The equation that blew up the market

From the Mises blog, as also O&M, comes this WIRED story of a mathematical model based on an equation that obliterated the derivatives market-

For five years, Li’s formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li’s formula hadn’t expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system’s foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it’s safe to say, won’t be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li’s Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

The important part-

Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

The bankers, investors, rating agencies, all of them simply ignored the model’s limitations, and Li’s warning – “The most dangerous part is when people believe everything coming out of it.” If I were ultra-religious, I would probably condemn Li and Co. for their hubris, playing God [with the market] etc etc. But even avowed deists like Bush and Obama suffer from a “God Complex” when it comes to markets; they feel, thanks to Keynes and his acolytes (found a new one today, in the Times of India), that the market is something that can be predicted, and centrally planned and controlled. As I have repeated again and again, it cannot be done because omniscience is not one of man’s abilities.

Philosophically speaking, everything in the universe works on the basis of the law of causality – effects always follow the cause. It follows then, that you can predict the consequences of a particular action given sufficient information. However, the more complex the phenomena and the more the variables involved, the less likely that you can predict anything at all. The problem with predicting anything as regards the universe, or the markets, is not uncertainty – it is lack of sufficient knowledge. If you try to do it – predict – regardless, you are indulging in scientism, and Hayek called it the pretense of knowledge. The actions of the bankers earlier, and governments now, flow from either their failure to understand the complexity of the phenomenon known as the market, or their belief in some twisted kind of determinism. Either way they will fall flat on their faces.

All this reminds me of Hans Bethe and his “Three Lectures” on Quantum Mechanics. In the third lecture, he says-

The inventors of quantum mechanics including the best ones like Bohr and Heisenberg and Schrodinger did a very bad service to people by putting that uncertainty principle so high in their discussion. Only the orbits of electrons and atoms cannot be described. But quantum mechanics makes exact predictions for all observable quantities; for instance for the wavelength of spectral lines. It is completely misleading to say quantum mechanics makes things uncertain. In particular, if there were no quantum theory then atoms could not exist because what you have is a nucleus – positive charge – and electrons around it. If you didn’t have quantum theory, the electrons would fall into the nucleus in quite a short time – a second or less – and you couldn’t have any atoms, you couldn’t have any chemistry, you couldn’t exist without quantum mechanics. So the idea that quantum theory makes things uncertain is totally wrong. And of course once the physicists stated it [the uncertainty principle], the philosophers were delighted and said well, everything is uncertain. That is not at all correct.

But, at least in the atomic domain, determinism does not hold. Laplace stated determinism two hundred years ago. He said: If I knew the position and the velocity of every particle in the universe at this moment, I could predict the future, exactly, and I could also predict the past, exactly, and everything is well determined. The premise of Laplace’s statement is wrong in the atomic domain.

The problem today is that people like Bethe’s philosophers and Laplace are running the world – into the ground.

A “convincing explanation”

Jacob Weisberg of Slate writes (link through Antidote)-

A source of mild entertainment amid the financial carnage has been watching libertarians scurrying to explain how the global financial crisis is the result of too much government intervention rather than too little. One line of argument casts as villain the Community Reinvestment Act, which prevents banks from “redlining” minority neighborhoods as not creditworthy. Another theory blames Fannie Mae and Freddie Mac for causing the trouble by subsidizing and securitizing mortgages with an implicit government guarantee. An alternative thesis is that past bailouts encouraged investors to behave recklessly in anticipation of a taxpayer rescue.

There are rebuttals to these claims and rejoinders to the rebuttals. But to summarize, the libertarian apologetics fall wildly short of providing any convincing explanation for what went wrong. The argument as a whole is reminiscent of wearying dorm-room debates that took place circa 1989 about whether the fall of the Soviet bloc demonstrated the failure of communism. Academic Marxists were never going to be convinced that anything that happened in the real world could invalidate their belief system. Utopians of the right, libertarians are just as convinced that their ideas have yet to be tried, and that they would work beautifully if we could only just have a do-over of human history. Like all true ideologues, they find a way to interpret mounting evidence of error as proof that they were right all along.

First, any intellectually honest person will note that libertarians are simply saying “I told you so”. They are agitated and angry, but they are not “scurrying around” because they don’t need to – they are not in power and they didn’t run the economy into the ground. Its the likes of Bush, Brown, Sarkozy, Chidambaram, and (surprise surprise) Putin who are scurrying around, and Chavez and Co. are a bit uncomfortable because falling oil prices might derail his slick socialism. Second, libertarianism’s biggest flaw is its broad definition – the situation is comic, adjust a couple of definitions and Hitler might probably qualify. The libertarianism I believe in is – limited government, zero regulation, and an absolute right to life, property, speech and expression. To my knowledge most libertarian philosophies are in agreement with this; other flavors, I don’t care. As for Greenspan calling himself a libertarian – there is a huge difference between actions and words; Bush supposedly stands for freedom. Concentrate on the actions, and you will know the man.

