Heard through the media grapevine after 1997 Asian crisis and 1998 LTCM crisis (which almost destroyed the system):

"The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning"

Heard through the media grapevine after 2008 credit crisis (which destroyed the system and almost caused a global depression):

"The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning"

To be heard through the grapevine after 2015 sovereign debt CDO crisis (which would do away with the euro, result in the acquisition of Greece by private equity funds, and force President Palin to expulse California from the Union):

"The answer is not to reject quantitative finance but to be honest about its limitations. Models have their places but they must be coupled with more subjective approaches to risk, such as stress tests and scenario-planning"

Let´s think about disgraced “financier” Bernard Madoff for a second. Why is he the uttermost epitome of inappropriate conduct? Why is he the poster child of fraudulent behavior? Why is he unremittingly fingerpointed as the exemplar of badness? Well, if we had to boil it down to a very quick rationale, it would be the following: Mr Madoff knowingly and vastly lied in matters related to financial activities, and such sizeable untruths caused untold despair and economic setbacks to others. That, in a nutshell, is his legacy to future explicators of financial happenstances. He will always be known as someone who produced deceitful fabrications that enriched him while impoverishing the many who got conned into believing.

My question is, shouldn´t we judge the rest of participants in the financial game by the “Madoff standard”? That is, shouldn´t those who, a la Bernie, contribute to monetary pain by purposely and deliberately duping the world also be loudly accused of fraud, relentlessly disgraced as scammers? I need to ask this, because it is not immediately obvious that those who share Madoff´s affinity for financial hoodwinking and capacity for social havoc-wreaking get called to task.

Take the promoters of quantitative finance. The complex mathematical concoctions that have been increasingly used in the markets for the past three decades have contributed to non-negligible chaos. In fact, it wouldn´t be far-fetched or insultingly irrational to argue that the employment of analytical models was behind the worst three market crisis since 1929. While an army of deniers remains hidden behind academic walls, it is by now pretty much conventional wisdom among many practitioners, analysts, and regulators that things like the Black-Scholes-Merton option pricing formula, the Value at Risk capital charge-setting radar, and the Gaussian Copula CDOs-rating model decisively aided and abetted the unleash of the malaises of October 1987 (one-day 25% drop on Wall Street, threatening the system), September 1998 (LTCM blow up, threatening the system), and 2007-2009 (credit crisis, destroying the system).

But even those who do admit to the failings of the quanty concoctions have typically shied away from being too harsh on the concocters and their intentions. When analyzing the excusing that has typically followed the (chaos-igniting) malfunctioning of the math, it is impossible not to distill the main message: the modelers were acting in good faith, honestly trying to model the market as accurately and truthfully as possible; unfortunately, things went awry once the analytics hit the street, but such outcome (aka as “the perfect 1000-year storm” among financial theoreticians) could not have been predicted by anyone. In other words, the argument would go, there was no equations-driven deceit. The math that was peddled would have been peddled in good faith, the models would have been prospectively assumed to be sound and trustworthy, to the best of the modelers’ abilities. Lots of folks may have lost tons of money as a result of imbuing the math into finance, but not, the excusers would point, as a result of the mathematicians cheating anyone.

Or did they? Bluntly put, the assumptions of many of the most widely used financial models are so egregiously unworldly, so alarmingly unrealistic, so impossibly unseemly that it is very very hard not to contend that many peddlers of the quantitative snakeoil must have been perfectly aware all along of the meaninglessness of some of the solutions. Possibly even of the danger that they pose. But the incentives not to share such beliefs and to instead defend the model´s robustness may have been irresistibly tasty. As long as the math is assumed to be reliable and sound, the mathematicians can enjoy the glamour and paycheques of finance. And the math can be a wonderful alibi for banks to engage in the kind of trades that they love most. By conveniently (and widely unrealistically) projecting very little risk ahead, VaR and the Gaussian Copula, for instance, decisively allowed Wall Street and the City to play the Subprime CDOs game that eventually killed us all. If you are a modeller, are you really going to out the models as useless and dangerous or are you going to continue to trot along and profitably rate garbage as if it were gold?

