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Quants partly responsible for the crisis?

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I found an interesting article by Nassim Nicholas Taleb and Pablo Triana the other day, where they accuses the quants for being partly for the financial crisis we now face.

http://www.ft.com/cms/s/0/4f86d422-c48f-11dd-8124-000077b07658.html?nclick_check=1

By Nassim Nicholas Taleb and Pablo Triana
Published: December 7 2008 19:18 | Last updated: December 7 2008 19:18

On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese's wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese's rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the "bystander effect". This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods).

Let us start with the bystander. Almost everyone in risk management knew that quantitative methods - like those used to measure and forecast exposures, value complex derivatives and assign credit ratings - did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called "modern finance". LTCM was just one in hundreds of such episodes.

Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: "Lehman Brothers and Morgan Stanley use the model" or "it is on the CFA exam" or, the most potent argument, "modern finance and portfolio theory got Nobels". Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory - it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash - universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.

Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative "expert", shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel's credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves - quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: "Thou shalt not follow a multitude to do evil."
Nassim Nicholas Taleb is a professor of risk engineering at New York University PolyTechnic Institute. He is the author of 'The Black Swan: The Impact of the Highly Improbable' (2007). Pablo Triana is a derivatives consultant and author. His new book, 'Lecturing Birds on Flying', will be released in spring 2009



Found an interesting blog about this issue to: Stefan Karlsson's blog: Why Irrational Finance Practices Live On

So, whats your opinions about this and what future do you see for quants?




 
Let's blame the inventor of gun (powder) which lead to death of millions (if not trillion).:-k
 
It's certainly true that if you're flying in the Himalayas, it's criminal to watch your altimeter but not look out the window. This fact does not make it a good idea to throw out your altimeter altogether, though.
 
Read my blog: lawyers (trust) account

'Cause and effect' is difficult to access for politicans, lawyers and newsmen!
 
Taleb may make his dime these days on being provocative, but he's edging into Little Eichmanns territory *.

Overreliance on VaR, sure there was, but there's that pesky bias towards measuring what's measurable, not to mention regulatory strictures (how to determine capital adequacy without quantifying something?).

The metaphor mangling starts with Kitty Genovese (weasel-word "reportedly": sensationalist journalism warped that just-so story, whatever the effect's validity [seems to work both ways]) and culminates in a call to hold "bystanders" accountable for systemic problems beyond their control (responsibility was institutionally diffused to management, and risk experts who said "over my dead body" were roadkill).

I'm not up for a full fisking, but I'll take on the distortions in one paragraph:
Almost everyone in risk management knew that quantitative methods - like those used to measure and forecast exposures, value complex derivatives and assign credit ratings - did not work and could provide undue comfort by hiding risks.
The o-rings on the Challenger "did not work" at extreme temperatures either, as engineers duly and dutifully reported. Managers decided such concerns need not impede decision-makers. Quantitative methods do not encompass all potentialities for a variety of reasons, and fail outside the domain determined by underlying assumptions (e.g., compare errors in extrapolation to interpolation).

Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called "modern finance".
Again, factors operating well outside the range of specification for the quantitative methods. There's a reason not to own one entire side of the market, and there's a reason provisions are made against liquidity and model error. What's been discredited is again overreliance on these methods, the conceit that they capture every aspect of what they model, but that's confusing the map with the territory.

Perhaps also overstated, but cf. a dissenting view on The Black Swan

* Ward Churchill may have "popularized" the phrase, but anarcho-primitivist John Zerzan coined it.
 
Dave Haan's link is to author Eric Falkenstein www.efalken.comThis site has a link to his blog, which is very worth reading.
His academic papers, and his general thoughts on Taleb, are also interesting.
 
Taleb and Triana say:

Almost everyone in risk management knew that quantitative methods - like those used to measure and forecast exposures, value complex derivatives and assign credit ratings - did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing.

And this is correct. But it's silly to blame quants for the current crisis. Quant methods and the presence of quants merely provided a fig leaf, a veneer, of intellectual respectability for the practices of the real movers and shakers. And even the movers and shakers were impelled by imperatives inherent in the economic system. The roots of the present crisis probably lie in a neo-liberal ideology going back thirty years, involving the deregulation of financial markets and an increased emphasis on finance at the expense of the real economy. That is to say, the causes are systemic and not so much to do with actual culprits who wittingly brought this about.
 
Its very easy to blame, criticize the existing system,say all quants and their methods are AHs.

But if you chose to say so then you must provide a solution mathematical or operational.Nassim Taleb doesn't seem to provide an answer he is just asking questions and blaming the quants.

