In Finance, History Often Written By Losers

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.

Comments

[Pete Muldoon]

Good Post.

I think the reason that failure is rewarded by a continuation of power is because it is not a failure to the people who are responsible. The CEO's, executives and traders who over-leveraged their companies to the point of insolvency still made out like bandits. They are not returning the bonuses and salaries they got from engaging in unsustainably risky behavior. They did not rely on VAR, or get fooled by VAR; they used VAR as a justification for behavior that they knew, or should have known, was risky.

So until the shareholders, regulators, and taxpayer collectively understand these faulty theories and are willing and able to end their use, we will have more of the same.

[NevaforLeadership]

Wasn't the Black and Scholes Option Pricing Model the culprit that contributed to the demise of Long Term Capital Management in 1998?

[research]

What group is willing to spend billions for decades centuries even to accomplish their goals: multinational Corporations, World central Banking. Ever since FDR, the greedy people have been funding think tanks and "controversial" authors supporting deregulation of money and reduction of democracy. It will probably always be worth it to greedy sociopaths to attack democracy and support their own unlimited plutocratic desires.

Throughout history, the people have learned over and over again that GREED is the Evil, in fact, Greed appears to be the Main cause of all evil.

Over and over again, we tricked and lured back into worshiping greed, only to crash and suffer.

The DLC is the latest Trojan horse from corporatist. Plan "B"

was 10 years in the making, corporatists can afford long range plans. If the Reagan revolution didn't completely destroy democracy and unleash greed.
With all the MSM, corporatists, it was easy to arrange to sucker punch Dean and Kucinich, and convince the audience of their unsuitability, since only facts contradicted that.
Till the people learn, the people will suffer further degradation.

Obama fooled us. I hope I am wrong: Obama has till the 2012. Rahm fooled us, with his hand picked stealth corporatist conservative fake democrats. In 2010 we will have access to better information from the Internet, than ever before. We will be able to go to group like MOVEON (who the GOP and DLC "censured") and see who the fake democrats are.

Kucinich/Dean 2012!

[DiogenesOfAlaska]

2/2

But I think your point of view on the relation of theory and practice is skewed as well - and most likely, the same thing happens in your book, if the title suggests anything about its content: it may very well be the case that some theoreticians are many years behind some practitioners. But if there's any way at all proper risk management can be implemented, there's no way around sound theory. To count on practical success alone when it comes to risk management is to abandon risk management. It is true that in some areas of business, this is actually the right choice, because risk management is impossible in some markets. But those are deals that shouldn't be done in the first place, or if at all, they should certainly be done only by people betting strictly their own money that they can afford to lose in full.

[DiogenesOfAlaska]

1/2

You are intermingling things of a quite separate nature.

Whether some option or option-price formula gets named after the 'true' inventor or after one of the many reinventors is a minor question of fame - and hence irrelevant. It is also fairly common in science and in mathematics in particular. In fact there is even a Murphy-type law stating that no formula or idea is named after its true inventor. It doesn't matter and everybody knows it.

The other question is about failure in a job with huge amounts of money at stake, typically other people's money. That's quite a different story. But here the reason has nothing whatsoever to do with chic or stylishness of fancy names of fancy formulas. When it comes to highly paid jobs, people tend to not pay attention to that. The problem is, indeed, that they often also don't pay attention to performance. And that's bad.

[marlovian]

Occasionally, HuffPo actually posts a useful thread. This is one of those rare occasions.

[NevaforLeadership]

You might be interested in the following link. HuffPo didn't actually provide it. A poster provided it in a HuffPo Palin thread.

One of the most interesting articles I have read through HuffPo.

http://www.alaskadispatch.com/palin-watch/1283-palin-how-she-gained-control-and-then-lost-it

[FloresdelaHoz]

Senator Gramm, Robert Rubin, Larry Summers, Hank Paulson, Hank Greenberg and Joe Cassano should be tried as traitors for exposing America to trillion of US$ in derivative losses and exposure as well as creating a global financial meltdown that has been globally blamed on the US and the UK . These greedy narcissus facilitators of Financial Weapons of Mass Destruction (“FWMD”) critically wounded Anglo-American capitalism. They have done more harm then all our foreign enemies combined.

Murdoch should also be tried as a traitor for using his media empire to employ smoke and mirror tactics (e.g., tea party) to help out the Wall Street Oligarchy from having to face the music for their actions. Murdoch's media empire should be broken up in the US before it does more harm to America.

Geithner and Cuomo are owned by Wall Street, they should be replaced with Krugman and Eliott Spitzer NOW.

[ThePeoplesKey]

Agreed.

Banks should be outlawed from doing anything other than banking. That is, providing a place to house and distribute capital issued by treasury. A utility if you will. Why was the secondary mortgage market created to begin with? In order to provide liquidity to lenders so more money would be available to lend to potential home owners at less cost and less risk than could be provided by "in house" deposits or what's known in the industry as "portfolio lending." Without getting into a long diatribe about how it all works, suffice to say that it worked very well for decades until banks were allowed to become "investment banks."

My question is this; since historically it has worked so well, why not remove the middlemen (lenders) entirely and just lend from the treasury directly to citizens through what would basically be "bank utility" companies? Everyone would pay far less interest and the treasury would get the interest profits directly from citizens. Seems to me that this scenario would be far more efficient, safe, profitable, and reduce the need to tax in other ways to fund the government.

Of course, that's probably why it will never happen . . .

[Bush-Rolled]

Couldn't agree more. And one of the most egregious consequences as you state, is that when the manipulated profits, often very substantial, compete for products and services with hard-earned dollars, prices for goods and services go beyond the reach of the productive members of society.

[elkabong]

True wealth (besides the good one gives to the world) is created by taking raw materials and producing finished goods for market not by pushing paper around - no matter the direction.

[Henry]

You would do yourself a world of good to always make the comparison of what a newly minted financial instrument actually produces in comparison to the work product of a farmer producing wheat. Financial instruments are glowing if they produce money but money is not something which should add to the gross domestic product. For a simple example: What is it that naked shorting contributes to the economy? You say, maybe it contributes liquidity. But what if it is really used to manipulate price so a group of corrupto bandits can make a take? Wall street is full of bandits creating money that has not been earned. This money competes for the rest of products and services contributed by people who have actually earned by contributing something to the pie.
The problem here is not the crooks (what they do is legal) it is the system that permits this bs.

[WIpatriot]

Right you are, Henry.