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Lombard Street On Computer Models Versus Looking At The Facts

Tyler Durden's picture




 

This is Part 1 of a series from Lombard Street titled "Last Spin Of The Wheel For Europe's Banks." As the title indicates, Lombard Street is hardly bullish on Europe's chances to avoid a fate that was described earlier by the IIF, only this time instead of just €1 trillion which would be the cost of a Greek disorderly default, the final tally will be many orders of magnitude higher and will also drag down the ECB, and the world with it.

Computer models versus looking at the facts

In 1974, Hyman Minsky explained the unfolding of credit cycles with his Financial Instability Hypothesis. It identifies three types of debt financing: hedge (borrowers can pay principal and interest from income, so risk is minimal); speculative (borrowers can pay interest from income, but need liquid financial markets to refinance the principal at maturity, so defaults rise when liquidity is impaired); and Ponzi (borrowers can’t pay either interest or principal out of income, so need the price of the asset to rise to service their debts and defaults soar when asset prices stop rising). Confidence rises over a prolonged period of prosperity, so a capitalist economy moves from hedge finance dominating its financial structure to increasing domination by speculative and Ponzi finance.

Financial markets and the economy are relatively stable when hedge financing dominates, but become ever more unstable as the proportions of speculative and Ponzi finance rise. The rising instability causes cycles of increasing severity until fear takes over and financial markets suffer a self-reinforcing spiral downward. Banks are the core of the financial system, so Minsky correctly says bank balance sheets deteriorate until inability to  service liabilities causes a ‘Minsky Moment’ – a debt crisis that forces bloated asset prices down to levels that are appropriate to the real economy of  production and income.

The questionable lending practices and the banking business models that caused the 2007–08 banking crisis and Great Recession certainly fit Minsky’s definition of Ponzi finance. That ‘Minsky Moment’ was a major turning point in global financial and economic history. It began the correction of all the imbalances that have accrued since the last major turning point – the huge monetary stimulation in response to the Penn Central non-bailout in 1970. (It changed the focus of most central banks from guarding against inflation to protecting banks from everything.)

Many analysts ignore financial debt when computing debt to GDP ratios – odd because financial debt is always a factor in financial crises. Financial debt in the US has fallen 20% from its high at the end of 2008, but is up 10% in Europe, shifting the locus of the banking crisis to Europe, where the quality of sovereign debt has fallen as financial debt has risen. Moreover, bankers on both sides of the Atlantic are continuing two serious errors that were major factors causing the last banking crisis;

  1. putting more reliance on computer models than common sense and
  2. failing to purge their balance sheets of failing assets due to inadequate net tangible equity to absorb the losses.

Contrary to the hype, computer models are very fallible. As predicted in February 2007, they greatly underestimated financial risk by failing to incorporate obvious correlations as well as being responsible for rating securities based on home equity loans and sub-prime mortgages AAA. Reliance on computer models also explains the failure to spot turning points. Only external shocks divert models from moving towards the equilibrium position, so all forecasts tend to be straight lines. Computer models don’t, and probably never will, identify turning points.

Failure to adequately price complex financial instruments, especially CDOs was a major factor in the 2007–08 subprime crisis. Securitisation effectively hedged the specific factors leading to default, such as personal illness, but failed completely to address the risks common to the entire securitized pool, such as an economic downturn and rising unemployment. Investors in the Euro Area (EA) mispriced sovereign debt for a prolonged period of time, but for a different reason – the false assumption that a common monetary policy plus the political promise that no country in the region could default reducedidiosyncratic sovereign risk within the euro. This assumption led to higher risk EA economies borrowing at low rates for a decade, thereby building up excessive debts and external obligations (see chart 1). For example, 10-year government bond spreads over Bunds for Spain and Italy heading into the currency union and until the financial crisis were very depressed (see chart 2).

In addition, models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly. No such people exist or ever have existed. Desires and fears, i.e. emotions, drive all human activity. They are neither rational nor linear, so can’t be modelled. However, they do fluctuate within given parameters most of the time, so the resulting behaviours can be modelled as long as the emotions stay neatly within the  parameters and historical relationships continue. This is a big ask and gives rise to another three problems that bedevil model predictions. First, extreme  events pop up far more frequently than mathematical theory predicts. Second, models can’t predict when an extreme event will occur. Third, they can’t give any reliable information on an extreme event – even after it has occurred – so the models still can’t incorporate the effects on economies and financial markets of the reversal from the ever increasing leverage of the past to the present deleverage.

