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On Wizards and Wise Men
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Steve Lohr of the NYT reports that Wall Street’s Math Wizards Forgot a Few Variables:
In the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. They, after all, invented the exotic securities that proved so troublesome.
But the real failure, according to finance experts and economists, was in the quants’ mathematical models of risk that suggested the arcane stuff was safe.
The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.
That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.
“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”
In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.
The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.
Much of the early work has been done tracking online behavior. The Web provides researchers with vast data sets for tracking the spread of all manner of things — news stories, ideas, videos, music, slang and popular fads — through social networks. That research has potential applications in politics, public health, online advertising and Internet commerce. And it is being done by academics and researchers at Google, Microsoft, Yahoo and Facebook.
Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets. A team of six economists, finance experts and computer scientists at Cornell was recently awarded a grant from the National Science Foundation to pursue that goal.
“The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets,” explained Jon M. Kleinberg, a computer scientist and social network researcher at Cornell.
At the Massachusetts Institute of Technology, Andrew W. Lo, director of the Laboratory for Financial Engineering, is taking a different approach to incorporating human behavior into finance. His research focuses on applying insights from disciplines, including evolutionary biology and cognitive neuroscience, to create a new perspective on how financial markets work, which Mr. Lo calls “the adaptive-markets hypothesis.” It is a departure from the “efficient-market” theory, which asserts that financial markets always get asset prices right given the available information and that people always behave rationally.
Efficient-market theory, of course, has dominated finance and econometric modeling for decades, though it is being sharply questioned in the wake of the financial crisis. “It is not that efficient market theory is wrong, but it’s a very incomplete model,” Mr. Lo said.
Mr. Lo is confident that his adaptive-markets approach can help model and quantify liquidity crises in a way traditional models, with their narrow focus on expected returns and volatility, cannot. “We’re going to see three-dimensional financial modeling and eventually N-dimensional modeling,” he said.
J. Doyne Farmer, a former physicist at Los Alamos National Laboratory and a founder of a quantitative trading firm, finds the behavioral research intriguing but awfully ambitious, especially to build into usable models. Instead, Mr. Farmer, a professor at the interdisciplinary Sante Fe Institute, is doing research on models of markets, institutions and their complex interactions, applying a hybrid discipline called econophysics.
To explain, Mr. Farmer points to the huge buildup of the credit-default-swap market, to a peak of $60 trillion. And in 2006, the average leverage on mortgage securities increased to 16 to 1 (it is now 1.5 to 1). Put the two together, he said, and you have a serious problem.
“You don’t need a model of human psychology to see that there was a danger of impending disaster,” Mr. Farmer observed. “But economists have failed to make models that accurately model such phenomena and adequately address their couplings.”
When a bridge over a river collapses, the engineers who built the bridge have to take responsibility. But typically, critics call for improvement and smarter, better-trained engineers — not fewer of them. The same pattern seems to apply to financial engineers. At M.I.T., the Sloan School of Management is starting a one-year master’s in finance this fall because the field has become too complex to be adequately covered as part of a traditional M.B.A. program, and because of student demand. The new finance program, Mr. Lo noted, had 179 applicants for 25 places.
In the aftermath of the economic crisis, financial engineers, experts say, will probably shift more to risk management and econometric analysis and concentrate less on devising exotic new instruments. Still, the recent efforts by investment banks to create a trading market for “life settlements,” life insurance policies that the ill or elderly sell for cash, suggest that inventive sales people are browsing for new asset classes to securitize, bundle and trade.
“Good or bad, moral or immoral, people are going to make markets and trade via computers, and this is a natural area of financial engineers,” says Emanuel Derman, a professor at Columbia University and a former Wall Street quant.
You have to hand it to the quants. Always looking to model the world by adding "more variables and more dimensions of uncertainty to predict waves of group behavior".
