Will Rogers was correct

   Recently I read Michael Lewis’ book The Big Short. I have read several books which attempt to explain or at least describe the financial collapse we experienced several years ago. Mr. Lewis’ book is by far the best and I recommend it for those interested in this subject. His book is not without short comings however. One is its failure to adequately address what is addressed in a terrific article by Felix Salmon in Wired Magazine, “Recipe for Disaster: The Formula that Destroyed Wall Street.” Here is the link to the article:

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1

 The article describes the “Gaussian copula function” or formula. This is in essence a mathematical function (equation) developed by a PhD mathematician in the 1990s and used by wall street "Quants" (financial wizards with mathematical backgrounds) to determine the risk of CDOs composed of residential mortgages. The formula did not depend on historical information to determine risk but instead used market data about the prices of credit default swaps. Say what? - but that is my point in this Observation. The upshot is that our Quants took this formula and ran with it. I know at this juncture you don’t understand and frankly after reading the article I still don’t understand what the Quants saw and how they concluded that they had things figured out on the risk of these CDOs. But that in fact is what they thought and they convinced everyone else that mattered (including Wall Street CEOs and people at the rating firms) that they, the Quants, had successfully quantified the risk on these esoteric financial products. The article places a great deal of emphasis on the fact that although the formula was fine as an intellectual exercise (that is it worked when you placed close restrictive parameters on the values that could be given to the variables in the equation), for practical real world application (where those parameters did not exist) the equation was fatally flawed. On that precise point no one (including the Quants or the people who either didn't inquire or gave up trying to understand and just assumed the Quants were too smart to be wrong) had figured this out until it was too late. The use of the formula permitted and justified the development and dramatic (suicidal) expansion of the market for CDOs and related products (such as Credit Default Swaps on CDOs which consisted of subprime residential mortgages). The rest is described in Mr. Lewis’ book. Looking back over 2007-2009 I went over some of my Observations from that period that relate to the points I have raised here. I have reproduced them below with an added [editorial comment].





• Separating the truth from fiction




“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.”


Charles Mackay – Scottish Philosopher



If you don’t understand something ask for an explanation. If the explanation doesn’t make sense ask for clarification. If it still doesn’t make sense the problem is not you or your capacity to understand. It’s that “it” doesn’t make sense.


Implying that people who “don’t understand” are dense is a common persuasive tactic of people who themselves don’t actually understand (or worse).


The problems we often encounter are not caused by our lack of mental capacity, but by our willingness to go along with such an implication.


-03/24/2008



• Demigod (Demon)


Corporate culture has a negative aspect I would like to address. I call it the deification (often later demonization) of senior executives. These folks are not demigods (or demons). They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm. They are humans just like the rest of us. Nonetheless this process goes on constantly, often the result of actions by their subordinates.
We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.
We should overcome the temptation to do so.


- 07/07/2008



• What happened (11/05/2007)


Here is my take:


People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence and a lack of perception of the amount of risk they are undertaking in making financial decisions. This in turn tends to burn them from time to time and it kick starts the law of unintended consequences hurting others.
10/01/2008 Supplement: Senior executives in financial firms, quasi governmental entities (Fannie, Freddie), and regulatory authorities listened to and accepted the explanation (by senior but subordinate experts) of the “risks incurred” for various proposed offerings and undertakings. The senior executives and those making a proposal were far too confident that the analysis of the risk/reward balance on the proposal was based on accurate and complete underlying data. That is a classic and oft repeated mistake. This led to tragic overconfidence and the assumption of a level of risk that was unknown and unprecedented sending the law of unintended consequences off on a gallop.
But make no mistake we all had a hand in this. Whining that it was someone else’s fault isn’t going to help.


-09/29/2008


• Never again! Really? The Devil you say.

