Saturday, October 18, 2008
Fools, or Knaves?
"But if regulators were oblivious to the danger, the question is why. In the case of Fannie Mae and Freddie Mac, the answer seems easy: Their massive lobbying machines thwarted every legislative attempt at reform. But what about the Fed, the Treasury and the [SEC], agencies that are not above politics but are known for their professionalism and expertise? Surely they had the capability and motivation to avoid a calamity of the type that is occurring. Why did they fail? The problem is that Wall Street and regulators relied on complex mathematical models that told financial institutions how much risk they were taking at any given time. The model predicts with 99 percent probability that institutions cannot lose more than a certain amount of money. ... As long as capital was greater than the value at risk, institutions were considered sound--and there was no need for hands-on regulation. Lurking behind the models, however, was a colossal conceptual error, the belief that risk is randomly distributed and that each event has no bearing on the next event in a sequence. ... What if risk is not shaped like a bell curve? What if new events are profoundly affected by what went before? The value-at-risk crowd focuses on each snowflake and resulting cause and effect. The complexity theorist studies the mountain. The arrangement of snow flakes is a good example of a highly complex set of interdependent relationships, so complex it is impossible to model. ... But compex systems are not confined to historical experience. Events of any size are possible, and limited only by the scale of the system itself. ... Financial systems overall have emergent properties that are not conspicuous in their individual components and that traditionall risk mangement does not account for", my emphasis, James Rickards (JR) at the Houston Chronicle, 3 October 2008.
It should be a felony for any financial institution holding federally insured deposits to lobby. Punishment: five years in the federal pen for the executives responsible and the lobbyist. Not up to five years, five years. The institution pays a fine of 1% of its last reported stockholders' equity as reported in Form 10-K, or if not publicly held, whatever it files with the OCC, for a first offense, 2% for a second offense, 4% for a third offense, etc., etc.. The SEC is known for "professionalism and expertise", by whom? The agencies JR mentions are hopelessly compromised. What makes JR think they believed VAR models were anything more than after the fact rationalizations for decreasing the amount of capital the institutions needed to operate?
JR confuses risk with uncertainty. I'll explain. A fair coin comes up heads about 50% of the time, actually say 49.99%, because at times, it stands on end, the coin having three dimensions. The coin is not a Flatland, 1884, Edwin Abbott character. There is no risk here, but the result of each coin toss in uncertain. Where a hurricane lands, a Houstonian matter of interest, is risky as you can't model everything with respect to hurricane paths.
We should not get carried away with the normal distribution. Even things we think are normally distributed may not be. Leta Hollingsworth (LH) wrote Children Above 180 IQ, 1942. Working with New York City (NYC) school children, this is from my memory, I read the book about 40 years ago, she identified 24 NYC school children who qualified. LH believed she found 80% of the children who would have qualified. Her result suprised her. Why? With a SD of 16.4 and mean of 100, 180 IQ is +4.88 SD. Such an observation should be seen in about one in a million cases. With 900,000 NYC school children assuming LH was correct, 180 IQ was at the 1/30,000 level, or 33X as frequent as a normal distribution would indicate. Fat tails are real.
Now for an IA war story. One of my last Chicago classes was business policy. The professor had been a large and prestigious consulting firm's senior vice-president before joining Chicago's faculty. He had two engineering degrees from a prestigious engineering school. The day's topic was oil industry rates of return (ROR). Many of his oil company clients as a consultant had complained about oil drilling's poor ROR, for a very "risky" activity. I thought for a minute and said, "the market doesn't reward risk you can diversify out of. Therefore your oil company clients didn't know what they were talking about". "Why is that IA?" "Because of a 'fallacy of composition', what is true for one thing may not be true for all things of its class". "Go on". "Suppose Big Oil drills 10,000 holes a year. While it is true any individual hole may be dry and 90% are, that means nothing for oil industry rates of return". "Why is that"? "Because oil holes are like coin flips. If Big Oil drills 10,000 holes, it knows beforehand that 900-1,100 will be productive. Since it drills lots of holes, where's the risk"? Then I went up to the blackboard and drew some diagrams of ROR for one well, two wells, and say 10,000 wells. The professor became livid and got red in the face. My whole class looked at me, horrified. The discussion ended. Why was this a hot topic? It was late 1973 and we had just seen the "oil shock".