If this all sounds familiar that's because it's an old debate in social sciences that can be traced back to the Keynes Tinbergen debate. This is a classic debate which explores the problems of statistical inferences in modeling human behavior. I quote Keynes:
“the broad problem of the credit cycle is just about the worst case to select to which to apply the method, owing to its complexity, its variability, and the fact [that] there are such important influences which cannot be reduced to statistical form”
Most of the problems Keynes raised were real and his warnings on the specific question of business cycle are still relevant today. Unfortunately, in the last fifty years, econometricians have done little to take the con out of econometrics. I quote Edward Leamer:
"The econometric art as it is practiced at the computer terminal involves fitting many, perhaps thousands, of statistical models. One or several that the researcher finds pleasing are selected for reporting purposes. This searching for a model is often well intentioned, but there can be no doubt that such a specification search invalidates the traditional theories of inference. The concepts of unbiasedness, consistency, efficiency, maximum-likelihood estimation, in fact, all the concepts of traditional theory, utterly lose their meaning by the time an applied researcher pulls from the bramble of computer output the one thorn of a model he likes best, the one he chooses to portray as a rose. The consuming public is hardly fooled by this chicanery."
But the wizards of Wall Street remain undeterred. They will come up with new ways to model all risks, including systemic risk. Will the consuming public be fooled by their chicanery? I don't know about the consuming public, but I guarantee you that the pension parrots will be fooled by their chicanery.
This doctrinal thinking in finance is not limited to quants. One of the U.K. government’s panel of economic “wise men” under former British prime minister Tony Blair, Roger Bootle is critical of Alan Greenspan’s assertions during his tenure as U.S. Federal Reserve Chairman:
In order to help free markets back on their feet, central banks around the world need to take better account of economic bubbles before they burst, says Roger Bootle, managing director at Capital Economics.
"In my view the Greenspan doctrine is dead," the London-based economist said to a packed audience nestled into the British Columbia conference room at the Fairmont Royal York hotel in downtown Toronto.
One of the U.K. government's panel of economic "wise men" under former British prime minister Tony Blair, Mr. Bootle is critical of Alan Greenspan's assertions during his tenure as U.S. Federal Reserve chairman that bubbles are hard to recognize until they bust.
Mr. Greenspan argued that it was very difficult to discern whether an increase in asset prices was justified by economic fundamentals or the result of speculative activity and concluded that central banks should not try to target asset prices.
We should move towards a regime where bubbles are not tolerated as a key part of the main objective, Mr. Bootle said.
That means a more "variable" approach to inflation, with price stability to be the objective over the medium term. Instead of simply having inflation targets, he thinks more weight should be given to price-level targets to prevent major asset classes from inflating dramatically.
Too often ruled by greed above common sense in the decade leading up the financial crisis, Mr. Bootle says capitalism desperately needs to enter a new phase, where conscientious free markets are governed, not necessarily by more regulation, but better regulation.
"We should know now that greed is not good, and what's more, that the encouragement of it is downright stupid," he said. That's the lesson to be learned from these past few years, he said, but often we learn the wrong lesson. He remains worried that a massive wave of new regulation will render us ineffective in promoting long-term welfare.
Mr. Bootle listed several reasons for the failure of financial markets over the past two years, including inadequacy of capital and liquidity.
Until recently, he noted that some banks were lending out 40 times their capital, compared with just 20 times in the early 1990s and just six times at the beginning of the 20th century. The dramatic increase in bank leverage was exacerbated by inadequate knowledge and understanding by executives at the top of the global financial system and their inability to assess the excessive risks at hand.
Overseeing this was a regulatory system and monetary policy that failed on both fronts, largely due to its unwavering commitment to "efficient markets." In the case of Bernard Madoff, Mr. Bootle said the SEC was given countless indications of what was going on and chose to ignore them.
While the market can not be left alone entirely, Mr. Bootle thinks there are areas where the role of government needs to be reduced.
"In the U.K., there is a push to regulate and control everything," he said.
