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The Formula That Killed Wall Street
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."
G+R+E+E+D
I want peace on earth and goodwill toward man.
We are the United States Government! We don't do that sort of thing.
There is nothing wrong with using a model. Models are good. They help us simplify the world so that we can understand it. For example, we have hundreds of competing climate change models that explain what is going on and predict what we should expect. We model the weather for forecasts. And so on.
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.
This game will waste your life. Don't clicky!
Diversity.
Life is not for the lazy.
- 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...
"A door is what a dog is perpetually on the wrong side of" - Ogden Nash
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.
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.
In a way ironic that a guy from rural china comes to play, lives the american dream of wealth and glory, and (partly) causes the most massive failure of free market economics in the history.
A BIG part of the problem is Washington's tendency to reward economic losers at the expense of the people who know what they're doing, and I'm NOT just talking about the poor. There are plenty of the high-salary types who have some sort of governmental loophole or backing that saves them when they screw a big company up.
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.
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.
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".
In the land of the blind, the one-eyed man is usually crucified.
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?
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.
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.
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.
Free Martian Whores!
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?
Seven puppies were harmed during the making of this post.
"produced a single number to characterize risk" isn't this what Equifax, TransUnion, Experian and others have been doing for decades?
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'.
Well, maybe. If we use the Dow Jones Industrial Average (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.
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When I think of Wall Street, one of the first things that springs to mind is a photo I saw sometime late last year. In it, a protester is holding a home-made sign with the text, "Jump you bastards".
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.
Where's the Kaboom?
There's supposed to be an Earth-shattering Kaboom.
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.
Seven puppies were harmed during the making of this post.
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.
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make install -not war
Blaming greed for a financial crisis is like blaming gravity in a plane crash.
\u262D = \u5350
Preposterous! Human gullibility is one of the few things that has no limits.
Support Right To Repair Legislation.
I think you may have misrepresented his views or oversimplified them. Part of Taleb's claim is that these models are based on historical data which doesn't account for future disastrous events. He gives the example of a turkey, who having been fed for many days, would conclude that the humans is his friends based on its historical data. He's right up until the day before Thanksgiving. Worse yet, these models give traders a misguided sense of security so they make huge bets that would give them pennies for days and take away millions or billions of dollars when that one in 1,000,000,000 event happens. The problem is that the probability for the disaster was based on historical data, which haven't even recorded such a disaster. Worse yet, he states that the thing these data and model are suppose to represent is constantly being change and manipulated, ie. people make investment decisions based on the models, which then affects the model itself. His essential thesis is that people don't account for Black Swans. People see a bunch of white swans but have never seen a black one so they conclude that all swans must be white. In short, most of the traders on Wall Street are not familiar with Popper's philosophy of science. They think they're doing science and "finacial engineering" when all they're doing are making bad bets.
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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.
Deleted
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.
\u262D = \u5350
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.
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 and Black-Scholes 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 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.
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!
The enemies of Democracy are
So what? Most money in the world today is fiat currency. It's just a number. It doesn't mean anything intrinsic in itself; it's only value is what people are willing to do or exchange in return for that number. It can exponentialise itself all it likes. As long as I get paid a billion dollars, and my rent, food, utilities and entertainment cost $999m, we're set. Our current problems are down to governments forgetting every lesson they've learnt on macro-economic management since the fall of the gold standard and refusing to slash and burn until capacity is cheap enough to invest in.
[FUCK BETA]
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.