Wednesday, December 10, 2008

Why so serious?

From the Epicurean Dealmaker blog:

Felix Salmon is getting "bailout fatigue." I am sure he is not alone.

He is tired and frustrated with the Fed's and the Treasury's ad hoc approach to the financial crisis, and the appearance that they are pissing away the $350 billion Congress advanced to them with no rhyme, reason, or accountability. He wants a plan, and he wants one now. Give us a strategic plan for the next installment of the TARP, he urges: give us a roadmap.

But we already have a map, Felix. Unfortunately, we sailed right off the edge of it some time ago, into uncharted waters.

Here be monsters.

* * *

Many commentators, myself included, have pontificated ad nauseam on the social, political, economic, and institutional sources of our present travails. I will not punish you further in that regard. However, I think it worth exploring, briefly, one or two deeper facets of the pickle we find ourselves in today.

One of the most remarkable intellectual breakthroughs, or paradigm shifts, in the markets over the past quarter century has been the widespread mathematization of finance. Due to the pioneering work of thought leaders like Fama and French, Miller and Modigliani, Black, Scholes, and Merton, traditional practices like security valuation and portfolio selection have been completely transformed, and huge new markets have been constructed out of whole cloth. Underlying many of these developments has been the sophisticated adoption of the concepts of probability and the tools of statistics to define and describe the behavior of securities, derivatives, and markets.

The mathematization of chance, in this context, has been an extremely powerful and useful tool. Vast swathes of our intellectual landscape have been colonized by statistical methods and concepts, and finance has proved pleasingly susceptible to such treatment. So susceptible, in fact, that trillions of dollars of new financial instruments and markets have sprung into existence on the back of it. Without the tools and techniques of statistical finance, many securities and markets would simply not be possible. Without the ability to model and manipulate the workings of chance through mathematics, we simply could not be where we are today.

However, these powerful new tools came prepackaged with a potentially dangerous cognitive trap. Probability is a notoriously slippery concept to get a handle on. Few people understand it well.

It is my belief that many quants, hedge fund managers, and investment bankers came to believe—consciously or not—that, by explicitly embracing and accounting for chance, they had tamed it. They spent countless millions of man hours designing and implementing elaborate mathematical models and risk control systems based on aleatory principles that could predict, with remarkable accuracy, the variation in return and behavior of securities and derivatives under normal circumstances. They spoke confidently about "value at risk" and "maximum expected daily trading loss" as if they knew what they were talking about. As if those terms actually meant anything. And then they trotted off to their bank, or their prime broker, or the Discount Window to borrow a couple more turns of leverage against their proprietary positions.

But you cannot tame chance. That is what makes it chance. At base, implicitly attributing the kind of predictability these individuals seemed to ascribe to chance was a fundamental error, a category-mistake.

To use an example from the not-so-distant past, could the principals at now-defunct hedge fund Long Term Capital not see that pegging the odds of losing all their capital in one year at 1024-to-1 against was ludicrous on its face? (And I am not arguing that Myron Scholes and the other LTCM propeller heads picked the wrong distribution for their probability estimates, as if settling on a Levy skew alpha-stable distribution with α = 1.8 and β = 0.931 would have been more accurate than a lognormal one.) In all intellectual honesty, how could they possibly know? Hubris, yes, but more importantly epistemic blindness was at play here.

For even if you have guessed (or calculated) the probabilities correctly, giving one-in-ten-million odds that a life-destroying asteroid will hit Earth in the next ten years does you no good when a Manhattan-sized meteorite is discovered hurtling toward Rio de Janeiro the following day. In retrospect, it seems pretty clear that it is far more important to plan how you intend to deal with an unlikely event when and if it does happen than to shrug and say it will probably never happen. Disaster planning and scenario testing are far more valuable risk management practices than fine-tuning the estimated volatility inputs to your CDO trading model.

Perhaps some of the lapsed mathematicians and physicists on Wall Street who designed these complicated securities and derivatives and created the programs to model their behavior understood this. Perhaps not all of them were blinded by the power of statistical methods or the efficacy and accuracy of probability-based theories of physical behavior like quantum mechanics into believing their elegant formulations were complete and accurate descriptions of securities and markets dependent on human beings. But somewhere between the PhDs programming Ito's lemma in C++ in the basements of investment banks and hedge funds and the Executive and Investment Committees approving proprietary trades, this understanding got lost.

And the shit, as they say, eventually hit the fan.

* * *
So does that mean we should throw away 25 years of finance theory, and scrap billions of dollars of software and systems designed around its principles? Should we go back to throwing sheep knuckles in a dirt circle to make decisions under uncertainty? Of course not.

But we need to rediscover a little more respect (and fear) for the ineluctable and irreducible operations of chance in our lives, including in the the markets. We need to keep reminding ourselves that having a 95% confidence level that our hedge fund will not lose more than $100 million dollars in a day does not mean it won't lose $500 million tomorrow, or $75 million a day for ten days in a row. We need to rediscover that well-understood probabilities are usually more stable in the long run, so the whipsaw of short term events doesn't blow us up before we can profit on our longer-term investments.

And it's a good idea to have a plan, a direction in which you'd like to go. But its always a better idea to have back-up plans as well, alternate routes you have mapped out in case your main chance doesn't work out as expected. Keep those in your back pocket, so you don't frighten the Congressmen or limited partners you rely on into paralyzed immobility. But keep them nevertheless.

And hope—pray—that some whackadoodle with the means and the understanding to do it doesn't decide to show everyone just how tentative our hold is on reason and predictability in the financial markets.

That way madness lies.

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