Sunday, December 07, 2008

Why Irrational Finance Practices Live On

Nassim Nicholas Taleb and Pablo Triana provides an interesting and largely true indictment of irrational financial practices, and more specifically the use of various quantitative models for risk management who are useless or even damaging (as they provide a false sense of security), with the models of Robert Merton and Myron Scholes that were awarded with the Nobel price in economics, but led to disaster when being tested in practice in their fund "Long Term Capital Management".

They express frustration over the fact that these models despite their failure live on, and calls for everyone to confront the quants and point out their uselessness. But what they leave out is why this irrational business practices live on. That they live on in academic circles should perhaps not be too shocking as no market test exist there. What is more interesting is that they live on in financial firms who do face a market test. The explanation for that is very simple though, that because failed financial firms are bailed out by the government, this means in effect that their failed practices are bailed out too and live on.


Blogger Eric Dennis said...

Which models are you claiming were useless or worse with regard to the mortgage meltdown?

There are generally two categories of models for the valuation of mortgage securities: (i) those using historical default rates to predict future ones, and (ii) those taking a set of present, liquid securities prices as inputs to price illiquid ones.

Models of type (i) are naive because they do not at all take into account long-term macroeconomic trends; they simply neglect the business cycle. These models are the ones used by the legally enforced oligopoly of ratings agencies. The banks were not generally dumb enough to use them.

Banks used models of type (ii) to exploit arbitrages (including arbing the ratings agencies models). Insofar as they were long mortgages, it was probably not as a consequence of some predictive model recommending such a naked strategy.

Models of type (ii) can be said to incorporate a view of the business cycle -- namely, the market's view as embodied in the tradeable prices passed as inputs to the model.

Insofar as type (ii) models produced unreasonable valuations, it was primarily a reflection of the unreasonable but *actually traded* prices passed in, which is to say a reflection of the standard kind of globalized entrepreneurial error arising in the midst of a credit bubble.

3:31 AM  
Blogger said...

I don't quite agree with the reason why these so-called 'risk management' methods keep existing.

No bank, hedge fund or other institution would actively consider the government bailout backstop as a real risk mitigation insurance in good times.

The fact is that these models do limit downside risks fairly well in so called 'normal market conditions'. Their risk managers were blind to the fact that all these methods cease to produce useful results when 'normal market conditions' cease to exist. And that is the exact thing these models were built to protect the investors from. So there is an inherent paradox in there and it should have been staring all these risk managers in the face. Maybe if you're too close you can't see the wood for the trees.

7:59 PM  
Blogger stefankarlsson said...

Eric, bank economists did in fact use the (i)-version of modelling in almost all cases (with only a fex exceptions like Paul Kasriel and Stephen Roach) which is why they fail.

Marc, did I write anyting about deliberately accepting losses? No, what I referred to was how irrational practices are weeded out through what one might call "natural selection", which is the way things work in most sectors, but not the financial one, where bailouts have prevented this process.

9:02 PM  
Blogger said...

Sorry Stefan,

I still don't agree with your idea that irrational practices are weeded out by 'natural selection' in all other industries bar finance because of the bailout option. You will remark that irrational practices exist in numerous other industries just as well. Let me name a few: airline industry, mining industry. They all run a high risk of failure over the long term, but on the short term they are all racing to maximise their capital returns. Most mining companies go bust. Most airline companies go bust. They don't (usually) get bailed out.

Ergo the reason they work with doomed business models must be
- that they are forced into this by competitors doing likewise
- that there is sufficient incentive for management not to care about the longer term. Generally speaking they are overpaid and have much to gain and little to lose.

11:55 PM  
Blogger stefankarlsson said...

Marc, the examples you give have nothing to do with irrational practices but with the cyclical nature of their businesses. And that is not the same thing.

And your alternative explanations make no sense at all. You can't be forced by competitors to do something that is irrational. If it is irrational for your business, then it is irrational to do it, period.

And having short-sighted managers begs the question as to why companies have the irrational practice of compensating managers that way.

7:23 AM  
Blogger Eric Dennis said...


Do you mean economists who work at banks and publish research reports? But this business is wholly separate from the role of banks as leveraged intermediaries and risk takers. Research reports are mostly just a press operation. The trading desks at the banks have been generally risk-managing with type (ii) models.

12:02 AM  

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