"What people don't seem to realize is that the aspect of the system that went badly wrong was in fact the most heavily regulated one. The banks were heavily regulated. They just happened to be incompetently regulated," he said. "So it is not obvious to me that the answer is to extend the thrust of regulation further, but make it better."
Mr. Bootle is right and he echoes the advice of George Soros. We do not need more regulation but better regulation. Quants can play a part in better regulating the system, but regulators also need to hire people who understand markets and can qualitatively assess the risks of the strategies and instruments being peddled. Believe it or not, quants do not hold a monopoly on wisdom.
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A question for Leo, at your leisure:
While it's certainly reasonable and plausible to reconcile the wreckage / carnage conceived on the parts of Wall St engineering gone amok, where might you / others stand on the matter of US govt direct interference with housing?
I am talking about CRA & politicizing Fannie Mae and Freddie Mac into the "lesser lights" on the credit spectrum. On the surface, CRA lending should work; I don't recall the exactness of the initial legislation, but ideally the proponents wished to legislate some modest lending rules to the least of us. I also want to say that certain Congress leaders began pushing FNM/FRE into pursuing yet more of this type of loan for portfolio / securitization.
Combine that push with a broader goal of financial 'ownership'; low interest rates (arguably maintained too low or a tightening too markedly slow); and lastly a very lightly regulated environment for the mortgage finance companies (New Century, Ameriquest chief among many). Now that those same mortgage finance firms failed, it seems that role is largely forgotten.
Blame black-box models...but in the bigger scheme this problem was out of hand on a myriad of "price points" along the way. My apologies if this has been covered previously, and I just missed seeing it. Thanks
*Late in 2007 UBS (mortgage strategist) had issued a very thorough report, attempting to reconcile then then-developing quagmire with the S&L debacle in the 1980's. The parallels: Congressional dallying & delay, a regulatory environment rife with loopholes, and a seemingly unclued public. It took years to clean that up.
Anyone who still believes the smallest fragment of our current malaise was not 100% deliberately planned and executed to the nth degree decoupled from reality long ago. There is absolutely no question the unholy government [money elite] alliance declared war on private U.S. household wealth with such insidious financial innovations. They were purposely intended to eviscerate private wealth [the source of all independence]. Go back and review every single policy prounouncement of this government from Sept 08 to now and ask yourself if its policy prescription by design has not specifically, and I submit intentionally, resulted in additional wealth destruction at its core. Don't be fooled into this second round 'green shoots' 60% market runup. Participate if you wish but know now that its nothing more than the second phase of a three-part plan and the second hammer is poised to fall. The money elite is hellbent to never allow total U.S. household net worth [i.e., independence] to return to its 2007 peak.
The bigger problem is "Black Box" modeling vs. "White Box" modeling. Most of these models are completely Black Box which for a complex systems assures that there is no learning or understanding about the reality from the model parameters and assures that sub-components of the model can't really be tested.
These are termed 'Black Box' because the methodology is considered proprietary, and in the best of circumstances it is a tool that more than compensates for the cost of maintenance and update. The best techniques involve daily download of relevant market data and re-running all requisite programs and algorithms, at least once daily if not more often.
Don't believe me...call James Simon of Renaissance and see if he'll let you take a peak. I'd bet John Paulson would gladly offer his as well...
I second SWRichmond’s first paragraph (#70892.)
Moreover, I remember a speech about deterministic chaos some fifteen years ago. One point was that it is mathematically impossible to predict the position of a pendulum, imagine one in a Grandfather clock, long-time, if that pendulum oscillates over the top (If driven faster that thing rotates.) There will be a point where the pendulum is exactly standing at the top ready to drop left or right. Any little uncertainty will make the difference whether it drops to the left or right. Moreover, that uncertainty has to be there because measurement accuracy is limited by Heisenberg’s uncertainty principle and any numeric approximation has exponential error propagation.
Any engineer should know that trends not based on laws of physics can not be safely extrapolated; probably that is one difference to financial model-makers.
