Why Are We Here?

A number of you have asked me to sum up my thoughts on the causes of the current crisis.  One way to surmise this is to read some of my some of my posts over the last year, but I will also try to write an extensive post about this at some point soon.
In the mean time, at a basic level, my opinion is that the causes of the current turmoil boil down to this:

  1. Hubris: People massively overestimated their ability to analyze the future with simple financial models.
  2. Leverage: Regulatory institutions encouraged risk-taking by turning a blind eye to capital controls and other limitations on leverage.
  3. Innovation: Financial innovation pushed the envelope as securitization driven by 1) and 2) fueled a massive real estate and private equity boom.
  4. Incentives: At each step of the process, incentives were put in place for individuals to create deal flow, issue more mortgages, buy more companies, and otherwise push more paper. At no point did any individual feel that the risks they were creating would be born by them personally…and as it turns out, even by their firms.
  5. Reinforcement: A continuing rising tide convinced each of the players that the models worked, that the system was properly tuned and that nothing was wrong.
  6. Reality: It turned out that the models were vastly over-simplified, that the world was different than expected, and there was too much leverage in the system gone haywire to turn it around.

The key takeaway from all of this is simple: Finance is as much art as it is science, and as such it is much more difficult to model than any other science.

Never forget: Finance is not Physics. The so-called “risk free” rate is not analogous to the speed of light. It is not a truth in any hard sense. 

Nicholas Taleb explains in this article why some risks are difficult to estimate: The Fourth Quadrant: A Map of the Limits of Statistics

When Nassim Taleb talks about the limits of statistics, he becomes outraged. “My outrage,” he says, “is aimed at the scientist-charlatan putting society at risk using statistical methods. This is similar to iatrogenics, the study of the doctor putting the patient at risk.” 

Without any of the above factors, we would not be where we are today. Where to go from here is something I am also hoping to spend some time thinking about soon.

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  1. Pingback: Taleb On Uncertainty | Paranoid Bull

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