors each with equivalent information systems (including risk modeling, present-valuation, and product-viability forecast, whatever).
In a vaccum, a model, assuming a static system might be appropriate. Balance-sheets, due-dilligence, market trends, geo-politics, etc. are all valid. But consider that the other two investors have the power to effect the system. Consider that they can manipulate, propping up an industry, or willfully collapsing it (over-buying, or short-selling). By acting irrationally in the short term, they can sufficiently distort all the measureable parameters to your equation to force you to act inappropriately.
Thus by taking a short-term hit, one of your competitors can gain a much greater long term advantage.
Thus, KNOWING that you use certain models, allows your competitors to game the system.. Note they need to have significant resources in which to do this.. But the old addage that you need money to make money exactly applies here. Why would a wealthy person only accept 3% to 15% ROI when they can control certain markets and earn 500%.
Now explicit market manipulation is illegal. But there is nothing illegal about gambling (sadly). Thus betting against the 'known wisdom' is perfectly legal.
So now you have two camps.. Conservatives that trust their models (blind to the fact that people can manipulate them in the long-run). And advanced speculators who bet against the market. Over time, if one is considered unbalanced, then more and more itchy investors will switch from one side to another.. Until an equilibrium is reached where any and all metrics become meaningless - An equal proportion of investors will honor measureable data as there are people betting against the data. The raw data therefore has no material impact as to the future valuation of an asset. Note, as such a system evolves, the 'measureable' data will change over time. Namely instead of measuring the viability of a company, you measure the prospects for news and bet based on historical trends of the news outlets, not whether the news is good or not.
This can only happen if you have a gaussian distribution of strategies. Namely a massive pool of investors operating independently with an equal liklihood of choosing one of an infinite number of strategies, such that an equal ration of buy/sell decisions could be produced.
You can think of it as the classic "Is the poison in your drink or mine" attempt at gaming the system. Any number of strategies can be employed to decide which action is best, but the more you employ, the greater resemblance to random-decisions is created.
The short is, no formula can adequately valuate a market that is based on such a recursively adaptive system. Determining the risk of a car accident, a plane accident, a flood, etc. These are deterministic to a large degree (short of global warming and legalizing pot). But the college that first advocated investment strategies based on such finite metrics should be unaccredited in my view. A car owner isn't trying to game the insurance market, but a stock holder or company seeking stock value is.
Re:Or there's my financial formulae (Score:3, Insightful)
- Don't spend the money you don't have
So... no mortgages for anyone, then? Or small business loans? Or raising funds for large capital expenditures (say, building a new chip fab)?
- Don't do credit unless you absolutely have to
Wait... doesn't that fly in the face of your first "rule"?
Here's an interesting rule about absolutisms: they're rarely all that absolute.
As an aside, leveraged investment, which includes all the things I listed above, among many other things, is a very good thing. The problem is, your average bank in the US was leveraged 30:1, which is absolutely frickin' insane. Fortunately, this crisis will force businesses and people back down to more healthy leverage ratios.
Preposterous! (Score:5, Insightful)
Preposterous! Human gullibility is one of the few things that has no limits.
Re:the formula that killed wall street: (Score:2, Insightful)
Huh? In other words, if I have the intellect and the good fortune to make an extra dollar, I shouldn't?
Nice way to selectively quote me. The rest of the quote was "with a little bit of wisdom and an outlook on the future". The rest of the post was lamenting the attitude in our society of only caring about the short term at the expense of the long term. Do you disagree that this is a regrettable trend?
If you have the intellect and good fortune to make an extra dollar then go for it. But if you are making that extra dollar at the expense of two dollars tomorrow then would it not be better not to make that extra dollar? Our entire corporate culture the last few years has tended to place a premium on next quarter instead of next year or the next five years and many of us think that is to our long term detriment.
Make retirement funds for the middle class purely interest bearing again. I'm not even being sarcastic - all my retirement is in inflation based securities
Good for you. All of my retirement is in securities. I've taken a beating the last few months but I've got >35 years before I retire so I'm fairly confident that I'll come out ahead in the end. Let's come back here in 30 years and see which did better -- my securities investments or your cash investments.
I'm in disbelief of the 401k mania over the past 15 years - and scold republicans for wanting to replace S.S. with 401ks.
I'd love to replace my SS with a 401(k). As it stands now I'm going to pay into this system for my whole life only to see the benefits slashed before I retire. I could do way better with that money than Uncle Sam will ever do for me. By all means junk SS and replace it with self-directed investments. People who do their homework will make out just fine -- those that don't, well, that's not my problem.
