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Quants, Models, and the Blame Game

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Yves here. Donald Mackenzie, author of An Engine, Not a Camera, which described how the development of models like Black Scholes affected practice in the financial services industry, has written a paper which describes the role of the Gaussian copula function, which a Felix Salmon story cover story in Wired depicted as central to the credit crisis. This is a crude summary, but here goes. When you mix a bunch of assets together and you want to know how much you’ve reduced the risk of price movements, you need to know the correlation of their price movements. Similarly, if you are putting together a structure, like a collateralized loan obligation, and want to diversify the assets to reduce the reduce the odds of default, you’d need to know the default correlations. The Gaussian copula model was used historical CDS spreads to develop default correlations. The model was used widely in the construction of collateralized loan obligations which are actually a type of CDO, but the popular press has taken to using that term only for “asset backed securities CDOs” or ABS CDOs. The problem was that Felix also suggested that the model was integral to the growth of all types of CDOs. Lisa Pollack, in summarizing the key bits of the paper, explains why this is an overstatement, that the Gaussian copula formula wasn’t used in creating ABS CDOs (or even the underlying mortgage securities). There is another way to know that this formula was not used in ABS CDO pricing. The template for CDS on asset backed securities was published by ISDA in June 2005. Mortgage backed securities and ABS CDOs were well established by then. The only change you saw (and it was a biggie) that resulted from the development of CDS on mortgage securities was the development of synthetic and heavily synthetic CDOs, and their structures copied those of old-fashioned CDOs made entirely of bonds.

Cathy O’Neil, a quant, looks at the key question raised by this paper: why do flawed models become widely accepted? I’d hazard that it has to do with distaste for complexity. Decision-makers really want simple heuristics. They don’t like ambiguity or having to weigh lots of tradoffs, even though that is what they are paid to do. Yet oversimplifying complex situations is seen as legitimate; look for instance, at how widely the flawed model, Value at Risk, has been adopted.

By Cathy O’Neil, a data scientist and member of the Occupy Wall Street Alternative Banking group. Cross posted from her blog, mathbabe

Recently a paper came out written by Donald MacKensie and Taylor Spears. It’s about the role of the Gaussian Copula model in the credit crisis, and it’s partly in reaction to Felix Salmon’s article in Wired from February 2009. Both Felix Salmon and Lisa Pollack have written responses to this paper, and they’re quite entertaining and worth a read.

Without going into too many details about the underlying models, which I might do in another post, I wanted to spend some time appreciating this paper for bringing up two issues that I believe far too few people give notice to:

  1. The politics of being a quant. The pressures on a quant inside an investment bank, a ratings agency, on a trading desk, or for that matter in a risk group are real and need to be understood.
  2. The narrative of blame. Who gets blamed when a model fails? For that matter, who is responsible for making sure it works at all?

Politics

In the paper, they discuss the concept of a “model dope,” which is a rhetorical device helping you imagine an idiot who ‘unthinkingly believes in the output of the model’. The paper explains that, as far as they could tell, there were no such actual people, that the quants they interviewed all knew the model was and is flawed and overly simplistic.

I completely believe this, and I think it wouldn’t surprise any quant who’s worked in the industry. Quants are the guys who get metaphorically paraded out in front of the bank, with their Ph.D. hanging out as a kind of badge, but when they get back to work are put back in the mines. It’s a trader’s world, or a salesman’s world, and nobody asks the quants for their nuanced opinion on the validity of basing billions of dollars in transactions on these models if the P&L looks good.

Let me say it this way: how many places employing quants to create risk or hedging models have their quants actually in charge of stuff? Very, very few is the answer. The quants are not in charge, they rarely have real power, and as soon as they produce something semi-functional and useful, they no longer own that thing – it’s been taken away from them and is owned by the real power brokers.

Which is not to say the guys in power don’t kind of understand the stuff- they do, they’re smart, but they’re not typically wedded to the idea of intellectual integrity. They typically understand it well enough to see how it can be gamed.

So I don’t think it was the quants that were promoting the wide use of the Gaussian Copula model. In the paper, they explain that it happened for essentially political reasons:

First, it was easy to talk about, since an entire correlation matrix of default was boiled down to one number, “base correlation”:

“If traders in one bank … had to ‘talk using a model’ to traders in a different bank that used a different copula, the Gaussian copula was the most convenient Esperanto: the common denominator that made communication easy.”

Next, it allowed traders to book P&L on the same day they made a trade:

“The most important role of a correlation model, another quant told the first author in January 2007, is as ‘a device for being able to book P&L’,”

Next, once it was widely used, it had staying power just because it was difficult to explain something else, not to mention difficult to admit the current model’s flaws:

“Here, the fact that the Gaussian copula base correlation model was a market standard provided a considerable incentive to keep using it, because it avoided having to persuade accountants and auditors within the bank and auditors outside it of the virtues of a different approach.”

Putting that stuff together, we can see that the mere, lowly quant’s objection, if there was one, that the model sucked was the least of the considerations of the powers-that-were:

“From the viewpoint of both communication and remuneration, therefore, the Gaussian copula was hard to discard.”

Blame

As to the question of blame, that’s also all about power. Just because the objections of quants were likely ignored doesn’t mean we can’t blame them after the fact – that’s another useful thing about quants, since they even admit the models were overly simplistic. Easy fall guys.

By the way, I’m not saying that quants rebelled against the misuse of their models, that they tried their best to warn the public of the known flaws of the Gaussian Copula or any other model for that matter. In fact I don’t know of many quants who did stand up to these assholes, partly because they were paid really well not to, and partly because they were not the alpha males in the place.

I’m just trying to point out that blame can get kind of murky. If a quant comes up with a model and says up front, hey this is just a sketch of something, it’s not totally realistic, but it’s better than nothing, and then the investment bank ignored the quant’s misgivings and bets the house on the model, who is responsible for the resulting risk?

In other words, I’d love the quants to grow some balls, but it’s going to take a major revolution in the power structure for that to be enough.

A Question

The two issues of politics and blame raise for me a larger question in reference to modeling. Namely, why and how to models develop?

[This is a cultural question, and separate from the standard (and interesting) questions you usually hear people ask of a model:

  1. What does the model claims to do?
  2. How well it works with real data?, and
  3. If it is widely employed, how the model affects the market itself?]
Here are some examples of why I think models are built.
  • To simplify a businessman’s day. Instead of reading out results from 5 trading desks, we want to dumb it down to one single number, so we employ a modeler to come in and do their best to summarize with one P&L number and one risk number. In other words, it’s the modeler’s job to turn a report into a sound bite. Of course the problem with that model genesis is that it doesn’t necessarily make sense to combine a bunch of numbers into one number. Sometimes the world is actually complex and needs to be understood with a nuanced view. Sometimes a sound bite isn’t enough.
  • To sound incredibly smart – in other words, pure spin doctoring. I encounter this more in tech than in finance, where there are enough model-savvy people that you can’t be quite as blithe about hiding bullshit in a model. But this is real in finance too, and I think is used to confuse regulators all the time.
  • To dissect, or attempt to dissect, various kinds of ‘unintentional risk’ from ‘intentional positions’. This is the single most dangerous kind of model, because on paper it can look so good, and can seem to work for so long. Credit default swaps can be thought of as manifestation of this goal – an attempt to separate default risk from holding-a-bond risk. The problem we face is that our models are never really that good, or even testable, and there are unintended consequences of these new-fangled contracts that sometimes cause catastrophic events.
  • Of course, in quant shops like D.E. Shaw or RenTech or Citadel, there are also quants who try to predict the market or trade superfast on currencies, which is different from the stuff I’ve been talking about which mostly deals with hedging and risk, with different kinds of corresponding risks.
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131 comments

  1. F. Beard

    When you mix a bunch of assets together and you want to know how much you’ve reduced the risk of price movements, you need to know the correlation of their price movements. Similarly, if you are putting together a structure, like a collateralized loan obligation, and want to diversify the assets to reduce the reduce the odds of default, you’d need to know the default correlations. Yves Smith

    But don’t all risky asset prices tend to fall during the bust while their risk of default increases? So isn’t the wisdom of diversification (cf Ecclesiastes 11:2) negated by the synchronized instability of our money system?

    1. YesMaybe

      Not necessarily. For example, I think it’s safe to say a CDS is a risky asset. But it would go up in value as the bonds it’s for go down in value. Of course, then there’s also the risk that the person who wrote the CDS won’t be able to pay in the case of a general clusterfuck. So… no and yes?