The answer is simple, criminalize gross financial negligence. So long as the only penatly for losing billions of other people's money via undue risk taking is that you might be out of a job (or a bonus), there will still be too much incentive to just "go for it."
"There is a significant problem in keeping competent people in the US regulatory environment. The money is not there and the politics are there. Anyone worth their salt would not see that environment as an appealing career endeavour."
>>That is essentially the biggest problem. Why work as a regulator when you can make a lot more money at some investment bank?
Leo
"We should know now that greed is not good, and what's more, that the encouragement of it is downright stupid,"
Encoragement of greed is not bad nor is it stupid as long as there is a corresponding encouragement of FEAR.
I'm not an engineer or MBA so I like to keep things simple. Until the 20 somethings (and their masters) are made to feel fear for the consequences of their actions, by allowing them to go broke, all the regulation that can be thought of will do no good. If fear is encouraged as much as greed, little regulation is necessary.
I, unfortunately, have upfront dealings with our illustrious US regulators. The issue is not regulatory structure it is regulatory competence. Essentially, most if not all of the regulators our completely outmatched from a competency standpoint, and often an intellectual standpoint to deal with the financial community.
There is a significant problem in keeping competent people in the US regulatory environment. The money is not there and the politics are there. Anyone worth their salt would not see that environment as an appealing career endeavour.
An additional thought: this focus on the flawed nature of quantification and financial wizardry is merited. What should be kept in mind, is that more broadly speaking there are many "gatekeepers" or "enablers", who in very practical terms failed at their job as well.
Just a few to consider: Moodys, S&P, Fitch; OCC, OTS, NCUA, FED. Insurance regulation regards to AIG, MBIA, Ambac, FGIC (those monoline insurance companies,,,what a f**cking disaster)
Perhaps it has been done before, but the backdrop on how MBIA, Ambac and their ilk went from sleepy insurers of municipal debt to wacky insurers of wacky MBS should be well-known by now.
"Barclays is spinning off $12.3bn (£7.47bn) of troublesome assets to a fund based in the Cayman Islands and run by two senior former employees of its Barclays Capital investment management arm.
The bank is LENDING Protium, the newly created fund, $12.6bn to finance the deal, which is also being financed with $450m from the fund's partners."
More accounting wizardry
Financial engineers 'jumped the shark' when CDO (squared, cubed) was introduced, and don't forget carried 2/3 blessings from the "blessed 3 NRSRO". Using a top-down approach, the Wall St firms (public & private) will always have access to (and generally pay much better) than any regulatory agency, state or national. Regulators will always lag the innovation...so perhaps beef up regulation to minimize. I could strongly guess that regulator knowledge of VAR practices is pretty limited.
Crank up the RBC requirement for any national bank whose primary business is something different than taking deposits / making loans. Higher capital cost will/should generate a greater hurdle to exceed for any IRR calc.
25 years ago, financial wizards helped to improve the delivery mechanism for dispersing risk in the MBS markets. This typically is over-looked. CMO, IO strips, PO strips...while complex the basics for cash-flow modeling is generally quite simple.
Going from that time to today, the worship of all things quant just goes too far. When every asset class becomes correlated to 1.0, that's when we got problems.
"The term "engineering" conjures up images of safety; bridges that can be trusted, airplanes that fly, men on the moon!....so "Yes! We'd like to buy some of this financial engineering! We can all make a shitload of money, right away, and it's perfectly safe because it's engineering!"
Anyone who asserts that the economic behaviour of billions of individual humans can be modeled to 100% accuracy, or even to a sufficient level of accuracy to use as the basis for a 40:1 leveraged financial system, needs to be gibbetted. Right away."
SWRichmond,
Priceless quote.
Leo
Agreed. And Leo, keep up the fantastic work - you are the anti Vitaliy Katsenelson.
Thanks Leo, and thanks above, also, for your comments.