I dislike (hate is a better word) utilitarianism and utilitarian defenses of liberty. Since a lot of liberals and weak kneed capitalists defended capitalism on utilitarian grounds and went on about how capitalism and free markets were good because they raised standards of living, brought about competition, etc, instead of saying that free markets are right because they are free, because freedom is right, because freedom is moral, these “defenders” find themselves unable to answer criticisms regarding “market failure”. Blaming bad laws and excessive regulation, though these are to blame, does not cut it. And the backlash led by some sections of the illiterate public and a “too literate” media has successfully convinced people that the”free market” is to blame.

Unlike dodo-nomics, the predominant economic theory of our age – pushed to the forefront by the greatest dodo of them all – John Maynard Keynes, and new dodo-nomics, something his worshipers adhere to (ad hominem? guilty), libertarianism believes that government intervention in the market is bad – unconscionable. And unlike some people who can only slot men into two categories – conservative or liberal, without recognizing other forces at play such as communism / socialism and fascism/ corporatism, libertarians understand both, and hence oppose both. Its a nice trick Weisberg plays – saying that Marxism and libertarianism are on the opposite sides and are stricken by the same illness – dogma.

Communism, the purest form of socialism, will never work without a despotic government and without force – the philosophy places society above man, and only an idiot will work watching others eat while others eat watching him work – “from each according to his ability, to each according to his need.” Its bound to fail, and it will kill many in the process. And Marxists cry that it failed because people are not good enough.

Libertarianism, on the other hand, places the individual above society. It derives individual rights and freedom from natural rights, not out of some fuzzy concepts like democracy (rule of the mob). It does not claim that it will lead to some kind of Utopia – such an event depends on how individuals interact with each other in a free society. And libertarianism does not claim that it can somehow control human behavior – it does not recommend selective lobotomy on people’s brains to meet its ends. So, if companies and employees gave out loans without checking the credentials of the borrowers, they were doing it either because they were stupid, or greedy or scared. And libertarianism does not have a cure for this behavior. The punishment, a harsh one, is provided by an “unfettered” (TRULY FREE) market where such companies will sink, such employees will lose their jobs and won’t get new ones (how did you sanction a loan to someone who does not have a regular income, Mr. X? No answer? Good bye.) and governments won’t have the power to bail them out. But the pragmatist that Weisberg is, he is not willing to let this happen, or give ordinary people who took bad decisions “a wonderful lesson in personal responsibility”, or tolerate the creation of “thousands of new jobs in the soup-kitchen and food-pantry industries,” a reference to a massive systemic collapse, depression, joblessness – 1929 redux. The difference between Marxism and libertarianism should be apparent – clear as daylight, at least to those who have not shut their eyes purposely.

Weisberg writes further, “any competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.” But of course – you let the murderer go and catch hold of the one that called the cops while the murder was in progress – plot of Bollywood film #362 of 1986. Worse, the murderer is judge, jury and executioner. I say, go right ahead. It makes no difference. Tighten the screws as much as you want. When the most feared regulator in the world – the Soviet Union – couldn’t stop its economy from collapsing – what makes people think that more regulation will somehow prevent the next disaster? In Book II of Aristotle’s Politics, the greatest philosopher in the history of mankind defends the institution of private property from Plato’s totalitarian republic and its communal laws. And while his defense talks of “censure” (modern day regulation), and he feels that ethics and politics belong together, he points out a very important problem with human nature-

It is clearly better that property should be private, but the use of it common; and the special business of the legislator is to create in men this benevolent disposition. Again, how immeasurably greater is the pleasure, when a man feels a thing to be his own; for the love of self is a feeling implanted by nature and not given in vain, although selfishness is rightly censured; this, however, is not the mere love of self, but the love of self in excess, like the miser’s love of money; for all, or almost all, men love money, and other such objects in a measure. And further, there is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property. The advantage is lost by the excessive unification of the state. Two virtues are annihilated in such a state : first, temperance towards women (for it is an honourable action to abstain from another’s wife for temperance sake) ; secondly, liberality in the matter of property. No one, when men have all things in common, will any longer set an example of liberality or do any liberal action ; for liberality consists in the use which is made of property.

Such legislation may have a specious appearance of benevolence ; men readily listen to it, and are easily induced to believe that in some wonderful manner everybody will become everybody’s friend, especially when some one is heard denouncing the evils now existing in states, suits about contracts, convictions for perjury, flatteries of rich men and the like, which are said to arise out of the possession of private property. These evils, however, are due to a very different cause — the wickedness of human nature. Indeed, we see that there is much more quarrelling among those who have all things in common, though there are not many of them when compared with the vast numbers who have private property.

The magic potion that cures wickedness (and if you read further, ambition and hedonism), where is it?

His final words-

The worst thing you can say about libertarians is that they are intellectually immature, frozen in the worldview many of them absorbed from reading Ayn Rand novels in high school.