      On a slightly humorous note, I think the real issue isn’t what happens “when you mix a bunch of assets together” but rather what happens when you mix a bunch of assholes together.

      1. jake chase

        Keynes said all anyone needs to know about uncertainty vs risk in his Treatise on Probability (1923). Only id**ots playing heads they win with other people’s money model uncertainty. The only premise the banks operated on was that they would become filty rich before the music stopped and the FED would eat their losses.

        1. F. Beard

          Thank for the recommendation! I also ordered Keynes “A General Theory …”.

          Economics is so odd…

          1. enouf

            oh i think not — “Economics” (macro) is a deception — but on the microscale (local, community-based), perhaps — why do you think a *County* is the fundamental building block of the “State”?

            Love

      1. F. Beard

        Some people justify the boom-bust cycle by comparing it to nature. Where then is the analogy in nature to a world-wide Depression? There is none.

        Our money system is thus “unnatural.” Where is the Green outrage over this?

        1. Mark P.

          ‘Where then is the analogy in nature to a world-wide Depression?’

          I’m sympathetic to your general message. But just to begin with —

          http://en.wikipedia.org/wiki/Permian-Triassic_extinction_event

          Also, your Bible talks about fallow years and there are in fact plenty of instances in nature where an animal or plant species has expanded (with greater access to some food resource or territory) and then suffered a population crash.

          1. F. Beard

            Good points. I guess I should have qualified that question with “within human history” (the Flood I consider Supernatural).

          2. F. Beard

            Also, your Bible talks about fallow years … Mark P

            Yes, but crop failures are localized. Also, the irony of Great Depression I was that food and cattle were destroyed because farmers could not get enough for them to pay their costs while people starved. The irony of this Depression is that there is a housing glut with homeless, formerly employed people.

          3. enouf

            @ F. Beard

            In a word; Entitlement

            How dare those wicked, down-trodden slaves even THINK that possibly they might be *entitled* to some help from their Masters….. heh

            Love

          1. F. Beard

            You miss the point. The current Depression is nearly world wide, not limited to a specific region like Canada.

            The world has a mono-culture money system and it is tightly coupled too.

          2. skippy

            @beardo…. Humans now cover the earth, currency aside, as its a byproduct. Human activity alone, supported by consumerist ideology, multiplied in orders of magnitude by technology, resists eons of built in friction.

            Skippy… elasticity is a bitch… eh.

          3. Nathanael

            Boom-bust cycles are a natural result of exponential population growth in ecology.

            However, the busts suck BIG TIME for the individuals dying of starvation. Natural does not mean good.

            Humans now have the ability to control their population growth artificially. We should use it. Otherwise we will have the mother of all busts quite soon.

          4. Nathanael

            I will say further that we are truly blessed to have discovered a way to control our own population through contraception, rather than through territorial fighting (which is how most top predators control their population).

            But it will mean nothing if we don’t use it.

        2. enouf

          As you should already know; the “boom-bust” crapola is just a figment of delusional deception and acceptance, not even worthy of the word ‘imagination’ ; a derivative of (global, at this point) acceptance of a fiat currency.

          Love

          1. F. Beard

            acceptance of a fiat currency. enouf

            Fiat is the ONLY ethical money form for government money.

          2. enouf

            that gets to the heart of the problem; Govt is no longer a functional entity put solely in place, empowered by the people, for the people. “Govt” has been hijacked and is basically one large PRIVATE global corporation. ..One with no borders/boundaries, without allegiance, without loyalty .. without HONOR or LEGITIMACY.

            I loathe even having to use generalities like ‘Gov’t', ‘Public’, ‘Private’, as you know; so many times are these terms blatantly bandied about, with no concise definitions used (and accepted as axiomatic) when in reality the incestuous intermarraige and fornication of Public and Private has been consumated ad infinitum.

            So in closing; I cannot let you say ‘ … Gov’t fiat …’ without a challenge since you/i/we would be more than hard-pressed to find when in the past (historically) Public/Private wasn’t incestuous ..atleast to some degree.

            Love

            Love

  2. Finance Addict

    So honest quants with intellectual integrity readily admit that

    “The problem we face is that our models are never really that good, or even testable, and there are unintended consequences of these new-fangled contracts that sometimes cause catastrophic events.”

    Yet much of finance continues to run on these models. Backstopped by taxpayers, I might add.

    Yes, Virginia. The financial singularity is here. http://financeaddict.com/2012/06/have-we-arrived-at-a-financial-singularity/

    1. Just a thought...

      You running for political office?

      The quote you cite is part of a more nuanced argument than the broad swipe at financial models I read in your comment. Her point, as I read it, is that it is important to be aware of the constraints to ones ability to model using limited observations and over-simplification as well as testing the robustness of the model after the initial development. Individuals who broadly use models that attempt to dissect “‘unintentional risk’ from ‘intentional positions’” to establish markets for products like CDS are either unaware of, or knowingly ignore, these constraints.

      1. albrt

        I am a big fan of both Lisa Pollack and Cathy O’Neil, but I thought Lisa’s post came closer to making the point that the copula was mainly used for keeping score, not mitigating risk. The bankers were interested in quantifying their bonuses, not quantifying risk.

        As Warren says below, the point of these models is “using complexity for intentionally stealing another person’s lunch.” That’s what bankers in our society do. They don’t really do anything else.

        Any other theory about what the bankers are trying to do with a model is just another layer of complexity for the cover story.

    2. LeonovaBalletRusse

      FA link: Schwartzman is quoted: “losses are inevitable”–what is far from inevitable is that those using this system will eat their losses. That’s for hoi polloi to do.

      The conclusive quotation is bonkers. Really, if THEY want to forfeit their brains, must WE be the necessary victims of inevitable errors? Oh, I forgot: that’s not a bug but a feature.

      “Godzilla” indeed. Will Prof. Koo please step up?

    3. financial matters

      Interesting article on the financial singularity. I liked the contribution of technology forecaster Paul Saffo.

      “Imagine [...] an institution with the analytic resources of Wall Street players, the reach of Google, and the openness of Wikipedia. Such an observatory would leverage the capacities of cyberspace to become a global (and cost-effective) clearinghouse for economic information. Its scope would extend far beyond the data collected by established entities today, for example probing deep into the world’s illicit economies and exploring the market implications of rapidly spreading social media.”

    1. LeonovaBalletRusse

      Well, if “robots” do it, no one is liable they claim. Who programmed them on whose orders for whose outcomes? Skewed “transfer of liability.” Really, can humans transfer their liability to machines they program? “The dog ate my homework?”

        1. stripes

          As long as the obedient slaves believe everything they are told and keep cooperating, complying and conforming, they will become more and more oppressed. The 1% only rule by secrecy, lies and weapons of mass deception. It is a war on our minds and what they can make the masses believe.

          1. Douglas

            The lies are there because bullets are expensive. Don’t pretend there aren’t any more bullets and we have nothing to fear but fear itself.

  3. stripes

    If it makes no sense, its fraud. Alan Greenspan said derivatives made no sense to him and he said they were dangerous.

  4. sierra

    From a non-math genius and one who is doing extensive research into the financial crisis of ’08, my simplistic take on the whole idea of “modeling” is:
    Attempting to marry the pure science of mathematics to the behavioral “science” of economics.
    In the “clutch” it can’t be done.
    But, I agree with the article’s author that “quants” were/are/can be blamed by their superiors’, risk managements’ and other financial managers for the ultimate failures of models.
    Recall the testimony back in ’09 by the heads of the largest banks/financial houses in congressional hearings regarding the models; Question was put forth about whether a “downside” tot he real estate market was factored into those models….the answers from all of the witnesses was, “No”.
    The story of the “quants” in this latest fiasco is a fascinating one and one that is not emphasized enough.

    1. LeonovaBalletRusse

      “failure of models”–you mean like model of Kruger the Match King, but facilitating insider data/”money” transfer via electronic steroids/speed/Meth?

  5. Warren Celli

    Yves said; “Cathy O’Neil, a quant, looks at the key question raised by this paper: why do flawed models become widely accepted? I’d hazard that it has to do with distaste for complexity. Decision-makers really want simple heuristics. They don’t like ambiguity or having to weigh lots of tradoffs, even though that is what they are paid to do. Yet oversimplifying complex situations is seen as legitimate; look for instance, at how widely the flawed model, Value at Risk, has been adopted.”