Naturally, by choosing the latter approach you would be incurring in intellectual fraud. People endowed with prestigious doctorates, and who might have previously dreamed of academic glory and yearned for the pure discovery of knowledge, would be corrupting sacred scientific methodologies. They would have contributed to transforming advanced mathematics and statistics into misleading sales pitches in search of a quick buck. They would be (knowingly) contributing to a lie that clouds understanding and that puts the world at large in undue danger. Is that a lesser crime than the one committed by Bernard Madoff?

http://blogs.reuters.com/columns/2009/10/09/dynamite-the-nobel-prize-in-economics/

October 9th, 2009 Dynamite the Nobel prize in economics Did you know that worms cause cancer? They don’t, of course, yet in 1926 Johannes Fibiger won a Nobel Prize in medicine for this “discovery.”

The Nobel committees for science prizes rarely make such amusing blunders, but those awarding the medal for economics have a long history of endorsing ideas that are useless, incorrect and even dangerous.

With the latest winner of the $1.4 million windfall due to be named on Monday, the case is stronger than ever for scrapping the prize altogether. The economics award — created in 1968 by Sweden’s central bank — has always been the odd man out.

Far from celebrating those who have “conferred the greatest benefit on mankind” as Alfred Nobel intended, the economics prize has done more harm than good.

The prize has fostered a faith in economists that is often misplaced. Friedrich Hayek, who won in 1974, said he would have advised against creating the award. The title, he said, “confers on an individual an authority which in economics no man ought to possess.”

Laureates, he suggested, should be required to take “an oath of humility … never to exceed in public pronouncements the limits of their competence.”

Sadly, economists, as a caste, have showed no such humility. The Nobel imprimatur has encouraged us to exaggerate the scientific quality of the dismal science.

Unlike their counterparts in physics, chemistry and medicine, economists have precious little predictive power. Lately, there has been much soul searching about the failure of economists to anticipate the 2008 meltdown. But given the profession’s history it would have been surprising if they had.

Over the past 20 years economists have failed to forecast any of the major twists and turns of the U.S. economy. Economists, as labor leader George Meany once grumbled, is “the only profession where a person could be considered an expert without having once been right.”

Worse still, the Nobel committee has set its seal on ideas that have been extremely toxic. Nobel Prize-winning theories were behind the biggest market meltdowns since the Great Depression.

In 1987, wide acceptance of the Black-Scholes-Merton option pricing model helped turn a market stumble into the worst one-day fall in Wall Street history, threatening the entire system. The model was rejected by traders, yet a decade later Robert Merton and Myron Scholes picked up their check from the Riksbank.

Or take Value at Risk models — backed by the Nobel Prize-winning portfolio theories of Harry Markowitz — which was culpable in both the panics of 1998 and 2008. These models helped justify skimpy capital ratios in the run-up to 2008.

“These theories have managed to transform tranquillity into turbulence, creating crises out of nowhere,” says Pablo Triana, author of “Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?” He adds: “The Nobel Prize helped give them respectability.”

And Nobel-endorsed economic theories helped justify the aversion to regulation showed by policy makers like Alan Greenspan. A long list of laureates from the Chicago school from Gary Becker to Edward Prescott helped promote the idea that governments should stand aside.

If the Swedish central bank wants to give away 10 million kronor a year, that is their business. But the prize should not be allowed to coast on the prestigious Nobel brand. Surviving relatives of Nobel are right to ask that their name be taken off the prize.

Aside from a new name, the prize should also come with a label:

WARNING: These theories should not be used by everyone. Side effects can include: financial crises, turbulent stock markets and banking collapse.

From Wells Fargo (ironically, one of the early pioneers in all things quant) I find it ever more puzzling that VaR defenders never say "VaR is good", rather they say "VaR is bad, but the least bad of all" So I guess for them the pre-VaR world was a cesspool of badness, a plague of incompetent war-scarred market warriors boorishly drawing on their experience-honed gut and intuition. The effrontery of such equations-lacking impudent rogues!

Editor's Note: Dave Napalo, Wells Fargo Senior Risk Management Specialist, answers questions from our readers, covering financial risk management concepts from the basic to the complex, giving you the background information you need to effectively manage the risks you face every day.

Q: I recently saw an opinion article in BusinessWeek that attacks VaR, or value at risk, as a questionable financial risk metric. Do you consider it a valuable tool? The author, Pablo Triana, seems like a lone wolf howling in the wild against many accepted quantitative practices and I am curious to know your stand on his criticisms.