Re:Nothing wrong with models. (Score:5, Insightful)
As most of the people responsible walked away with a fat profit, one could posit that they did learn from history. Why should they care that they screwed over the rest of us? Our economic system ignores externalities on that scale. Burn down a house, go to jail. Burn down the economy, get a fat bonus.
Re:Picking up pennies in front of bulldozers (Score:3, Insightful)
It wasn't li's fault because money is broken. (Score:4, Insightful)
It has been broken since 1694.
Credit is an exponential function. Go check the national debt (in any country) for the last couple of centuries. It's an exponential growth curve. Credit has an exponential function built in to to it. When credit is created, it is created with an equivalent amount of debt attached, which pays interest.
So you have : credit on one side | debt + interest on the other.
So in order to work AT ALL, the supply of credit must grow exponentially every year to pay the interest on the previous year's debt. If it doesn't, there is a monetary collapse as the debt consumes the credit.
Li's function simply allowed the process to continue until they ran out of people to lend money to. The problem has been there as long as money lenders.
Re:Nothing wrong with models. (Score:4, Insightful)
Actually the assumption is this. "Lousy" mortgages are mortgages with 12% chance of default (and this was extremely high, most were something like 2% or so).
So let's calculate what happens :
1000 "lousy" mortgages, $200000/house, profit if fully paid back = $20000, over 20 years, profit in case of default = value of house (which rose about 1% per year on average). Default occurs "on average" after 1 year.
So let's see :
Initial investment : 1000 * -$200000 = -200000000
Income from defaults : 120 * ( $200000 + 1% * $200000) = $24240000
Income from success : 880 * ( $200000 + $20000 ) = $24240000
Total profit : $24240000
I dare you to find the flaw in these numbers. Yet there was a flaw. Without an education in statistics you will not see this coming, and even if you do, it's not trivial at all :
That 12% failure rate was non-uniformly distributed. So what happened ? First 10 to 15 years nobody defaulted, resulting in a house price hike that was a lot higher than anticipated (and therefore further increasing the profits and decreasing the risk to the banks), and then, after 16 years of tiny amounts of failure, huge amounts of people started defaulting all at once, causing a massive decrease in house prices.
This is where the theory of "let's just support the banks for one year and they'll pull through" theory comes from. IF default rates drop massively it will work.
So why did this break the banks ? Well due to hedge funds. Hedge funds are the equivalent of using borrowed money in a casino. If you win, it multiplies your winnings. If you lose, it multiplies your losses. When a small loss accumulated, it was massively multiplied (as in a factor of 1000 was not rare) by hedge fund managers. Whether the "smaller" original loss would have been enough to topple banks, we'll never know. One thing is for certain, all these "oh I predicted it" hedge fund managers are like the devil laughing at his victims burning ... they're not innocent of the crash, at all. They're the maffia bosses who massively profit by making loans they KNEW the debtors wouldn't be able to repay.
And now they act all "I told you so".
They saw a disaster coming, and by worsening the disaster, they made their fortune. These people should be hanged from the highest available flagpole, not celebrated.
Fantastic flash explanation [crisisofcredit.com]
Re:It wasn't Li's fault. (Score:5, Insightful)
>The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.
Or the managers didn't understand their explanations -- or more likely yet, didn't *want* to understand their explanations.
This doesn't look fundamentally different than the Challenger explosion: the technical staff knows there's a problem, keeps saying that there's a problem, but their upper management is invested in there not being a problem. It's really difficult to explain something to someone whose job depends on ideas that conflict with what you're explaining.
Re:Or there's my financial formulae (Score:3, Insightful)
While I agree with you on a personal finance level and that a lack of moral sanity is a problem on the larger scale, the personal goals at a larger level would constrict the economy.
No. Responsible behavior by our financial institutions would not constrict the economy. It would simply not artificially inflate the growth of the economy. This is a good thing, artificial growth cannot continue forever, and we all suffer when the market corrects. Slow and steady wins the race.
Re:Nothing wrong with models. (Score:5, Insightful)
Burn down the economy get a big fat check is about right.
The problem with slow justice, is that it gives the appearance of no justice. Bernie Madoff will, in all likelyhood, die without spending a day in PMITA Prison.
And his family will keep the benefit of all the Billions that disappeared, because all the assets in trusts and such are untouchable by the law, even if they are ill gained. That is what a trust was created exactly to protect. Trusts are nothing more than legal money laundering.
And there is nothing wrong with making a profit. The problem isn't profit, or even greed. The problem is that people will use the rules in place to screw others and hide the loot. It doesn't matter what the rules are, and the more complex the rules, the easier it is to hide malfeasance. More rules don't stop it. People will do evil regardless of the rules.