    A different take; Warren Celli, a non quant but expert on baloney, looks at the key question raised by this article; Why does flawed baloney become widely accepted? I’d hazard that it has to do with using complexity for intentionally stealing another person’s lunch. Deceivers really want complex lip stick on their pigs. They love ambiguity. The more complex it is the more easily they can confuse the marks, unload their deceptive products, and get their loot. Complexity is also a great cover for deflecting from their foundational crimes of control of interest and corruptly buying and controlling the government.

    http://www.fountainofbaloney.com/fb2images/ubalcurve-2.png

    Deception is the strongest political force on the planet.

    1. Yves Smith Post author

      WC, you love Manichean characterizations. Aside from considering this reply, I suggest you read Alex Carey’s Taking the Risk Out of Democracy, which is the most thorough history of propaganda in the US that I’ve read. One thing he points out is that inculcating black/white characterizations creates fertile ground for propaganda. So your refusal to see any grey is part of the problem.

      As to models, no, there are plenty of players who also use financial models, not to steal, because (mirable dictu) they don’t have customers! Start with proprietary trading firms (as in private, no customers, trading for their own account). The leaders in the early 1990s were O’Connor & Associates (a client of mine for a bit) and Chicago Research and Trading. I can’t speak for CRT, but O’Connor was run by quants (the biggest partner was passive, he’d staked the company, but the working partner with the biggest share, and who was also deferred to on any call regarding risk was also the best quant). And they were constantly updating their models and very cognizant of risk.

      And if you read about LTCM (the best account is Roger Lowenstein’s When Genius Failed), the partners, even after the firm failed, were convinced their models were right (so they weren’t as smart as Cathy’s quants). They weren’t out to exploit people, they were a classic example of hubris. Similarly, a ton of quant hedge funds blew up in August 2008. Again, they weren’t trying to screw customers, they got it spectacularly wrong.

      Shorter: Don’t assume malice when incompetence may suffice as an explanation.

      1. LeonovaBalletRusse

        Such authentically “proprietary” trading would seek accuracy and “justice” as it were. But what happened with “other people’s money,” especially when the putsch was on in later 1970′s by Merrill et al. to bring the “money of the masses” into “brokerage” play, when Wall Street Week was the coolest propaganda going for the “facilitation” process? “Calling all cows” was the Siren Song. The elimination of Glass-Steagall’s “division of powers” and the release of regulation that formerly forbade pitching derivatives to Institutional Trustee customers (Pension Funds, Mutual Funds working 401K’s et al.), permitted FIRE to consume the country, while “No Dogs Barked.”

        1. Ms G

          Yes LBR. The lynchpin of the whole machine is OPM. I say let them play with their own $$ but also not in any way that can possibly AFFECT real world developments (viz., LTCM).

      2. F. Beard

        because (mirable dictu) they don’t have customers! Yves Smith

        Yet if they used “credit” they used the population’s stolen purchasing power.

      3. financial matters

        Well said Yves. The malice seems to come out more when looking at complex over the counter derivative products, very well described in Das’ Traders, Guns and Money.

        Here the quants were used to make tailored models for individual clients which were virtually impossible to understand and heavily favored the writer of the contract. Or were used in various types of regulatory or tax arbitrage.

      4. proximity1

        RE:

        “Similarly, a ton of quant hedge funds blew up in August 2008. Again, they weren’t trying to screw customers, they got it spectacularly wrong.”

        Indeed, they did. But that was four years ago now and still, the same people who then “got it wrong” insist that if everyone would just get out of their way (and, really, there is practically and obviously no one in their way) they’ll be happy to insist on “handling things.”

        They’ve handled them–as they did the last time and the time before that and the time before that and the time before that and etc. And the whole point of their efforts now is to ensure that they keep on handling them.

        That’s what seems to me to be the point of the now-fashionable idea that the solution is in greater centralization in economic management in Europe. As you so often say, Quelle surprise! What “we need” is what Brussels globalizers have always been angling for: greater market centralization, more uniformization.

        When genius failed, it decided that to improve the game of Russian Roulette, the key is to put more rounds in the chambers rather than just one, as before.

        Moreover, it seems that you miss something very essential when you write that,

        “Cathy O’Neil, a quant, looks at the key question raised by this paper: why do flawed models become widely accepted? I’d hazard that it has to do with distaste for complexity. Decision-makers really want simple heuristics. They don’t like ambiguity or having to weigh lots of tradoffs, even though that is what they are paid to do. Yet oversimplifying complex situations is seen as legitimate; look for instance, at how widely the flawed model, Value at Risk, has been adopted.

        But this “begs the question” –and not in the silly and so often currently misused sense of “prompts the question”– no, I mean it really begs the question, takes as true the very premises which are at issue:

        The question, ‘Why– (i.e. How)– do flawed models become widely accepted?’ includes all that goes with the rationales for favoring flawed models in the first place— a preference for simplistic (but false) representations of real-world phenomena is no less being questioned and has to be explained just as the flawed models themselves do, flawed because they are unrealistically simple.

        But how and why can the simplistically flawed models become widely accepted?

        I see a leading candidate as answer to this important question:

        All over the world, for more than forty years, all the most important would-be financial and management leaders, are systematically trained in the dominant (and false) economic mythology about rational markets, etc.

        We need to recognize what “this” phenomenon really means and represents in its purest and most fundamental sense–we need to recognize, that is, its “nature”, its “character. But we can’t do that because MBA’s, top management schools train the “General Staff” of the business world and do that by misleading them into thinking that uniformity, which runs all through their world-view, is essential to efficiency, and in turn, then, to “success” when allied to a “killer-product strategy”. This is pseudo-science aping real science.

        Real science, taught through natural life-sciences, recognizes this system of education in flawed models as a self-reinforcing (positive-feedback) closed-loop, and, therefore, a recipe for inevitable disaster, since, as Konrad Lorenz cites in The Waning of Humaneness his earlier text, Behind the Mirror (p. 29):

        (p. 37) Every cycle with a positive feedback leads sooner or later to catastrophe.”

        (he notes, unless there is some exogenous limiting intervening agency acting on the feedback loop, and, here, there is nothing intervening short of the catastrophe itself.)

        We are a species that learns essentially via catastrophe. Real science is one of the only (occasional) exceptions. But business management and finance are in no way like a real science. They are human arts, and all human arts with unlimited positive feedback lead to catastrophe in their practical consequences.

          1. Nathanael

            Heh. You know, I’d actually be more willing to accept that than what I’m seeing from the Bank CEOs.

            “Your honor, all the people I killed — it was their fault. They were asking for it. And I have a right to kill more people, too. Now let me go before I kill you.”

        1. skippy

          Sex and Profit[?]… over torquing the planetary financial nut?

          Children are completely egoistic; they feel their needs intensely and strive ruthlessly to satisfy them. – Sigmund Freud

          Skippy…. Manufacturing of consent… Nawwwww…

          PS. For beardo… Just as a cautious businessman avoids investing all his capital in one concern, so wisdom would probably admonish us also not to anticipate all our happiness from one quarter alone.- Sigmund Freud

          1. F. Beard

            Just as a cautious businessman avoids investing all his capital in one concern, skippy

            That wisdom, like very much of economic wisdom, comes from the Bible: Ecclesiastes 11:2.

            But alas, I was raised Catholic and given an early vaccination against the Bible.

        2. F. Beard

          of the now-fashionable idea that the solution is in greater centralization in economic management in Europe. proximity1

          That “666″ thingy, long predicted by the Bible.

        3. Nathanael

          “Every cycle with a positive feedback leads sooner or later to catastrophe.”

          Basic principle of engineering, as well of all forms of society.

          Put in simplest form, a cycle with a positive feedback must cause a measurement to tend towards infinity (this is just a mathematical fact).

          (The exception is where there is some form of controlled damping which kicks in at some level and stops the positive feedback; that’s OK.)

          The social and engineering problem with this mathematical result is that *infinities don’t exist in reality*. The positive feedback cycle will instead inevitably reach the stress-induced breakage point of the material (in structural engineering), an underlying resource limit (in ecology), et cetera.

