Monday, November 2, 2015

On reviewing the recent economic unpleasantness: 2005-2010......................

     What did Bernanke, Greenspan, Geithner and others think was really going on, as risk built up in the banking system?  Perhaps Upton Sinclair pad provided the answer:  it was more convenient, politically and ideologically, not to look or analyse too closely.  And even now politicians and the public are ready to believe that the bewilderingly complex transactions entered into by clever and very highly paid people are the product of profound understanding rather than ignorance and confusion.  Surely that sophisticated mathematics is being put to good use?
     Yet there was and is little justification for this confidence.  The affairs of large financial institutions were impenetrable;  the instruments being traded were hard to understand and impossible to value.  The risk models that were employed were essentially irrelevant to understanding the impact of extreme events (the situation, of course, for which risk models ought to be designed).  David Viniar, CFO of Goldman Sachs,  claimed as the global financial crisis broke in August 2007 that his bank had experienced "25 standard deviation events" several days in a row.  But anyone with knowledge of statistics (a group that must be presumed to include Viniar) knows that the occurrence of several "25 standard deviation events" within a short time is impossible.  What he meant to say was that the company's risk models failed to describe what had happened.  Extreme observations are generally the product of "off-model" events.  If you toss a coin a hundred times and all the tosses are heads, you may have encountered a once in a lifetime statistical freak;  but look first for a simpler explanation.  For all their superficial sophistication, the masters of the universe had no real understanding of what was going on before them.

-John Kay,  Other People's Money:  The Real Business of Finance

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