Jump, you fuckers.
http://www.youtube.com/watch?v=yge311sFhC8
I am an engineer. I take vigorous exception to calling MIT finance charlatans "engineers". Engineers are responsible; engineers do not design systems based on lies. Engineers design systems based on rigorous science, with even more rigorous testing, because we know lives are at stake each and every day. We use accepted scientific methods to quantify risk. When risk warrants it, we design systems to be capable of withstanding misoperation by humans. When needed for safety, we include redundancy.
MIT financial charlatans design systems for one purpose: to steal money. They do so precisely by misrepresenting risk, as we have seen.
The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.
This last is either a lie as a cover up, or an admission that the MIT super-grads are in fact complete fucking morons. Which is it? Let's see: senior IB managers interested only in short-term gain hired inexperienced and overeducated twenty-somethings who promised them massive short term gains called "financial engineering". The term "engineering" conjures up images of safety; bridges that can be trusted, airplanes that fly, men on the moon!....so "Yes! We'd like to buy some of this financial engineering! We can all make a shitload of money, right away, and it's perfectly safe because it's engineering!"
Anyone who asserts that the economic behaviour of billions of individual humans can be modeled to 100% accuracy, or even to a sufficient level of accuracy to use as the basis for a 40:1 leveraged financial system, needs to be gibbetted. Right away.
“We’re going to see three-dimensional financial modeling and eventually N-dimensional modeling,” he said.
How many lives will be destroyed while he's working out the kinks? JHFC.
+1000 (also a trained engineer).
"The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed."
First, the models for risk are, for the most part, absurd. They primarily rely methods like regression and standard deviation -- which do not explain, quantify, or predict risk. There's a reason why asset managers include "Past performance does not guarantee future results" And yet, history is precisely what is used in risk-modeling. Secondly, modeling human behavior is also absurd. If that's possible, then communism might actually be a viable system. There's a lot of study devoted to behaviorial finance, and while it is important, it has its own major faults (assumptions) in predicting risks. The glaringly obvious point I'm making is this: Risk cannot be Truly Quantified, b/c if it could, it would cease to be a risk. Therefore, attempting to mitigate an unknown risk will always have limitations. What this quote above is overlooking is that Government interference INCREASES uncertainty, and thereby increases risk and, by extention, decrease the effectiveness of tools that manage risk. The solution is not using more complex models necessarily, but rather provide market partricipants a system that is free from government intervention.
SWRichmond,
I enjoy your posts. You have good insights.
I have been pondering about financial engineering for years. Financial engineers help to do accounting tricks by throwing smoke and mirrors. This will end only when enough people lose enough money that there is nothing left to lose (i.e. collapse of US $)
I work in Mechanical engineering research. My observation is that true engineering is done by Bachelor degree holders while Masters and Ph.D. holders in engineering have become as destructive as financial engineers. They keep building useless computer models that represent fiction. (I am old fashioned Ph.D. in Mechanical Eng)
Same thing in Civil Engineering. I feel that when journalists award Wall Street's games of financial trickery with descriptor "engineering", they hurt real engineering, since real engineering is applied science, and science permits no trickery. But why should those journalists work hard to determine or explain important facts and differences, since so few of them own their own media outlets? After all, if one were to spend one's life as a slave of a billionaire Robber Baron publisher, why should one not be a lazy slave? But thank goodness for the blogs! And let us hope that the Fourth Turning, those kids in school right now, will have opportunity and courage to do much more worthwhile work.
Regulation just provides a breeding ground for incompetence.
Look at Barney Frank, Chris Dodd, Chris Cox, Mary Schapiro, Chuck Schumer.
Look at the whole NY State Legislature.
Look at our national government.
Add inevitable corruption to incompetence and you have something worse than just leaving it alone.
Every one of the last bubbles was created with the help of regulation.
Of Wizards and Wise Men or "How to make a better bubble!" The loans sold were guaranteed to fail. Those loans were placed in packets guaranteed to fail. How is this complex? All the quants want is to squeeze the profits longer and better predict went to short and retire.