          In economics the limit which is usually reached in booms is the *limit of credulity* — the limit to people’s willingness to believe something which looks absurd on its face. In busts the limit is often the point at which people can’t stop being optimistic (since most people have an optimism bias), so a new boom starts. But it is sometimes the limit of revolution — the degree of suffering after which people decide that this economic system isn’t worth it and it’s time to overthrow the people in charge by any means necessary.

      5. Warren Celli

        Yves, you love shades of gray and you love to give people the benefit of the doubt. Seeing the shades of gray is an admirable quality. Giving people the benefit of the doubt is less so, especially when the overwhelming evidence is that hypocrisy and deception are on the rise. I see and appreciate the shades of gray, especially over time — the Universal Baloney Curve is a very gradual curve not just a straight line inverse relation — but I give few people the benefit of the doubt. Our past perceptions place us on different positions of the trust scale. It is a matter of individual viewpoints and trust.

        As to models, I agree with you, they can be put to good use or bad use and they are always subject to unforeseen forces. We model the weather quite successfully now but many people still look out the window before dressing to go outside. Again it is a matter of individual viewpoint and trust. But modeling the weather does not yet materially change the weather and there are few opportunities to use the information gleaned to harm others.

        But not all models are equal. There are many shades of gray as to their ability to impact society positively or negatively. Financial models have the capacity to be abused and cause great harm to society, especially as the society has already been shaped and enslaved by the corrupt machinations of finance in past generations.

        Given that corrupt enslaved societal base (caused by that old fashioned Vanilla Greed for profit base), with such an un-level playing field tilted to finance and corruption, and, given that it has more recently been far more corrupted, (by the newer — castrate regulations — Pernicious Greed for control) it must be incumbent upon the moral person that at some point you no longer justify the stinking deception. The deception has become so putrescent, so odious, so damaging to society, that to even argue forensically the modeling science involved in the deception is to validate and legitimize the aberrant diseased rot that it emanates from — the Xtrevilists that created it.

        Yes, inculcating black and white characterizations is fertile grounds for propaganda. It is at the very heart of creating divisiveness. The Xtrevilist aberrant elite are quite good at it.

        And yes, I propagandize back, in black and white terms, to focus on the aberrant self anointed piggish rich elite at the top. But I have also said many times that the disease is contagious. I have recognized the shades of gray — that we are all capable of such evil and aberrant behavior. And that we must all make the personal choices necessary to cure the disease and institutionalize the sickos at the top.

        Don’t assume incompetence when Xtrevilism may suffice as an explanation.

        http://www.boxthefox.com/

        Deception is the strongest political force on the planet.

        1. skippy

          A country for 235 years… out of which… we have been at war for 209.

          Skippy… If you can’t do it, give up! – Sigmund Freud

        2. Mansoor H. Khan

          Warren Celli said:

          “overwhelming evidence is that hypocrisy and deception are on the rise”

          The good news is that “badness” (hypocrisy and deception) cannot continue to rise unchecked. There will most likely be a severe collapse of our modern systems (banking, supply chains, etc). People will then re-think much of this stuff and there will (god willing) be a awakening and enlightenment.

          Here is how the bankers’ game is played:

          http://aquinums-razor.blogspot.com/2011/11/here-is-how-bankers-game-works.html

          mansoor h. khan

          1. stripes

            Yes Monsoor…some choose to believe this latest manufactured crises was an accident caused by greed….It was caused by greed but, it was no accident. This is their evil end game Hitler plan for mankind which is COMPLETE COMMUNISM….AKA……GLOBAL TOTALITARIANISM. They rely on our full cooperation…complying and conforming obedient bankster debt slaves to pull this scam off…..! Don’t drink their kool aid America…!

        3. proximity1

          RE:

          “And yes, I propagandize back, in black and white terms, to focus on the aberrant self anointed piggish rich elite at the top. But I have also said many times that the disease is contagious. I have recognized the shades of gray — that we are all capable of such evil and aberrant behavior. And that we must all make the personal choices necessary to cure the disease and institutionalize the sickos at the top.”

          But, unlike Yves, your approach in “propagandizing back” tends to discount as insignificant or even non-existant that, conflicted about their part and their place, these evil and aberrant people can also not only demonstrate mixture of better qualities and practices, they can experience profound changes in themselves, become “different people” from what they’d been for years.

          You recognize one side of the picture–”that we are all capable of such evil and aberrant behavior” but not the other, a capacity for the same individuals to hold and practice beliefs that run counter to this “evil and aberrant behavior” that, for you, is their main, and so only significant, characteristic here and now.

          Warren, were you born “on the side of the angels” or did you “get there” (such as we may have) as “I did” (LOL!)— by some more or less tortuous and confused zig-zag which only gradually and partially has relatively “smoothed and straightened” itself in its path to this present-and-still-deficient-status of mine?

          I agree with you in thinking that there are a lot of really odious “white-collar” criminals who should have long ago been arrested and brought to trial, convicted wherever the evidence can show their guilt, and sent to prison for lengthy terms. But I think the only safe and sane course requires we examine every case, case by case and with care and attention to attenuating, mitigating circumstances when those are really present and meaningful.

          I’d prefer arrest, conviction and wherever it’s possible, correction and reform –and where it isn’t, confinement and control, but as little revenge as possible in the confinement and control, and no cruelty or brutality at all.

          1. Claire

            proximity1: “I think the only safe and sane course requires we examine every case, case by case and with care and attention to attenuating, mitigating circumstances when those are really present and meaningful.”

            But when you say, “the only safe and sane course requires we examine every case, case by case and with care and attention to attenuating, mitigating circumstances”, who is this “we” that you’re referring to?

            Because outside of this blog, in terms of people I have contact with day to day, I have trouble finding a single person who thinks that any crimes were committed by Wall Street, let alone major crimes, or who is even remotely concerned by this issue.

            Thanks to massive propaganda, the majority of Americans seem to believe that unionized teachers are a bigger issue than Wall Street crime, and would probably agree with Roger Lowenstein that “Wall Street is not guilty”.

            Only a handful of bloggers (with a limited audience and little money) are keeping this idea alive and they’re up against thousands of MSM reporters (CNN, FoxNews, NPR, ABC, NBC, NY Times, WaPo, Atlantic Monthly, etc) with billions of dollars in resources and the ability to broadcast their pro-Wall Street propaganda 24/7, 365 days a year.

            Yet, according to you, these few bloggers with few resources and almost no audience, should, without anger and always keeping a calm and moderate tone, “examine every case, case by case and with care and attention to attenuating, mitigating circumstances”?

            Just for the sake of argument, let’s suppose they spend a few more years examining every case and finally have enough evidence to conclude: “look here, we can say without any doubt that this Wall Street banker is guilty of crime and should be prosecuted!”

            What should they do then, call up the SEC and try to present their evidence, or send a letter to Jamie Dimon, asking him to please look into it?

          2. proximity1

            RE : Claire’s post–

            “Claire says:
            June 23, 2012 at 9:47 am

            proximity1: “I think the only safe and sane course requires we examine every case, case by case and with care and attention to attenuating, mitigating circumstances when those are really present and meaningful.”

            “But when you say, “the only safe and sane course requires we examine every case, case by case and with care and attention to attenuating, mitigating circumstances”, who is this “we” that you’re referring to?

            “Because outside of this blog, in terms of people I have contact with day to day, I have trouble finding a single person who thinks that any crimes were committed by Wall Street, let alone major crimes, or who is even remotely concerned by this issue.”

            I’d had in mind by “we” mainly people such as you find here and news/mass-media, and courts, state and federal.

            But this (and those) don’t really respond to your question which is as tough as it is good: What can “we” do about it? –that is, about the massive corruption in the business and financial world.

            The first thing we can do is what we’re doing here–informing ourselves and each other and discussing these issues and the meagre means available to address them.

            The second is to realistically examine our real resources–imaginatively–and, if the results are bleak, resisting despair, ask: what is the best I can do for myself, my family, my friends in the given situation, that….

            Much depends, too, on the sort of time horizon you are thinking in. Do you mean what can anyone do this month?, this year? in the next two, three, four or more years?

            According to the way you answer, the approach could be very different.

            If, for example, you’re looking at circumstances in the immediate that are rather desperate, then if possible, you should try and examine what you have, what you need, decide whether there are reasonable efforts you can make to get yourself in a better position under any of the scenarios you regard as most likely in your place and position.