A: For the record and for other readers who might want to consider the source document, the column appeared in the July 30, 2009 issue of BusinessWeek, and can be accessed at the following URL: http://www.businessweek.com/magazine/content/09_32/b4142068736481.htm

While you characterize Mr. Triana as "a lone wolf howling in the wind," the article, "The Risk Mirage at Goldman", echoes the concerns of the highly respected Nassim Taleb, author of The Black Swan. Mr. Taleb has also argued that VaR isn't effective at measuring risk. Triana is a firm believer in Mr. Taleb's work and has written many pieces arguing for the end of VaR as a risk measurement tool.

In addition, one could add Myron Scholes to the list of critics of VaR. Scholes, the co-creator of the Black-Scholes pricing model for options, has asserted that VaR models mistakenly assume that the volatility of asset prices and the correlations between prices are constant. Mr. Scholes knows whereof he speaks, having been up close and personal when the hedge fund he helped found, Long Term Capital Management, disintegrated in 1998 as debt markets collapsed in a manner models failed to anticipate.

The recent distress in the finance industry also must call into question the limits of VaR as a means of assessing risk. But to dismiss it out of hand, as Mr. Triana's column suggests, seems short-sighted. It's an argument that brings to mind the old saw attributed to Winston Churchill's assertion about democracy, with a twist for the financial world: Capitalism is surely the worst economic system, except for all the others that have been tried. And VaR might be the worst system for assessing risk, except for all the others that have been tried.

But specifically with respect to the article referenced, Mr. Triana sets out a series of arguments that seem particularly questionable when closely examined. His main proposal is that VaR, based on historical data, should be replaced with intuition and a common sense approach to measure the risk to which firms are exposed. He claims that firms are manipulating VaR to misrepresent their level of risk: "The person supplying the data to the model can essentially select any dates." Further, he argues categorically that financial institutions need to increase capital cushions and deleverage over-extended balance sheets. However, the question remains as to what level of capital is adequate.

Our rebuttal to Triana's arguments would revolve specifically around the following issues: (1) experience-based systems for measuring risk would still be based on the past-- specifically, a risk management practitioner's personal past and experiences; (2) there is no reason to believe that risk measurement manipulation would decrease with the abolition of VaR; and (3) an increase or decrease in capital-on-hand is a response to perceived risk; this does not make it a substitute for risk measurement altogether.

VaR provides an objective, non-biased method to systematically determine the risk of a portfolio's collective positions. It would be impossible to intelligently discuss a portfolio's risk components without actual, concrete numbers. One could obviously ask a trader how he feels about the risk in his trade book based on his personal intuition, but most managers of risk would in all likelihood prefer to see an objective non-biased assessment.

The author claims that VaR can easily be manipulated by cherry-picking data, which simply isn't true. Banks and other institutions are heavily regulated entities that must follow stringent rules to calculate their risks. Current regulation does not allow for obvious misrepresentations. Regardless, it's difficult to believe that experience-based measurement systems would be less susceptible to manipulation than a historical-data-based measurement tool. One of the oldest assumptions in any traded market is to be suspicious of a trader anticipating the future who is "talking his book." VaR may be subject to criticism, but human emotion and psychology are not forces to which it will fall prey.

While many may agree that banks and other financial institutions need to carry more capital as a cushion against potential losses, this is not relevant in a discussion of risk measurement techniques. VaR can be a useful tool to determine how much risk is inherent in a particular portfolio. The required capital reserves that should be on hand then become an extension of the amount of risk that needs to be offset. That, however, is a subjective assessment and is not a direct product of VaR, or any other system for measuring risk.

The financial crisis of 2008 and 2009 brings to light that VaR must receive a portion of the blame for what has transpired. After all, the financial fallout and massive write-downs of value from the financial industry indicate that VaR methodology did not accurately predict an outcome that we know only in retrospect presented a huge risk. This conundrum reminds me of an economist I once worked with who unwittingly and laughably had the penchant for announcing in his morning briefings, "We expect no surprises today." Surprises by their very nature are unknowable in advance.

VaR attempted to anticipate and measure risk, but was not prepared for the Black Swan that crossed its path as the housing market began a financial meltdown. The challenge and attendant opportunity now is for financial managers to expand their risk metrics knowing what recent history has instructed to make VaR a more robust tool for managing risk. VaR may not be an infallible predictor of the future, but our assertion is that it will work better than any rule-of-thumb guesstimate that Mr. Triana is pining for.