Bad people don't follow the rules, and will use the rules as an excuse to do bad. They use the rules to take advantage of others. Once people realize that rules are for the law abiding, not the law breakers, then we can get rid of all the stupid rules which don't prevent anything.
Re:Nothing wrong with models. (Score:4, Insightful)
It's not even just that justice is slow. The rich and powerful let guys like Bernie screw people over so that when shit like this goes down, they have a sacrificial lamb. The plebes get to watch a perp walk, and the real bad guys get off scot-free.
The thing about rules is that if you don't have any at all, the bad guys will simply claim they did nothing wrong. If you have too many, it's also a problem. But fixing the problem requires agreement on how many is too many, and which ones are stupid.
The bad guys know that with too few, or no rules, they can get away with even more. They like people like you, who do their cheer-leading for them. If we did away with all rules, you'd be some fat cat's garden slave.
Re:Oh Please... (Score:3, Insightful)
The case for the free market *is* ethics. Respect for property rights imply an unregulated free market and strongly suggest capitalism.
I took the position that a free market would have produced losses and inefficiencies due to mispricing of correlations, how is that descriving a "magic clockwork" ?
Of course. Especially government.
There's a strong case for this theory though, it's not an ad hoc theory trying to fit the facts, it's a been here for more than 70 years and fully fits the facts. I suggest you open Hayek or Mises.
Very simply put, when the short term interest rate is artificially prevented from rising, carry trades will take enormous proportions, something they wouldn't be able to do if they had to raise short term capital from a free market in lending.
Yeah yeah. You just said human are always greedy, so greed's explaining power is 0.
Re:Nothing wrong with models. (Score:3, Insightful)
Trying to blame this economic/financial meltdown on the housing market is like trying to blame the cards when you lose at 3-card monte. Sure, they're involved in the problem, but the root of the problem is the game itself, and the guy behind the game.
If it weren't housing, there would have been some other bull crap that everyone poured their money into because some financial model said it couldn't fail. There still would have been a bubble, and worse yet people would have still been involved in back room deals that amount to high-stakes gambling involving more money than anyone in the world actually has.
Re:Citation, please (Score:1, Insightful)
but our population keeps expanding, and those resources keep getting more scarce.
But technology is advancing at the same time too. We're currently using a minuscule fraction of the resources available to us. Consider the amount of energy available at the atomic level, it's massive. Not to mention the sheer amount of power fed into the Earth from the sun. There is essentially limitless* power available and just sitting out there waiting for us to figure out how to use it.
* "Limitless" from our current point of view. I'm sure once more power is available we'll figure out how to use it all to do even grander things.
Re:It wasn't li's fault because money is broken. (Score:2, Insightful)
Wealth isn't static. If you invest 1kg of gold into my new gold mining business, and in a year, I've mined 2kg of gold, it is easy for me to repay the debt + interest.
The problems occur when someone lends money to someone who can't turn that credit into an "investment" that pays at least principal + interest.
You can print as much money as you want, but if you don't create real wealth with it, you just end up with inflation.
All models have limitations (Score:4, Insightful)
The book Black Swan, which should be read by anyone interested in this topic, says that the hideous lie is that people claim that "they're better than nothing", when, in fact, they're worse than not having any model at all.
Say it with me: "All models are wrong. Some models are useful". A bad model CAN be worse than no model but it doesn't follow that all models are worse than no model. In fact it would be impossible to do anything without creating models of the world around you. You do it all the time without even being conscious of what your are doing. Newtonian physics is technically a less accurate model than Einstein's general relativity but it remains very useful for a wide variety of applications IF you understand its limitations. In the economic realm Modigliani-Miller [wikipedia.org] and Black-Scholes [wikipedia.org] are very useful models so long as you understand their limitations - and they do have limitations like every model.
The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model to quantify risk.
They didn't blow up because they had a model. They blew up because they had an inappropriately applied model. LTCM applied their models which apparently worked well for the narrow field of fixed income arbitrage [wikipedia.org] to other areas like equity and currency arbitrage where the models assumptions combined with their excessive appetite for risk caused a catastrophe.
You correctly note that they failed to account adequately for extremely rare events but had they stayed within their original model parameters (fixed income arbitrage) and more reasonable levels of leverage it likely would not have been a big issue. Instead they applied their models to inappropriate financial instruments and levered up heavily which greatly compounded the problem. Worse, the financial institutions which lent them the cash failed because, like in the current financial crisis, they did not adequately consider the risks they were taking.