            Try and forecast for your own circumstances what, how and when your situation may improve or worsen and what you could do in either cases of various scenarios.

            It may be that you and I and just about everyone similarly situated can do little more or better than to recognize as clearly as possible and as early as possible where “things are and where they are headed if they continue on this course at this rate or more rapidly” and then take the best possible precautions under these scenarios according to your assessment of their probability.

            That is, I fear, a very discouraging reply to your question but it’s as honest and as realistic as I know how to offer at this point.

            I expect many things about our present social and economic circumstances to worsen significantly–and in varied degress, nearly everywhere in the world– and I take my task to be to try and foresee to the best of my ability what may occur, where, when and how it could affect my person and situation, and, in various scenarios, how I can be better prepared for those events.

            If I had to rank things, “score” them, I’d say that I’m concerned to find myself in circumstances which place me among people who “score” high in awareness, in social cohesion, that is, who know and practice and value habits of mutual aid and respect between strangers, a place in which there is as reasonably sound an “infrastructure” of life-necessities that in difficult times, could prove resilient. Communications and travel networks, information access and a working social system.

            Or, your view may be that your own circumstances are much better than anything I’m describing or, unfortunately, much worse. Not knowing the details, leaves me hard-pressed to offer more than this.

            Your question is one of the hardest. Outside of making real advances in organized public action, which has been made as difficult as possible this side of an openly operating police-state, there are not many obvious open avenues except to aggitate, look for and ally yourself with others–and if you can find them nearby, extend your search area.

            Please forgive me for so inadequate a reply.

          3. stripes

            Boycott the large multinationals and banks that have hijacked our country. Stop paying the unsustainable debt of the bankster crooks. Stop complying and conforming to fraud.

          4. proximity1

            a P.S. to Claire:

            I’ll try to be as brief here as I can be.

            (Okay, I failed on that point. My apologies.)

            I missed the rare opportunity your probing question, “But what can we do!?” offered to address some matters that usually go by the boards and try to place them in context–which may be the only still unfamiliar aspect I’m offering, the facts themselves being already widely recognized.

            RE, again, then,

            Because outside of this blog, in terms of people I have contact with day to day, I have trouble finding a single person who thinks that any crimes were committed by Wall Street, let alone major crimes, or who is even remotely concerned by this issue.

            Thanks to massive propaganda, the majority of Americans seem to believe that unionized teachers are a bigger issue than Wall Street crime, and would probably agree with Roger Lowenstein that “Wall Street is not guilty”.

            Only a handful of bloggers (with a limited audience and little money) are keeping this idea alive ….

            We need but still haven’t found the combinations of words and images, marshalled into convincing arguments, that are going to capture and focus the attention of our peers and convince them of the importance of what you and others can already see and understand while so many others don’t see it at all. But some such combinations exist and are worth our efforts to find them.

            You recognize rightly that you’re (we’re) facing not just a problem or even a set of problems but a system of problems which are suprisingly intractable–so far.

            It has helped me beyond what I can express to have gained at least some insight into the nature of this system and its sources and workings and, if you, too, do that or have done that then you’ll have the powerful weapon which comes from a clear(er) grasp of the nature of this system.

            Rational thought processes have been joined technical expertese and produced a technocracy which is, as Lorenz points out, “enervating” to most people’s life-sustaining impulses and motivations–in other words, it’s soul-killing. Faced with large and highly networked forces that they neither know nor can much influence, they become resigned and despondant–literally physically and mentally discouraged– about their own places and their own part in a larger cooperative society and simply reduce themselves to what is nearest and most accessible to them and their influence. All of that is reasonable and normal. Much of what you’d like them to “see” (as you’ve seen it) is in a literal sense still simply invisible to them.

            So your tack and mine, I think, should be to look for the “entry ideas, concepts” which can set up, prepare, the recognitions that remain beyond reach to the people you describe and want to reach. This is missionary work, to be blunt about it.

            A combined onslaught now produces a world in which we live in a “constant but contextless present”, without a meaning-giving past or a hope-inspiring future. This onslaught consists of several reinforcing and cooperatively working elements: the ethically-empty components of material commerce, joined to digitally-based mass-communication networks for advertising and other propagandistic purposes and a suite of rationally-driven economic imperatives which support and maintain a central–and centripitally gaining–authority which at the same time places atomizing, disintegrating pressures on us, those, the targets of mass-media, whose impulses, if organized, would be to resist these tendencies.

            To see this “picture of things” is to have the beginnings of a kind of psychic “armor” against it. You mustn’t underestimate the importance of that armor. In my case, it came through insights gained from my reading. Others may have the knack of gaining the same insights from their daily-life experiences.

            We also have to remain reasonable in our expectations or we risk, again, falling into despair. The progress I hope you seek is going to be long in coming. It’s going to require profound changes in people’s everyday assumptions about value, about what is important to create and preserve in society.

            Right now, all the negative forces I’ve mentioned are still at work and undermining what is left of democratically-organized social life. The directions are toward the private, the secret, and the centrally-controlled. And while all of that favors a conspiratorial view of the world, it doesn’t require much of one in actual practice because the automatically-occurring interests of the centrally-focused power structure produces a common set of interests anyway, without a formally operating conspiracy as a precondition.

            Habits which reinforce the techno order include,

            * greater amounts of time and attention given to all manner of digital networked media, to the expense of personal interactions on human-scale activities

            * a focus on immediacy as a time frame, and everything which places a premium on speed as an end and objective in itself

            * a tendency to dismiss or ignore context-giving relationships in favor of seeing everything in its discrete, separated quality–or, worse, imposing this where contexts would otherwise seem natural

            The opposite of the above make up part of what is correspondingly antithetical to the techno order,

            * greater time away from the networked digitally-based world, in favor of time devoted to the cultivation of appreciation– for art, for literature, for things which take time, things which grow, things which are, literally, alive. The natural world, the world of live music, theatre, and, when those aren’t available, reading alone and in groups.

            * a stubborn insistance on resisting pressures to produce immediate results, a resistance to accepting in everything an immediate or very short-term view of the situation

            * similarly, a resistance to ignoring context in the course of thought and examination, in reasoning in favor, of course, of looking for the valid context in which people and facts exist.

            I don’t advocate a passionless, cold, pursuit of these objectives. Rather, I find much about our circumstances worthy of deep resentment. At the same time, it would be a big mistake to allow that resentment to produce an easy division of the world into two camps consisting of the good on one side and all the rest on the other. Instead, lots of people who boast of their left-ish bona fides, in fact are very significantly aiding and abetting the soul-draining system.

            On the other hand, anyone who can and will really lend a hand a striking a blow against the system is my ally, whether he or she is a computer-programmer or middle-level manager in a bank. What counts for me is not what clothes one wears, or even (solely) who pays one’s salarly. It’s rather in what one is prepared to advance the sort of consciousness that is needed but still lacking in order to upset and reform a systemic order which, unless its successfully opposed and thwarted, threatens everything valuable and humane because it simply has no use for what is humane because it is not rationally efficient and profitable.

      6. jake chase

        Had anyone at O’Connor ever heard of Keynes? The idea of using mathematics to justify positions is complete hogwash. A trader simply makes a bet. Then, if he hopes to remain solvent, he watches what happens and adjusts.

        And can’t you please fix the edit function for these comments? It is 2012 and the backspace key doesn’t work!

    1. proximity1

      This presumes its contradiction in terms.

      “Quants” are, by nature and definition, “hired guns”. So, as such they don’t have what you mean by “balls”—that is, a capacity to act in direct opposition to the the aims and interests of forces in whose pay they are, forces to which they are inferior in power, prerogative, etc. as employees.

      So, what then would they be, if they possessed such authority?

      They’d be “the people in charge.” But let’s recognize and avoid one of Marx’s most fundamental mistakes in his determination to make a theory fit a set of real-world facts.

      There is no such thing as the characteristically, i.e. inherently, discrete “proletariate” class (or individual).

      If you take a member of this abstraction Marx called the “proletariat” in his or her real living form–an individual person — and put him into the role of owner/manager, he will sooner or later assume that point of view and, if handsomely paid, will assume it sooner.

      There are only people with varying tendencies to behave within a range between various extremes. They have in them a wide range of potential behavior. What’s actually manifested in their lives is some combination resulting from their own inherent genetic make-up, combined with their socio-cultural circumstances.

      But you don’t learn that in management school.