I still vividly remember reading his Capital Ideas on my Washington DC apartment´s couch almost fifteen years ago, being introduced for the first time to finance theory through his easygoing prose

I know that we (I) have criticized theory and theorists quite intensely in these blogs (mostly for good reasons I believe); but if I am honest I must admit that it was precisely those accomplishments (initially heard though the Bernstein grapevine) what originally ignited my interest in high finance and what inspired me to try to become a derivatives person. I very much doubt that I would have worked on a tradig floor, written financial books, and be penning this blog if I had not stumbled upon Capital Ideas all those years ago.

The advantage I had at the time is that, in my lovely innocent naivete, I didn´t know that the theories were wrong and all I saw through Berstein´s eyes were intelligent highly-credentialed people building rabidly sophisticated financial spacecrafts that promised to make tons of dough for their skippers. It was Capital Ideas that first made me want to become a financial astronaut. So in a big sense, and perhaps rather paradoxically for those who read my not-so-innocent current musings, I am in debt to theory-revering Peter Bernstein.

Not sure what he would have made of Lecturing Birds or my myriad of theory-doubting articles, but I hope that he would have found my arguments honest and truth-seeking, even if possibly not entirely his cup of tea. What I most certainly hope is that he wouldn´t have been taken completely aback by them. After all, without his initial inspiration it is a safe bet that those arguments would have never been transformed into printed ruminations.

Courtesy of FT´s Gideon Rachman, one of the best explanations I´ve ever heard on why obscurantists took over the campus:

"I heard something similar recently from a friend who teaches economics at Oxford, who was bemoaning the fact that the course there is increasingly maths-based. His explanation is that maths-driven economics is so obscure and uninteresting to the outside world, that the academics who specialise in it can spend all their time in Oxford, taking over the faculty. By contrast, the economists whose work is empirical and expressed largely in English find themselves in demand in the outside world - and therefore do not have the time to block the forward march of the mathemeticians"

As Taleb says in the foreword to my Lecturing Birds, it is history written by the losers. The guys no one could care about end up dominating the department (and thus the outside world´s overall perception of the Economics discipline) PRECISELY because no one gives a damn about them. Darwinism in reverse! Those discarded by the world survive, those embraced by the world perish The freak no one wants to be around wins, precisely because of his unbearable freakishness. I mean, I totally concur. Have you ever met an orthodox, cloistered economist? Did you also have the feeling that you were talking to Frankenstein or some other type of weird creature? Someone very very freaky. Very very unpleasant.

No, I don´t mean nerds. Economists are not nerds (they wish). Bill Gates is a nerd, the Google guys are nerds, Steve Jobs is a nerd. The world needs nerds, we love them, we want them, we embrace them, we admire them, we envy them, we want to be like them. But who the heck would want to be like an orthodox cloistered economist, envy them? Orthodox economists are the wrong kind of geek. Completely noncreative, just exam-taking idiot savants who had no option but to get straight As because they could not do anything else with their lives. And they know that full well, thus their Torquemada-like repressive and persecutoty attitude towards those more creative, more dynamic, more wordly, more brilliant. And thus their incontrollable cynicism and to-the-bone intellectual corruption.

Best thing I ever did in my entire life was spend my Economics undergraduate years doing anything but studying (dogmatic, stubbornly orthodox) Economics

If Robin Soderling wins Roland Garros this weekend, that would truly be a Black Swan. Possibly more so than the fall of Lehman or October 87. In fact, by beating Nadal the Swede has already gained swany status. In tennis, the rare event is way way less probable than in the markets. A non-top tier player almost never reaches a Grand Slam final, let alone win one. There´s no crash, no meltdown, no outlier in tennis.

As a staunch Federer supporter I pray for normality to rule once more on the court. But I also fear that the Black Swan, having so insultingly dominated its more habitual financial surroundings for the past couple of years, may have grown bold enough to extend its supremacy into the Parisian clay.