Emotions exceeding known parameters cause extreme events, such as stock market booms and busts. They are self-reinforcing spirals upward and especially downward that, once established, keep diverging from equilibrium until the driving forces fade or stronger counter forces reverse them. Ever-increasing desires for accumulating ever greater wealth faster and faster ignited a credit bubble that spiralled upwards until it burst in 2007 from a lack of new borrowers. The multi decade credit bubble and its bursting were extreme events. No model recognized the credit bubble or its collapse and no model is giving any indication of the plethora of problems now brewing in Europe.

 

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Mon, 03/05/2012 - 12:17 | 2224062 Ahmeexnal
Ahmeexnal's picture

There are no absolute truths. That's what Stalin's thugs would argue.

Mon, 03/05/2012 - 12:22 | 2224067 markmotive
markmotive's picture

Kicking the can...

Marc Faber says we are simply brewing an even larger crisis. The computers will crash and we will have to re-boot the system.

http://www.planbeconomics.com/2012/03/05/marc-faber-a-bigger-crisis-coming/

 

Mon, 03/05/2012 - 13:30 | 2224335 trav7777
trav7777's picture

what computers?  Faber is a systems engineering expert now too?

Mon, 03/05/2012 - 14:14 | 2224514 CPL
CPL's picture

I was about to say.

Mon, 03/05/2012 - 16:43 | 2225428 markmotive
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metaphor for the financial system

Mon, 03/05/2012 - 18:02 | 2225858 Panafrican Funk...
Panafrican Funktron Robot's picture

It's an analogy, dumbfuck.

Mon, 03/05/2012 - 12:19 | 2224070 SheepDog-One
SheepDog-One's picture

But if reality was reflected instead of fudged numbers and lipstick fed into computer models, banksters and politicians would be dangling from ropes. Cant have that now, can we?

Mon, 03/05/2012 - 12:23 | 2224078 LawsofPhysics
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Failure to understand exponential equations and what exponential growth in population really means with respect to the energetic cost and standards of living.  Same as it ever was, pass the icrap.

Mon, 03/05/2012 - 12:55 | 2224203 Vince Clortho
Vince Clortho's picture

Einstein would approve.

P =Ic2

Where P is profit, I is compound Interest, and c is the speed of the printing press

Mon, 03/05/2012 - 12:25 | 2224085 Shizzmoney
Shizzmoney's picture

Television: "The economy is improving!"

Me at the pump: "WTF is this shit!!!111"

Mon, 03/05/2012 - 12:30 | 2224103 SheepDog-One
SheepDog-One's picture

They overgassed the economic funny car too much too soon...now theyre staring at either a stock market collapse or gunning it faster and losing control for a $6 avg gas for summer/fall for ObaMao's corronation.  Corey and Trevor, you fucked up!

Mon, 03/05/2012 - 12:26 | 2224091 IndicaTive
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.....proper fucked.

Mon, 03/05/2012 - 12:27 | 2224092 orca
orca's picture

Lombard today released, together with euro-sceptic Dutch party PVV, a cost-benefit analysis of EUR membership of Holland. Benefit per year €800, cost per year €2,700. Cost of withdrawal estimated at €127bn, to be recouped in 2 years. The Dutchies, who are shellshocked as is already, don't know what to make of it.

Mon, 03/05/2012 - 12:28 | 2224097 LawsofPhysics
LawsofPhysics's picture

Yep, amazing how people respond when they see something they have not seen in a while, like the truth.

Mon, 03/05/2012 - 12:41 | 2224131 Mr Lennon Hendrix
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Roll that doja and pass the dutch!

Mon, 03/05/2012 - 12:41 | 2224119 Bob Bercy
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The facts, my dears, are that these guys have been predicting the imminent demise of the the Eurozone for the past twelve years. The other slightly inconvenient fact is that it hasn't yet happened. Even more inconveniently it now looks rather less likely to do so than it did just three months ago.

