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In Finance, History Often Written By Losers

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Nassim Taleb, the famed author and iconoclast, explains in the foreword to my new book how he spent nearly two decades trading a type of complicated financial product known as exotic options, on underlyings such as stock prices, interest rates, currencies, or commodities. In fact, he was there right at the beginning, when those products were being first invented by Wall Street and the City of London, in response to client needs and desires for ever more tailored risk taking. As the years passed, he was puzzled to see the publication of academic papers employing convoluted mathematics dealing with the theoretical analysis of those same exotic options (long after the real thing had began to be traded in the real world) where the products were named after the non-practicing theoretician, as if he had in fact first come up with the concept. Clearly, there was a big attribution problem going on. The world at large was being told something which was plainly not true. The real innovators were ignored, the faked ones were glorified. History got to be written not by those who actually made it into the game, but by those who didn't. What the winners created, the world was conned into believing that the non-winners had designed.

Finance is full of examples of non-winners being perceived and even declared as winners, and thus as the referential icons whose acts and opinions must be unquestionably bowed to and abided by. This clearly is a very dangerous process for nothing could be more lethal than transforming into admired ways that which has failed. Nothing could be more deleterious than allowing demonstrable failures to keep roaming among us, under the disguise of unassailable successes no less.

Take the famous Black-Scholes option pricing model. To this day, almost forty years since it appeared on stage, the indefatigable conventional wisdom remains that this is a practical, needed, successful breakthrough. And yet, the inevitable truth is that Black-Scholes, notwithstanding its technical brilliance, has always been a failure. It doesn't work and it can cause lots of wreckage (the October 1987 crash was indeed caused by the model). That it was awarded the Nobel a decade after it had become crystal clear how flawed and lethal the construct can be powerfully symbolizes how losing propositions are perplexingly allowed staying power in finance. Or take risk "forecaster" Value at Risk, a tool that as much as anything else caused the credit crisis. We had known for years that VaR had the potential for enabling recklessly leveraged reckless risk-taking. Taleb had loudly warned since at least 1996, including prescient mentions of bank failures and public bailouts. VaR had caused wreckage before, and its structural defects were insultingly obvious. Yet, what did bankers and policymakers do? Reward VaR with ever more power, with ever more influence, all the way to the current malaise. An underperforming device was once more rabidly promoted (it is still with us!), and now we burn as a result.

Or take flesh-and-bone characters. A lot of the people who just sank us are still running things, shaping the future for all of us. A lot of losers remain in positions of financial influence. How many Subprime CDO traders, structures, and salesmen who caused trillions of dollars in losses are still holding highly-paid jobs on Wall Street or the City? How many theoreticians who failed to predict and who sponsored destructive math are still being employed by universities and banks? How many regulators who failed to police and who allowed (in fact, enforced) the toxic leverage are still dictating policy? Far too many. Finance may be the only place on Earth where so many people who failed so much are not castigated, reprimanded, or forever banned from the premises. Losers are allowed to stay. Be not surprised then if a future similar destruction is duly unleashed.

Bad things and Texas-size misconceptions have surprisingly long staying power in financeland. Why? Perhaps it's losers protecting losers; perhaps it´s that no one had ever denounced, even noticed, these things; perhaps finance practice and theory are too complicated for outsiders to judge properly and thus the con goes on unperturbed. Whatever the actual reason behind the puzzle, one thing we can be sure of: we can't allow this to happen again. We must learn our lesson and irrevocably conclude from the present mayhem that we simply can't have so many deleterious non-winners not just roaming around but actually getting to shape things in the markets. Too much is at stake.