If you can't change the system then follow it.If you can't be a leader be a follower.
 
If you can't change the system then follow it.If you can't be a leader be a follower.

I think that is a terrible conclusion.

The likely solution is going to be more regulation and lower risk appetite for investors. I think all the bonus cutting at banks is just the beginning of their trying to show that they can still self-regulate despite all the evidence to the contrary.
 
It seems that the Editors of Scientific American are similarly confused about models and quantification and their limitations ...

(forgot to mention: posted at bookforum.com today)
 
It seems that the Editors of Scientific American are similarly confused about models and quantification and their limitations ...

Articles like this worry me. Quants were largely (but not always) hired to provide certain kinds of answers -- they were the fig leaf of intellectual respectability behind a huge racket. Had they behaved as whistle-blowers and pointed out the flawed assumptions and limitations of their "models," they'd have been chucked out on the street and replaced with others. They were merely hired hands, not masters of the universe. It disturbs me to see them being scapegoated. Next it will be the photocopier boys who will get the blame. The real culprits are elsewhere.
 
Paul Wilmott is (as usual) more on target:
Paul Wilmott's Blog

Go down to the post titled "Frustration":

As you will no doubt know, I have been frustrated by quants for a long, long time. Their modelling of markets is a strange combination of the childishly naïve and the absurdly abstract.

On a one-to-one basis many people working in banks will complain to me about the models they have to implement. They will complain about instability of the Heston volatility model for example. I will explain to them why it is unstable, why they shouldn't be using it, what they can do that's better and they will respond along the lines of "I agree, but I don't have any choice in the matter." Senior quants are clearly insisting on implementations that those on the front line know are unworkable.


And a large number of people complain to me in private about what I have started calling the 'Measure Theory Police.' These 'Police' write papers filled with jargon, taking 30 pages to do what proper mathematicians could do in four pages. They won't listen to commonsense unless it starts with 'Theorem,' contains a 'Proof,' and ends with a 'QED.' I'll write in detail about the Measure Theory Police at a later date, but in the meantime will all those people complaining to me about them please speak up...you are preaching to the converted, go spread the word!

Amen. And there are still imbeciles out there teaching measure theory to quant students.
 
By Michael Lewis in Conde Naste Portfolio:

To evaluate the situation, he urged his audience to "just throw your model in the garbage can. The models are all backward-looking.

The models don't have any idea of what this world has become.... For the first time in their lives, people in the asset-backed-securitization world are actually having to think."
 
What is wrong with learning some measure theory? It seems critical for fulling grasping Stochastic Calculus.
 
What is wrong with learning some measure theory? It seems critical for fulling grasping Stochastic Calculus.

I have some extreme cases in mind. With the kind of measure theory found, for example, in Shreve, I have no objection (or in Klebaner's Introduction to Stochastic Calculus with Applications).

A problem Wilmott hints at -- or perhaps I'm reading this in -- is that naive quant students unwittingly become slaves to the tacit assumptions behind stochastic ideas (and other mathematical tools), not understanding that their use needs to be flexible and limited -- there's more happening in the markets than can be captured by the inflexible use of these limited mathematical constructs. It's all too easy for a quant to spend a lot of time obtaining a numerical solution to an SDE (for example), not knowing this may not be an appropriate tool for understanding what's happening "out there."

And to make a point I've made before, what's happening "out there" has at a fundamental level been engineered by political decisions: that's where the "laws" of the market are ultimately coming from (barring short-term random fluctuations); not from the inbuilt structure of an SDE, martingale, or time series. It is very different in physics and engineering.
 
http://www.mckinseyquarterly.com/Co...erview_with_the_author_of_The_Black_Swan_2267
The omnipresent Mr. Taleb, on another web site.

"I kept going on and on against financial theories, financial-risk managers, and people who do quantitative finance.
I warned that they were dangerous to society.
Ban portfolio theory.
Frankly, anything in finance that has equations is suspicious.
I would also ban the use of statistics because unless you know statistics very, very well, it’s a dangerous, double-edged sword.
And I would ban linear regression.
Portfolio theory doesn’t work.
It uses metrics like variance to describe risk, while risk comes from a single observation, so variance doesn’t describe the risk.
It’s foolish to use variance."
 
Here's the one thing that really REALLY bugs me about Taleb and all of his black swan outcries:

If the events truly ARE black swans, that means they're so improbable that shouldn't it be extremely cheap to hedge against them with the proper exotics?

What am I missing here?
 
Taleb's thesis is that these are unlikely events that are woefully underpriced in the market because of poor models.

So, you are missing his entire argument, from start to finish.
 
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