They are the ultimate anti-Keynesians (along with ZH of course!) in their refusal to see the good sense in the old poof's famous dictum:

"When the facts change, I change my mind. What do you do, sir?"

 

Mon, 03/05/2012 - 12:44 | 2224150 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

So the consumer is rational?  Or a ponzi structure built of fiat can blow smoke in the face of reality for all of time?  Not sure what your arguement is other than the fact that the euro is still trading for goods and services, however marginally

And if you haven't taken a look at UE data across the EZ, and you haven't noticed all the protests from Greece to France to Spain, I suggest you do so.  Shit ain't looking good over there.

Mon, 03/05/2012 - 12:40 | 2224126 Mr Lennon Hendrix
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In addition, models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly.

And models assume this because economics assumes this.  Rational Consumer theory is a chief construct of Neo-Keynesian economics.  It is essentially the capstone of the whole theory, because it is through this rationalization that will move markets from A to B, and if we can't predict market movements, then Keynesian Economics has no science.

Mon, 03/05/2012 - 12:46 | 2224163 SheepDog-One
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'In addition, models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly'.

What? No they dont. Computer models are designed to baffle the sheeple with bullshit and get them to turn over the most money in the most efficient manner by steady constant flow of total bullshit.

Mon, 03/05/2012 - 13:02 | 2224233 toadold
toadold's picture

"Extraordinary Popular Delusions and the Madness of Crowds" by Charles McCay. In ye olde days it was required reading for new hires in a lot of stock brokerages. Also from the early days of IT, GIGO.

Mon, 03/05/2012 - 13:42 | 2224370 slewie the pi-rat
slewie the pi-rat's picture

our universe = crazed BiCheZ anchored in theFringeTM

we'll hafta come up with some new nonsense to compensate for the fact that everybody realizes we're onto something

hmmm... gang-banging blythe again...?

Mon, 03/05/2012 - 14:11 | 2224505 blunderdog
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Models are all just fine and good as long as you never forget they are HYPOTHESES.

Mon, 03/05/2012 - 14:32 | 2224534 jmc8888
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Every computer model is an incorrect guess (even if it somehow got the number right or whatever...it didn't get there the real natural way.).  It doesn't tell you anything real.  Because in life the events that are modelled are ALWAYS 0 or 1.  Computer models are like a universe unto themselves, and the models ain't nothing like the real universe.

All models are guesses.   No one should be making any decision based on a guess, especially one that gives the answer that comes from a limited universe.

The allocation of capital is best done when it focuses on the real benefits that can be created from nothing, and based on a REAL scientific basis. Capital for fusion.  Capital for waterworks. Capital for machine tools.  Capital for Space program. So on and so forth.  These would drive the physical economy.  These would create REAL wealth, which is better termed as the ability to procure necessities while expanding mankind's power over the universe.  So you'd create REAL wealth, plus in such a situation, people would gain lots of 'units of account', which is a poorer but more mainstream way of looking at 'wealth'.  It's really a two-fer.  More people get 'units of account', and more people get 'the ability to procure necessities'.

But they don't want it that way.  Because in the current way, they can always win, and not have to do squat for it.  In fact the less they do, the more power they get over others.  Which is how they procure the necessities.  After of course changing the rules to make sure they have enough 'units of account'.  But they also like to Sigmund Fraud it.  

So they come up with all these bullshit ways to fool people into following their system, of which computer models are one.  Computer models are a goalseeked invention (or even better...an invention which creates a conduit for goalseeking to be perpetually there and create a constant, supposedly controllable herd behavior...the whole Aristotle bullshit is caviar.) to keep people focusing too hard on the trees and not notice the forest for the betterment of the money masters.  How can the average idiot question that monetarism as an ideology be completely wrong when all the useful idiots believe in their metrics? Even believe in their 'science'.  Let alone that controlling or any manipulation in 'behavior' is a fraud which inherently creates an avenue for incorrect guesses and misallocation.  People spend hundreds of thousands to learn such bullshit, and then are paid into the millions to teach or speak said bullshit.  Using the best bullshit artists, financial entities and the like can earn billions of herd mentality swag.  All of course peasantry to the quadrillions that the masters create and print for themselves. 