Re:Nothing wrong with models. (Score:3, Insightful)
>>>If it weren't housing, there would have been some other bull crap that everyone poured their money into
Right. In 2000 it was internet companies. In 1991 it was savings-and-loans. And today, it's houses. They overvalued at $200,000 average when the true historical value is only $120,000. It was a bubble and it burst. Housing values plummeting (dropping about $40,000) is what caused banking stocks to lose value as investors fled.
Also you can't blame everything on the model. If a banker lies on forms (creating income the buyer does not have), that too is to blame. So too are commissions which create the desire to make a sale and pocket the money, even if the deal is extremely risky.
Re:Picking up pennies in front of bulldozers (Score:5, Insightful)
If they are random then why do they predict economic change with 100% accuracy?
HAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHA!
*gasp gasp*
HAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHAHA!
*pant pant*
HAHHAHAHA, oh God that's rich. Seriously, you meant that? HAHAHAHAHAHAAHAHAHAHAHAHAHA!
*wipes tears from eyes*
No other reaction is possible for such a statement. Is this a delayed posting from 2007? Not that it wouldn't be equally laughable, but at least it was conceivable to maintain the self-delusion that it isn't. Today? You're saying the economy is 100% predictable, and you're saying this today.
HAHAHAHAHAHAHAHAHAHAHAHAHAHAHA!
Re:Yes, it bloody well is. (Score:4, Insightful)
Re:Nothing wrong with models. (Score:3, Insightful)
It's even worse than slow justice, it's NO justice.
If I stole $1000, I would be in jail awaiting trial. He stole billions and he is confined to his mansion, A situation many people dream of, but alas, will never attain.
His family is set for life. At least some of the families of those he swindled are struggling to get by. Retirements that won't happen, college educations that will be put off for years or just won't happen, moving from a nice house to a rathole apartment, etc.
The rules are necessary and make good sense. The problenm is that the rules don't get applied to you if you have enough money, even if you have it because you broke the rules. The key (beyond being a sociopath) is to get away with it long enough to have enough money when you get caught.
Re:Nothing wrong with models. (Score:1, Insightful)
But housing prices went up 200% nationally between 1998 and 2003. Not looking at historical data is a huge mistake. There was a study done by some Yale professor where he compared home prices from 1890 to 2002 or 2003. I remember it was published in the NYTimes. Sorry I don't have the link to it. Probability that housing prices will drop I think is great. I know that banks are already taking 5 - 10% off of an appraised price in some areas already.
Re:Oh Please... (Score:2, Insightful)
The case for the free market *is* ethics. Respect for property rights imply an unregulated free market and strongly suggest capitalism.
You're missing a critically important point here.
There are unregulated markets, and there is the theoretical ideal of a free market. These are not the same thing. Most blatantly, the first can actually exist in reality, the second can't ever possibly exist.
Now, I think that a free market is a good asymptotic goal, but you really need to understand that it is nothing but a theoretical abstraction and can't exist in reality anymore than the frictionless planes of high school physics can.
Now, apart from making that huge but common error, you seem to be saying that even if such a thing as a free market were possible that it would necessarily be the same thing as an unregulated market. This is also completely false.
The inevitable end result of an unregulated market is about as far away from the ideal of a free market as its possible to get. Now, it's important to remember that the same thing is true of over regulated markets, which fact you don't seem to have an issue with. Given that, it's surprising that you have a problem grasping the fact that unregulated markets are necessarily incredibly unfree.
Here's a simple example which should make the problem crystal clear to you.
Assume I'm the CEO of Widgets Inc. We've been in the widget business for a long time and have done well financially, but we're the big dog. Now assume that you start up a company, NewWidgets Inc. with some great new innovations in widget making which allow you to greatly undercut my best price.
Now, in an *unregulated* market, what do you think would happen?
Well, I would take some tiny part of my large amount of funds and hire some goons to go torch your office, rape your family to death in front of you and then burn you alive.
Now without some form of regulation on the market, that would be the end of the story and most likely the end of any attempts by anyone to compete with me.
Now, you might try to claim that laws against murder aren't regulations of the market, but given the example I put forward, you'd quite obviously be incorrect as those regulations had the effect of regulating the market. The original reason for the establishment of anti-murder laws is totally irrelevant to the fact that it is a market regulation.
Now, once you realize that simple fact, it quickly becomes obvious that an unregulated market is inevitably a complete disaster. The only rational debate is one on what sort of regulations do the most to make the markets approach the theoretical ideal of a free market, rather than on whether or not any regulations are necessary. Some regulations are quite obviously necessary, but bad enough regulations could easily approach the disaster guaranteed by no regulations.