Intellectually immature and frozen in a Randian world view. That’s right. In a constantly changing world, we need to be “pragmatic.” All doors should be kept open. If there is a heavy food shortage sometime in the future, we should institute rationing. If that doesn’t suffice, we could think about population “rationalization”. One should not be dogmatic about concepts like freedom and rights – only the foolish libertarians do that. We, on the other hand, are pragmatic because we have declared that we are ideologically bankrupt.
And you could do much worse than read Ayn Rand; read Jeremy Bentham. Rand is good. So are Mises, Bastiat, Rothbard, Hazlitt and Hayek.

Like other ideologues, libertarians react to the world’s failing to conform to their model by asking where the world went wrong. Their heroic view of capitalism makes it difficult for them to accept that markets can be irrational, misunderstand risk, and misallocate resources or that financial systems without vigorous government oversight and the capacity for pragmatic intervention constitute a recipe for disaster.

Unlike the Marxists and the pragmatists, the libertarians don’t have a “model” beyond freedom and rights. They don’t plan to control the economy or society nor do they have some “desirable” ends in mind with people being the means to such an end.
Yes, they idolize capitalism – because its a system that guarantees freedom.
A market is not a person – reason is an attribute of a living person – a stone cannot be rational or irrational. But I am nitpicking; he meant irrational people, of course. Further, to know whether a market is “misallocating resources”, one should know what is the best allocation of resources; who decides that? Perhaps spending billions of dollars in Iraq by squeezing American taxpayers, or stealing from them through an inflationary monetary policy, or giving out loans to Wall Street based corporatists is. What is the definition of disaster and why is it so bad? What is “pragmatic intervention”? These are all undefinable concepts thrown up based on an assumption that there is someone out there who knows more about the market than its participants do – the government.

They are bankrupt, and this time, there will be no bailout.

Keep dreaming.

Now the question that I would have said blows a Titanic-sized hole in the “under-regulation is the root cause” theory, if this were not the case-

But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the “lack of basic information” allowed traders in derivatives “to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority.”

The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.

or this-

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

or this, the innocuous “margin call”-

The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG’s collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive — and ignored until it was too late.

Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty — the institution on the other side that claims rights to the collateral — senior to the AIG policy holders and bondholders.

- while the crisis had its roots in sub prime loan defaults and the crazy proliferation of “unregulated” esoteric derivatives obliterated the “unregulated” investment banks, how did the “regulated” AIG suffer a near collapse and how did “regulated” banking behemoths like Citibank develop billion dollar leaks in their balance sheets?

The articles above give a clear answer – a combination of lack of regulation (derivatives) and failure of regulation (Greenspan). Monetary policy (government) and lending money to people who don’t deserve it (market, and government) still bear the primary responsibility. But lets try to understand the socialist view point – the government is ready to bear the risks related to monetary policy, and even that related to “housing for all”; what its not ready to bear is the cost of the havoc that has resulted from trillion dollar unregulated gambles. What answer does utilitarian libertarianism have to this problem? The socialists say if the derivatives market had been regulated, this bust would not have happened. Allowing for Murphy and the law of unintended consequences, I would agree with them purely on utilitarian grounds. Since the government is not going to give up economic stimulation or stop regulating or stop its bailouts anytime soon, the market will necessarily get distorted, and since the free market does not exist, it won’t be able to punish bad business decisions. The only utilitarian argument I can make is that if a “true” free market were to exist, it would be better for all concerned. But then as Weisberg says, that sounds just like the Marxists. The truth is this – you cannot defeat socialism by turning socialist yourself.

The argument is not about economics, its one about philosophy. The philosophy that lies at the heart of Weisberg’s writings and modern day government is pragmatism – the philosophy of compromise. A government based on such a philosophy does not care about rights; it simply want to serve an end that was conjured up centuries ago, and use people as a means to that end. You are not allowed to ask why that end, or, why should I be the means to such an end? The end is unfulfillable in a free society – rational people don’t enjoy self-flagellation, and so governments demand that it can only be fulfilled if people are “good”, or if they are forced into being good. People are told to be pragmatic. The end I refer to is egalitarianism – forcibly equalizing the unequal; and it has been actively pursued. Since making people rich is difficult (fiat money is not wealth; if it were, Mugabe would be the richest man on the planet), the policy has always been to steal from the rich – make them poor. This is where the idea of regulation comes from. Governments cannot create any value on their own, yet think that they know how to lecture others about the same, and how to “allocate” resources. And when people won’t agree to their diktats, or worse, question them, they come down to their real avatar – the brute brandishing a stick – if you don’t listen to me, I will beat you. A utilitarian defense of capitalism and free markets plays into their hands; that the “greatest happiness principle” is as bad as “from each according to his ability…”, if not worse, is a different matter altogether.

Any attempt at compromising with such an ideology necessarily means a destruction of your own.