The belief in these metrics causes unwarranted legitimacy to be heaped upon the system as a whole.  The textbooks only teach monetarism.  The faux 'science' provides obfuscation, goal seeking, and tries to control and predict behavior.   The student debt creates the coercive, fearful pressure to sooooo drop out of reality, Timothy Leary is jealous.   The use of a brain is not required in the application of the monetary system.  The use of computer models only neuters whatever brain is left after the indoctrination process.  Don't use your brain when analyzing things....like where to invest...where the world's capital should go...what scientific endeavors must be undertaken to keep humanity going so on and so forth.  Instead focus on the 'approved' metric and follow the steps that you paid hundreds of thousands of dollars for to monetary happiness. 

Another thing on models.  They are static.  They not only create a universe unto themselves, but also pretend it's the same year.  It's so blatantly obvious that it is artificial. Then they try to tweak the model and say see..it's updated...it's more correct.  No, it still is a 0 model, no matter the tweaking.  Where can we go wrong, when instead of our best and brightest actually progressing mankind, focusing their mind on real things, they are dumbed down into pretending that a bunch of made up shit with all the limitations of a three year old mongoloid (which really is an insult to mongoloids..but not by me) not only tell them what has happened, but what things should and will be.   It's like someone went to Christopher Columbus and all the other great navigators and said, hey you don't need to sail a boat, that takes too much time and energy....plus you have to build a real boat...instead just imagine the new world....and they proceeded to do that.  Our best and brightest have fooled themselves into making their life's work less valuable than a tootsie pop...and the world may never know.  Well at least until all crashes down.

Because that in a nutshell is our system.  We dream we are doing big things, when really we are just sitting around while nothing gets done.   It's all just an illusion.  An ideological illusion that all the 'smart people' were dumb enough to buy into generation after generation.   43 years + of continued physical economic decline in a row for America, easily identifiable to anyone with eyes, and it still goes unnoticed by those indoctrinated to the lies of (anti-american) monetarism and their faulty metrics.  It's the equivalent of an economic Jim Jones, and everyone drank the purple kool-aid and said how smart they were.  Look at all they accomplished. Look at all the fiat they have (or once had) in their bank accounts.  Look at what they can buy.  Or how much they can take out on their credit cards.   To all the things that actually matter, the village idiot is smarter and more useful than the indoctrinated.

Just remember it took 63 years to go from the first flight to the moon.  No computer models necessary, but it did help bring us the smaller, later home computer.  Now it's been 106 years since flight and we're back to 1960 manned spaceflight capability.  It's a story of two tales.  One where even in asinine monetary land we tried to progress (the indoctrination had only begun...60's) versus the now where we kept with the asinine anti-american monetary system, and ramped it up to an ideological extreme (the indoctrination has fully penetrated and the original indoctrinated are retiring). We are not concerned with progress so we've dismantled it.   Then we told ourselves we saved money and how good we all were.  How we know we did the right thing, because we followed all the steps that were taught to us.   One big worldwide circle jerk at the expense of the human race.  It's worse than playing with fire.  We fucking with the survival of the human race, something not always dictated by what goes on within the confines of the Earth (may want to pay attention to the extinction cycle..and then notice where we are headed with an unclear head, acting a fool, under the spell of monetarism and its bullshit). 

If you want to free yourself from the monetary master's or madness...you have to first stop believing or using their metrics.  Otherwise the conduit to be fooled is always there, needlessly by the way.

Glass-Steagall

American Credit System

...focus on the real physical economy...and what science we really need to keep it going.....not how to judge the wrong, fudged, monetary metrics of fantasy.

Mon, 03/05/2012 - 16:55 | 2225504 DutchR
DutchR's picture

You like computers then you are going to lovez this:

School for quants:  http://www.ft.com/cms/s/2/0664cd92-6277-11e1-872e-00144feabdc0.html#axzz...

 

Col. Kurtz comes to mind

Tue, 03/06/2012 - 03:18 | 2227207 cnhedge
cnhedge's picture

 common sense is what we need.

http://www.jinrongbaike.com/

http://www.cnhedge.com/

Do NOT follow this link or you will be banned from the site!