Tuesday, May 5, 2009

that’s the Rubin trade: it works until it doesn’t

From Reuters:

Felix Salmon

a good kind of contagious

May 5th, 2009

Overconfidence and the financial crisis

Posted by: Felix Salmon
Tags: banking,

Malcom Gladwell kicked off this morning’s New Yorker summit with a talk about the causes of the financial crisis in general, and of the collapse of Bear Stearns in particular, and started provocatively, by saying that if his diagnosis of the problem is correct, then really “there aren’t any solutions”.

Gladwell’s diagnosis is simple: massive amounts of overconfidence, as revealed by its two most common symptoms, miscalibration and the illusion of control. Both of which can be seen in spades in the person of Jimmy Cayne, whose interviews with William Cohan for House of Cards show a man who’s really very deluded about what Cohan, and Cohan’s readers, are going to think of him.

More generally, said Gladwell,

What’s going on on Wall Street isn’t the result of experts failing to act as experts: it’s the result of experts acting exactly like experts act. It’s not a result of incompetence, it’s a result of overconfidence.

When we look for evidence of miscalibration in people, he said, we find it overwhelmingly in experts. We find it when people are in conditions of great stress and complexity and competitiveness. And we find it overwhelmingly with older, more experienced people, doing difficult things which they feel very strongly about.

Jimmy Cayne, said Gladwell, is the picture of overconfidence — and he’s quite typical when it comes to heads of Wall Street banks. And so, Gladwell concluded:

Our goal is not to enhance the expertise on Wall Street. Expertise they have in spades. Our goal is to rein in the expertise on Wall Street. Wall Street needs to be slower, less competitive, and a lot more boring.

This is undoubtedly true — the difficult thing, of course, is how to legislate it, in a world where banks are falling over themselves to repay TARP funds and start taking on lots of risk again. Here’s Matthew Richardson and Nouriel Roubini write in the WSJ this morning:

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn’t the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior — and it’s incredible that there are no restrictions against it.

But if there were restrictions against this behavior in particular, the same banks, or other banks, would find other ways to chase risk, just because they’re so confident that they can make billions of dollars — and get themselves out of their present hole — by doing so. They might even be right: 95% of the time, they probably are right. But that’s the Rubin trade: it works until it doesn’t. And although it’s the easy solution to the problem, it’s also a very worrying solution to the problem, because it just sets up yet another inevitable meltdown at some unknown point in the future."


First, a quote from my teacher, Paul Feyerabend:

“Modern science, on the other hand, is not at all as difficult and as perfect as scientific propaganda wants us to believe. A subject such as medicine, or physics, or biology appears difficult only because it is taught badly, because the standard instructions are full of redundant material, and because they start too late in life. During the war, when the American Army needed physicians within a very short time, it was suddenly possible to reduce medical instruction to half a year (the corresponding instruction manuals have disappeared long ago, however. Science may be simplified during the war. In peacetime the prestige of science demands greater complication.) And how often does it not happen that the proud and conceited judgement of an expert is put in its proper place by a layman! Numerous inventors built ‘impossible’ machines. Lawyers show again and again that an expert does not know what he is talking about. Scientists, especially physicians, frequently come to different results so that it is up to the relatives of the sick person (or the inhabitants of a certain area) to decide by vote about the procedure to be adopted. How often is science improved, and turned into new directions by non-scientific influences! it is up to us, it is up to the citizens of a free society to either accept the chauvinism of science without contradiction or to overcome it by the counterforce of public action. Public action was used against science by the Communists in China in the fifties, and it was again used,, under very different circumstances, by some opponents of evolution in California in the seventies. Let us follow their example and let us free society from the strangling hold of an ideologically petrified science just as our ancestors freed us from the strangling hold of the One True Religion!”

Possibly because of him, I always ask questions like: Why did you need to use math? What are the assumptions of any theory or thinker? Are they exaggerating, lying, fudging,etc.? Is the expertise a skill, a position in a group, etc.?

One thing is very clear, which is that expertise is no guarantee of the ability to reason, write, explain, intuit, etc. If someone were to take the time to document basic fallacies of logic or misstatements of what certain theories say or what certain thinkers believed in the major press sources, it would be a full time job. Just look at the wonderful blog called Adam Smith’s Lost Legacy. I thought of doing a blog like this on Burke, but almost everything written about him is wrong or misleading.

As to our topic, I find these claims of complexity laughable. The expert should be able to explain to you the risks in very simple language. If he can’t, then say goodbye. When you read some of the explanations given for this risky behavior, they often violate common sense or basic reasoning. If you take a risky product, then divide it up into less risky and more risky within the risky product, it doesn’t magically make the risky product less risky.

I’m for Narrow/Limited Banking precisely because we need a foundation to the free market that everybody can understand.

- Posted by Don the libertarian Democrat

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