      1. LeonovaBalletRusse

        Underneath it all, they have the souls of Noble Murderers. Many a timid academic in lust with power uber alles is a Serial Killer in Drag.

        1. Nathanael

          Well, that’s OK. Noble Murderers are far from the worst type we could have.

          We currently have Incurable Short-Term Thinkers running the world with the assistence of Killer Sheep. That’s a recipe for species extinction, which is something Noble Murderers try to avoid.

    2. proximity1

      P.S.:

      Moreover, why should anyone take as implicitly or explicitly true the assumption that the “Quants” are in some important way opposed to the theory or practice as dictated by their employers who hire and pay them?

      If you trust your models–and that’s what a Quant does, isn’t it?–there is always an infinite number of ways to rationalize and dismiss their failure to operate effectively in real practice without feeling obliged to abandon the primary assumptions in the validity of such models.

      Any Quant who can’t find a way to reason: ” The model is close, it “just needs a little tweaking here and there.” is a Quant who is on the way to being a short-timer.

        1. skippy

          I see it as more of – a – form – of – *no frills* time travel.

          Skippy… the worlds population – is – flying – on the economic equivalent of Nigerian airlines. Everyone flap your arms!

  6. Michael

    Interersting timing seeing the patent annoucnement on Wednesday titled “System and Method for System and Method for Generating Random Vectors for Estimating Portfolio Risk” which at its core covers fat-tailed copulas.

    Heady stuff even for the quant crowd, imagine mere mortal investor trying to absorb this!

  7. LeonovaBalletRusse

    A cruder summary: how to profit from Shinola+Shit in a “complex” Pie-in-Sky strung out to the nth degree of insider profits through permutations and “probabilities” according to quants.

  8. steelhead23

    As a professor of mine once said: “All models are wrong, some are useful.” This mantra should be used as a header on all quant correspondence. Beard above has a good point. If all the data used to create one’s model of say, the value of real estate investment trusts, is based on real estate trends and prices since 1950, it would be very unlikely to accurately capture tail risk. Add to this the tendency to look to “central tendency” to estimate risk and we have the recipe for disaster. Add to the pot the ability to book P&L at inception, meaning compensation for those “alpha males” at the sales desks, and disaster becomes cooked into the cake.

    This disaster did not occur because humans are stupid. It occurred because humans are far too clever for their own good. Much like the smart two year old who figures out the window latch on the second story window.

    1. LeonovaBalletRusse

      Yesterday, kevinearick posted on the very danger of quants and robots programmed with “past” data, AS IF …

      I guess they agree with Faulkner: “History is not dead. It’s not even past.” Do quants then think like Unreconstructed Confederates and other “dead” meat?

  9. LeonovaBalletRusse

    “the quants are not in charge”–but, hey, they get laid quicker and more often!

  10. GeorgeK

    In 09 I had an email discussion with a Harvard Physics professor about the models used on Wall St. He told me that in academia the top talent starts a formula with is then given to a grad student to finish and then it works it way back up the food chain to make sure the work is correct.
    Wall St uses the best and brightest to start a model, then the work is then handed off to lower level physicist to be finished. However, unlike academia, the finished model is then given to the trading floors without an upper level review by the super stars that are now working on the next project; resulting in bad models.

  11. George

    Much more fundamental than any of that :

    Economics produces the same kind of data as history. You can do correlations with it.

    Predictions based on history are always prefaced with ‘if things continue as they have’.

    In open, evolving, complex systems, things generally do not continue as they have.

    ‘Open’ == influenced by factors outside of the subsystem. For the economy, this includes fads, inventions, substitution of materials as prices change, the weather, the position of the Sun’s orbit around the galaxy, …

    ‘Evolving’ == the equations of state change, and you don’t get to retrace your state, and you may not be able to get there from here.

    ‘Complex system’ == not a mechanism. Economists use the term ‘system’, but don’t seem to use the meaning that other professions attach to that term. In biology we mean ‘rain forest’. In large-scale mechanical designs we mean ‘aircraft carrier’ or ‘nuclear submarine’. In computer systems we mean ‘the internet’.

    In economics, they seem to mean ‘simple blood pressure mechanism’, at least in monetary policy discussions.

    If you haven’t read it, ‘Black Swan’ is way ahead of this discussion.

    Think ‘rain forest in a changable climate’

    1. proximity1

      Did you mean to write,

      “Economics produces the same kind of data as history. You can’t do correlations with it.” ???

    2. Tim

      With respect to “Black Swan”: Is the book better than the movie? Because the movie *sucked*.

  12. Jill

    This is more complex :) It matters who the simplfied model is being sold to. The people in charge do exactly what you write about, exploit the model. They exploit it in at least four ways: 1. one you write about: {guys in charge}
    “understand it well enough to see how it can be gamed.” 2. the model gaves a framework of action to lesser intellects, people who are greedy but need the blueprint to show them what to do and 3. to convince the mark. Fially, many academics and opionion “leaders” make their living sponging off this type of thing.

  13. Jill

    I should say that people in charge aren’t really being sold the model, they are purchasing it.

    1. proximity1

      Maybe this is a distinction without a difference?

      Aren’t the real “sellers” of high-powered number-crunching the very graduate management schools and programs I’ve pointed a finger at?

      It seems to me that as “sellers”, we have Harvard Business School, Kellogg (sp?), Stanford, MIT, Wharton, and all their peers around the world.

      These programs have drawn –until recently and for how much longer?— many and maybe most of what are in the convential view “the best and brightest” young college grads, drawn them with implied promises of a better shot at a quicker track to the “good-life” by, again, the conventional view defined by TPTB of course, whuch includes generous numbers of the elite directorships of the grad programs.

      Somewhere I think I read of a student at an elite program asserting with resentment that he ‘or she) was the program’s “client”, “customer” and the answer came back, something to the effect of, “No you’re not. You’re the ‘product’ (being sold).” That might have been in Philip Delves Broughton’s book on his time at the Harvard GSoB.

      In any case, while they’re students, and for some time just after that in their first posts, these Whiz Kids are indeed the GBS programs’ “product” and many are sharp enough to see this, of course.

      The management which hires them upon graduation has surely already decidedly bought into the idea that models and the younger brightest grads who devise them are the all-important keys to glory and riches in the world of finance and mangagement. Those are the Robert Rubins, the Lawrence Summerses, and the Lloyd Blankfeins and uncounted others.

      But they’re also the Lloyd Bentsens, the Leon Panettas, John Podestas, William Perrys and William Cohens, right?

      At a certain level, the revolving-door is such a blur that it’s impossible to distinguish between the people coming from or going to the “corportate side” (includes military now) or the “academic side” and it may not really make any difference socially or academically and certainly not politically.

      1. LeonovaBalletRusse

        Ya think that conniving “Louisiana babe” at JPM (Frontline) didn’t know what she got going (especially for metastasizing in Old Europe via DB) for the Boss? Didn’t they “get out in time?” Tell me another fairy tale.

  14. Paul Tioxon

    One of the flaws is the use of mathematics as a tool of empirical research for the purposes of predicting human behavior. Instead of it being useful for revealing humanity, it reveal more about the necessary constraints of mathematic’s own rules, its own logic and its own nature, than that of the subject it claims to be modeling. Mathematics is a language, a symbolic representation of the real world, and as such, the social scientists are novelist, fiction wielding apologists. Better a long view of history, and real politik than the mystification of authority pretending to use the intellect, reason and science, the meritocracy of elite experts, as the ultimate foundation of legitimate, democratic policy. All that is really going on are projections and wishful thinking, which is then interpreted by two handed economists. And of course, these auguries always coincide with best interests of those already in power, already too wealthy to measure because they are the entitled aristocrats that can not fall from grace, ever.

    1. LeonovaBalletRusse

      You have a heart attack after eating a 16oz Porterhouse with butter at Ruth’s Chris (Pol Heaven). Will you let an algo determine whether to call an ambulance?

      1. GeorgeK

        Depends on who profits the most from your living or dying.

        Spouse and kids get insurance; but so does the bank you work for and they get a bigger payout. If your a big earner the algo will amitorize your earning potential over the next several years and might just let you live.

  15. Glen

    I think the prevailing model assumption is “I’ll be gone, you’ll be gone” (IBGYBG) and big fat fees.

    After that, it’s pretty much window dressing.

    1. LeonovaBalletRusse

      “Carpe diem” and let the devil take the hindmost. We are the hindmost.