Fresh from the Harvard Crimson oven:

"In light of these problems in the risk management process, (Professor Robert) Merton argues for more education in quantitative techniques, instead of shying away from them altogether. “One of the things I think comes out of this is a greater need for modern financial training and knowledge,” he says. “We should be teaching more about modern finance and these tools, not less.” "

With all due respect, this is akin to saying that one of the things that comes out of WWII is a need to translate Mein Kampf into more languages and to open up new Nazi indoctrination offices. When you are proposing as cure a heavier dose of that which caused the malaise, don´t complain if we endow you with the iatrogenist label

Now that my Lecturing Birds is out and about I find myself checking my Amazon.com sales rank almost perpetually. The fact that the new work is behaving more amicably than my prior (more technical, more specialized) literary effort dictates that the amount of time spent refreshing the Amazon page has become unbearably unprecedented. I am now officialy obsessed with the rankings and what they truly convey (is #100 equal to a millionaire book, #1000 equal to a global bestseller, #10000 equal to a decent-yet-not-extraordinarily-rewarding performance, #100000 equal to hold-on-to-your-day-job, #1000000 equal to well-at-least-your-mother-bought-a-copy?). Since I recently offloaded my stock portfolio, continuous monitoring of my Amazon run has become the new nail-biting stress-inducing juices-flowing addiction.

And yet, a writer should spend their time, well, writing not obssesing over the onscreen fluctuations of difficult-to-explain data (you might as well not have left the trading floor if that´s how you get your kicks). So, yes, I vow to use my laptop for pontification purposes only from now on. I better return to that unfinished chapter for my new book. But wait, just one last tiny look at my Amazon ranking.

It seems that Taleb´s enemies insist on playing right into his hands and shooting themselves in the foot. If not long ago Merton made some funny remarks during a Harvard roundtable, it is Scholes turn now.

Allow me to highlight the following from his recent q&a in the New York Times: Q: Some economists believe that mathematical models like yours lulled banks into a false sense of security, and I am wondering if you have revised your ideas as a consequence. A: I haven’t changed my ideas. A bank needs models to measure risk. The problem, however, is that any one bank can measure its risk, but it also has to know what the risk taken by other banks in the system happens to be at any particular moment. Q: What good is a theory of risk management if it applies to one tree instead of the forest? A: Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously the risk-management system of any one bank appears, after the fact, to be incomplete. We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.

I guess I don´t need to point how inappropriate/arrogant/ignorant/antisocial it is for Scholes (manufacturer and defender of flawed lethal theories, sinker of two funds) to openly admit that no matter what´s going on out there he is not changing his mind one iota and that risk management works just fine. The globe may be burning, hopelessly engulfed in a sea of VaR-Copula-NonNormal flames, but hey that´s no reason for this standard-bearer of theoretical orthodoxy to change his ideas just a bit. Let hubris keep rolling on, even after disaster has struck!

But again the point of this post is not to enlighten you on the obvious. Rather, I believe that Scholes interview enlightens us on the true defining characteristic of the theoretical finance establishment: utter cynicism, utter disregard, utter mocking, utter counterfeiting, utter conning, utter swindling, utter duping. The definite unveiling of such state of affairs is one of the most significant outcomes from this crisis. We have seen it hard at work among VaR defenders. Now we see it coming, in an even less remorseful fashion, from Nobel winners (btw, the Nobel was awarded for something that can´t work and that caused at least the biggest one-day drop in equity markets history; note to the Swedes: current events, with the final destruction of sigma and Normality, make that "Nobel" appear even more suspect and your misjudgment even more palpable) These theoreticians just don´t care if the theories work or not, if they destroy or not, if they are ridiculed or not. The lesser of them try to change the subject or cling to tired discredited one-liners so that they can go on making a living out of theorizing. The grandees like Scholes (fat bank account, academic tenure, a demonstrable ability to talk others into investing their money with him) engage in these debates just for the fun of it, for the fun of being able to publicly laugh at the world and loudly state with an open smile "I do not give a damn, and will never ever admit to any failings in my thinking; the world is burning? tough luck, and long live VaR"

For theoreticians to not admit failure in light of the latest mess is akin to Nazi officers engaging in Holocaust-denying. Self-serving, yes. Antisocial, yes. Scamming, yes. They take us for fools, yes.

Taleb mentioned Sudoku as a possible alternative occupation for the disavower-in-chief Scholes. It is tempting to argue that the Obama administration should perhaps devote some of that bail-out money to finance the construction of Sudoku houses where financial economists can devote their considerable brain power to activities other than concocting, promoting, and endorsing machinations with a demonstrable power to cause unemployment, poverty, and desperation.