Last week I was asked to explain one comment in my Observation. That comment was that “we all had a hand in it.” By “it” of course I meant the present economic conundrum. By “we” I meant to include the population at large.
I was then asked to explain my reasoning.1 I gave the following explanation:
We are all subject to human imperfection. I have discussed many of those imperfections (cognitive biases) in my Observations because they do impact our business and our lives in general. One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is:


People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis (remember my Observation about Chicken Little -03/17/2008). They are then unpleasantly surprised when the “trend” ends and things revert to the mean. Hence the following previous Observation:


• Yes but this time it’s different

It never is.
Why do you think they named it the “mean?”
Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it.

- 06/18/2007

Ok how does all of the foregoing apply to our present situation? When real estate began to “take off” (late 90’s) and that market condition continued until then general public perceived it as a trend this “cognitive bias”, called recency or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the possibility of making a large profit comes in the room a cognitive bias causes probability to head for an exit -05/27/2008).
Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans. Yes that’s how far logic strayed. All of us were aware of what was transpiring.2 We simply did not perceive how short the trend would last and how far and extensive the damage would be.
Then the trend ended and now -


We know how mean the mean is.
Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on.


People say that we should learn from this and never let it happen again. Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions. Our shortcomings are embedded in our DNA.


The best strategy in my view is to remember our shortcomings as human beings and do our best with those in mind to avoid repeating our economic mistakes.3




Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation) is no doubt going to have a field day with these peccadilloes.


1. There is no truth to the rumor that it was someone running for political office (no not the one you are thinking) that asked me.


2. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.”


3. In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People how to learn. The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome. In order to keep history from repeating itself we need instead to focus on the one thing we had and will have control over and that is our own conduct. That is why in my previous observation I said “Whining that it was someone else’s fault isn’t going to help.”


-10/06/2008





• Prognostication is a four letter word (and so is overconfidence)

I was all set with a different Observation for today but then a financial guru testified before Congress on Thursday. I read a transcript of part of his testimony and I just could not resist.
What he said was:

"It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."

What he meant was:

They thought they had it figured out but they didn’t and it turned out to bite everyone on the....*




*reminds me of when I was young and used to set off firecrackers with my buddies. Once we set off several hundred in a row without a failure. Then one of didn’t go off after being lit. Georgie Wade stuck his head over the darn thing; it flared up and burnt his eyebrows off.


-10/27/2008


• A lesson we all should learn

“It isn't what we don't know that gives us trouble; it's what we know that ain't so.”
- Will Rogers


An earlier Observation on behavioral economics bears repeating.


Risk taken by individuals and businesses often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption.
How does this happen?



• By overconfidence that the information one is going to base a decision on is (i) complete and (ii) accurate.


• By overconfidence in one’s ability to analyze the information that is available.
--------
You see what the Quants ultimately used the Gaussian Copula function for was to assess the likelihood (risk) that one ninja loan contained in a CDO would go bad at or about the same time another ninja loan in the same CDO had gone bad. In plain English, were the two events related or to use statistical language “correlated.” If the answer was no and you put a lot of those ninja loans in the CDO then the risk of the CDO itself going bad was reduced to next to nothing. The assessment was that there was no correlation (the formula assumed the correlation stayed the same) and presto you could conclude with mathematical certainty that you could rate a CDO crammed entirely with Ninja loans as “AAA.” No one stopped to consider a general real estate decline (because that was not a factor considered in the Gaussian Copula function) and hence a situation where the loans would act the same at the same time. The relationship (or rather lack of one) between loan outcomes was considered to be or remain constant.


In truth during good economic times there is no relationship between the outcome from one residential loan to another. So the correlation is zero and no risk to a ninja CDO. But in bad times the relationship starts to exist and gets stronger the worse times get until there is a direct relationship and a ninja CDO has sufficient defaults in its compiled ninja loans that the value of the CDO goes from par to zero itself. Poof.


Now someone like Will Rogers with a great deal of main street common sense would have stepped back from the fray and said to the Quants - “your idea doesn’t make sense and I am not buying your explanation.”


Unfortunately Mr. Rogers isn’t with us. Just remember it’s what you know that ain’t so...that really hurts you. Oh and you’re not stupid - if it doesn’t make sense it’s because “it” doesn’t make sense.



-01/10/2009


[There – now I feel better.]