  16. Lloyd C. Bankster

    Before 2008 I asked my quants to use Gaussian copula and estimate the probability of a 20 percent decline in house prices.

    They came back and said they had some very good news, then told me that a 20 percent decline was likely to happen only in a time frame many, many trillions of years longer than the history of the universe, a 25-sigma event.

    The quants told me that the Black Monday crash of 1987 was a ten-sigma event. Translated into English, they said that meant that had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much in a single day. In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically “unlikely”.

    During the 2008 Crash, Goldman’s CFO, David “Bones” Viniar, told me: “We were seeing things that were 25-standard-deviation moves, several days in a row. Twenty sigma is ten times the number of all the particles in the known universe; 25 sigma is the same but with the decimal point moved 52 places to the right. That’s the probability of a single 25-sigma event. Yet we’ve experienced it several days in a row. It shouldn’t be possible to be that wrong.”

    I blame the quants. For the financial crisis and everything, and so after the 2008 crash, I had all the quants blindfolded, and tied up in the basement, and then I forgot about them.

    No one ever asked where they were or what happened to them, so it’s not like they’ve been missed.

    Reading this article reminded me they must still be there, and I’d better send security down to check how they’re doing.

  17. Conscience of a Conservative

    Ultimately it’s the people not the models who are responsible, but without the models it would be harder. Didn’t Eddie Izzar say, “Gun’s don’t kill people, People Kill People, but so will monkeys if you give them guns”.

  18. Skeptical

    The primary reason that models became popular is that they offered deniability. A model could be rigged and the chances that someone would notice was very small.
    Models became a substitute for common sense and due diligence.

    There was no equation or flaw that made them worthless; they were designed to crank out the desired results.

  19. F. Beard

    I don’t give a flip what models people use.

    It’s the money system that is inherently dishonest. It will NEVER be made to work properly unless God is mocked.

  20. jsmith

    Um, so which worthless American POS would I rather listen to?

    A financial quant telling me how the entire financial system is NOT a mass network of fraud designed to ever increase the wealth and power of those at the top.

    OR

    A political pundit/aide/analyst telling me how the entire political system is NOT a mass netword of fraud designed to ever increase the wealth and power of those at the top.

    Seriously, I know technical debates about where to place the blame are fun but at the end of the day once you understand that the entire system needs be sh*tcanned then what’s the point?

    Every second spent still debating nuance is another moment lost rescuing a fellow soul from the grips of propaganda.

    If we’re going to discuss models at all, then why not discuss the general models that Marx left us as they seemingly are many times more accurate in describing capitalism and what crises inevitably affect a capitalist society than anything any capitalist has ever drawn up.

    So, quants, how does it feel that someone successfully predicted that you wealth-extracting fools would be doing exactly what you are now doing than 150 years ago?

    I hope “humbled” is your answer.

    1. SR6719

      “Let the dead bury the dead, and mourn them…our fate will be to become the first living people to enter the new life.” – Marx (letter Marx to Arnold Ruge 1843)

      1. James

        The popular (albeit more often than not misquoted) quote: “In the long run, we’re all dead.” – JMK

        But better still…

        “When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals.”

        and…

        “The love of money as a possession — as distinguished from the love of money as a means to the enjoyments and realities of life — will be recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease … But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight.”

        1. F. Beard

          So, according to Keynes, we weren’t prosperous enough to abolish usury and credit-creation?

          1. James

            Come on now Beard, you’re smarter than that. Keynes was, above all, a realist. Read it again in that light.

  21. Economista Non Grata

    Yves:

    OT: Just watched Moyers and Co…. Great job….! However, you’re in America, this is the only country in the world where corruption has worked it’s way up… Yes, it’s “democratic”, in every sense of the word….

    I understand your righteous indignation and sometimes I feel it as well… But we must keep our eyes on the Big Picture and the fact is that on a “global scale” things have never been better… Just be patient…. It was meant to be…

    1. James

      That’s the allure, although on a truly global scale things have in fact never been worse. But that’s a larger argument.

  22. WorldisMorphing

    Thank you Cathy.
    Thank you for your refusal of passivity. People in your field are no doubt incentivized to row the boat merely down the stream which makes your stance all the more precious and meaningful for the rest of us.

    By the way, could you give a nudge or two to Paul Wilmott for me. From his latest blog post he gives the appearance of being a little jaded…

    http://www.wilmott.com/blogs/paul/index.cfm/2012/6/11/My-Experience-Of-The-OCC-And-Their-Understanding-Of-Risk

    …which is rather sad because he seemed to be somewhat of a recalcitrant but nevertheless, willing (I think;) champion of good & virtue when interviewed for the quite excellent Dutch documentary “Quants: The Alchemists of Wall Street” (with English Sub-Titles)

    http://www.youtube.com/watch?v=ed2FWNWwE3I&feature=plcp

    Try prodding him a little. With Caitlin Kline and Alexis Golstein, you guys could, and should, build the momentum for a worldwide Tobin tax. I read Paul throwing a number like 0.008% . I think it’s a little low. You’d have my blessings if you were to slap him behind the head on that …
    ;)

  23. econ

    The quants were brilliant at maths and knew not much of finance while the financial types knew nothing about maths and the quants. What other sector of the economy could survive on this recipe?

  24. Hugh

    I agree with proximity one. You can not model processes which are not only irrational but self-referential. What relevance can a model have if it assumes a well-functioning system with sound foundations instead of the kleptocracy we, in fact, live under?

    What does it mean that quants are smart enough to understand the limits of their models (Is this even true?) but somehow were not smart enough or simply took an intellectual pass when it came to assessing the potential damage if their models were misused or abused? Fobbing off responsibility and culpability with a “Quants aren’t alpha males” seems really, really lame.

    There is also the question that if you are predicting the future based on past events, do you even know what past you should be looking at? Do you, as F. Beard pointed out at the beginning of this thread, even know about cycles of boom and bust? And even if you see some cyclicity, do you realize that not all cycles are the same, that the period from the mid-90s to today has only one approximate predecessor, the period between 1924-1936?

    And if we look higher up the food chain, weren’t the use of quants by Wall Street just a way to predate on the system, to skim off profits in the very near term with little or no concern for anything further out? Doesn’t the author more or less admit that this is what quants were used for?

    Finally as Warren Celli and jsmith note, aren’t the rationalizations and justifications of a bunch of well paid footsoldiers of kleptocracy just another distraction? As I have often said, kleptocracy is much more than a lot of looting going on. It is the whole system (run by our elites) which promotes, facilitates, and defends that looting. If we start cutting quants slack for their participation in a systemic criminal enterprise, where does it end? Do we let off all the media puppets, propagandists, and pundits for their heroic efforts to mischaracterize, misreport, and ignore all the looting going on? Do we say it was just an honest mistake to all those neoclassical and Austrian economists who gave intellectual cover for extreme wealth inequality and kleptocracy? Do we let off too the MMTers who see some criminality and maybe, like with Bill Black, a lot of criminality, but who still see the financial system as basically sound and can’t see the kleptocracy? If we aren’t going to let these guys off the hook, why should we let the quants?

  25. James

    Ahem. PERHAPS the fact that we HAVE TBTF economies based on theoretical quant models IN THE FIRST PLACE should be the primary concern? Never mind the fact that they’re then placed in the hands hands of certifiably insane Ivy League BS School grads whose only concern is perpetuating they and theirs? Just a thought.

  26. tiebie66

    Prox1 writes: “We are a species that learns essentially via catastrophe.”
    Yes, I fear, from a social point of view, this is why austerity is necessary. From an economic point of view, malinvestments need to be cleared and not allowed to deplete otherwise productive resources.

    1. skippy

      Nonsensical, the malfeasance (purveyors of fine financial dreck) is being rewarded and the enablers of productive resources aka labor are getting depleted – by – the clearing… cough… austerity.

      Skippy… the opposite of what you said… thingy.

    2. proximity1

      True, I do think that we, as a species, tend to learn essentially through catastrophic experience. But I also deplore that and think that we aren’t condemned to this in some absolute and hopeless sense.

      I meant to add in the post you cite this following–also from that sage observer Kondrad Lorenz (and by the way, I misidentified the positive feedback comment of his in its original source; Lorenz cites it in a footnote in The Waning of Humaneness at page 37, from his previous work, p. 29 of Civilized Man’s Eight Deadly Sins, (1974, N.Y., Harcourt, Brace, Jovanovich) which, alas, I dont’ have. Anyway, the following also comes from The Waning of Humaneness,

      “In a certain sense, becoming highly specialized is always, in the long run, dangerous for every creature doing this. Not only is it most improbable that the ‘way back’ can be found; as specialization increases, the possibility decreases that any new and different route can be found at all, should the route one is on turn out to be a blind alley. The number of possibilities for useful applications of every construct (i.e. adaptative specialization), including any tool devised by humans, decreases with its specialization.”

      As I’ve urged previously, we can recognize graduate business management education as an example of a specialized tool, one developed for the adaptive benefit of those admitted to these programs. But this specialization is not only fraught with the dangers that Lorenz points out as inherently part of all specializations, it is at the same time, a powerful purveyor of the antithesis of nature’s processes in speciation–graduate business programs promote a uniformity in analysis and practice, a uniformity that is extremely dangerous and the proofs of that danger are now everywhere to be seen.

      Florence Noiville, Nassim Nicholas Taleb, Benoit Mandelbrot, and others all point out that, to cite Ms. Noiville in J’ai fait HEC et je m’en excuse (I Went to Business School and I’m Sorry), graduate business programs are basically all formed in the same mold; she quized some from her class about their experiences during and after their terms at graduate business school:

      (Note: names have been changed to maintain the annonymity of those quoted)

      “Louis, a consultant in strategy and management, tells me that, for his part, HEC (his elite grad business school experience) ‘didn’t prepare me at all for these 25 years of professional life.’ ‘What I knew and understood about how the world works I gained by on-the-job experience abroad. At Jouy (the GBS campus) I got only basic techniques, lacking in any larger perspective, and an absence of solid grounding in human relations.’ He stressed the ‘ignorance of the history of crises (whether economic or otherwise), the blindness to the flux of resources (raw materials?) and the world’s productive mechanisms.’ … ‘Finally, Louis criticizes the monolithic model of explanation of business affairs’ and the curriculum ‘literally copied from American (U.S.) MBA programs without any introspection on them.’ ‘I confirmed this while at Stanford in the course of the IMP (International Management Program. At Stanford, at least, they occasionally questioned themselves, at HECn never.’

      In his work, On Human Nature (1978, 2004, Harvard University Press), Edward O. Wilson makes a similar point to Lornez’s about generality versus specialization when he considers how, from numerous angles, sexual reproduction is elaborately inefficient as compared to opther forms of non-sexual reproduction. Here, from Chapter 6: Sex (p. 121)

      “Evolution has devised much more efficient ways for creatures to multiply than the complicated procedures of mating and fertilization. … Nor is the primary function of sex the giving and receiving of pleasure. … (p. 122) Moreover, sex is in every sense a gratuiously consuming and risky activity. … Thus sex by itself lends no straightforward Darwinian advantage. … sexual reproduction automatically imposes a genetic deficit. If an organism multiplies without sex, all of its offspring will be identical to itself. If, on the other hand, an organism accepts sexual partnership with another, unrelated individual, half the genes in each of its offspring will be of alien origin. With each generation thereafter, the investment in genes per descendant will be cut in half.

      “So there are good reasons for reproduction to nonsexual: It can be made private, direct, safe, energentically cheap, and selfish. Why, then, has sex evolved?

      “The principal answer is that sex creates diversity. And diversity is the way a parent hedges its bets against an unpredictably changing environment.”

      I invite you to take a moment to mull over the irony here:

      In their wisdom, the directors and administrators of graduate business school programs have devised a highly rationalized and deliberate system which puts a premium on uniformized training—training which even includes presentation of case-analyses of techniques in “investment hedging” as a tool to “reduce risk”! That is, they’ve designed and implemented an elaborate system of training which in its very structure and conception, defies all that the natural world should teach us about the importance of not doing everything, making everything, all according to one uniform set of standard criteria and measurement.

      And, if that isn’t enough, now, with the world’s financial “order” in a general shambles, the received wisdom has it that the best remedy lies in making things even more uniform, more centrally-directed and controlled, so that next time, when the “chemistty lab” blows up, it will mean not one of many “discrete labs” here and there around the world, but the one and only, sole “lab” on which operation everyone, everywhere depends.

      Why would sane, intelligent men and women devise and then persistently promote and defend such an recklessly dangerous “order” even in the face of its manifest failures?

      In part I think it’s because in taking a very blinkered and short-term view, this arrangement tremendously enhances their power, prestige and, not least, their wealth.

      Socially–even economically!–theirs is a recipe for serial disaster and hardship for millions or buillions of people. But it serves the selfish interests of a tiny and powerful set of those who have important influence on the levers of power and on the way the social, economic and political course of our world is set.

      1. skippy

        Probably the shortest and most concise comment, I have read with regards to structural deficiency’s ongoing and its not just a financial problem either.

        Skippy… the biggest problem in my book, is the – personal debt* (*ie self imposed mental positioning some adhere too, which is completely at odds with the evidence) in an almost religious like contract, completely unable to divest them selves from it. Even in the face of diminishment or death for the want of forgiveness… FTW.

      2. jake chase

        I hate to generalize from personal experience, but the dumbest investor client I ever had was a (full) professor at Harvard Business School. He had been fleeced of $15000, which was all the money he had, in a garden variety pump and dump scam. Conclusions?

      3. tiebie66

        “But I also deplore that and think that we aren’t condemned to this in some absolute and hopeless sense.”
        I feel the same way, but as hope rather than belief, because I do not think the current state of the species permits otherwise. Perhaps we can evolve to some such state where we wouldn’t be condemned in some hopeless sense.

        In stable environments, specialization should be favored and in unstable ones, diversification. The upshot of this is that I think stable environments should engender stratified (Old World) societies and unstable ones egalitarian (New World/pioneer) societies. Education for all promotes diversification while competition promotes specialization. In principle then, we can adapt socially to changes in the environment provided they are not too rapid/extreme. Thus, the presence of biological and social diversification (i.e. mutation and education) make me think that as a species we engage the environment with a negative feedback loop. But to avoid catastrophes, we need to engage via a negative feedforward loop instead.

    3. F. Beard

      The “purging of malinvestments” argument from the Austrians IGNORES justice and is therefore not very imaginative either.

      1. tiebie66

        I wonder if you could elaborate, please? I find that I share many of the values that you espouse, but not always the perspective or the approach to implement them. I also find that I must weigh short term negative effects against long term ones but find it hard to estimate them.

        1. F. Beard

          The Austrians ignore that “credit-creation” cheats borrowers too and that deflation harms innocents and investments that would ordinarily survive.

          A universal bailout, including non-debtors, is what is called for but the Austrians never call for it!

    4. Nathanael

      A more extreme theory is that, as a species, we only learn when the stupid people who were causing the trouble are executed en masse. On more depressed days I adhere to this theory.

  27. twodecimals

    I used to be a modeler for a large dev firm, investments with 20 year time frames. I always disclaimed the models I created as having the “illusion of accuracy”. Everything was accounted for, the right number of units, closing costs, etc., but the timing was all projections. Partners would ask to see 2 decimals of the IRR.

    Any model projecting out over 18 months is probably flawed. Multiple years is a joke. Banks lent us $100s of millions based on these projections.

  28. Nathanael

    Here’s a simple heuristic: if the management is honest and knows their business, it’s worth investing in. Otherwise, run as fast as possible.

    That would be called “traditional banking”. Unfortunately, it requires work. You have to personally investigate loan applicants and understand their business sectors. Today’s megabank execs are LAZY so they want to do no work at all.

  29. Nathanael

    “To simplify a businessman’s day. Instead of reading out results from 5 trading desks, we want to dumb it down to one single number, ”

    ^^^^
    THIS

    is the sign of a bad manager.

    A competent manager is worth his weight in gold. But a competent manager doesn’t DO stuff like this. A competent manager needs a simplification of the state of the company/division/department, but NEVER asks for an oversimplification.

    However, competent managers are rare.

    I have come to the conclusion that one sign of a good company is how few managers it has. It is so difficult to find competent managers than you can never expect to have more than, say, ten, so if your company has more than that, it’s going to be incompetently run. (Businesses like Berkshire Hathaway get around this by deliberate selection schemes where they buy entire companies with good management on condition that the management stay.)

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