There are some really, really smart people in finance. Most of them are not that. It's about networks and relationships mainly. Who you know, what sports team you like, what the latest internet thing you can show your customers that is what drives it when you get out of the OTC markets.

A lot of it is throwing out stuff and seeing what sticks from a business perspective. Also and this is a big beef I have personally most of it is short term thinking because the bonuses come on the quarter so everything is done in light of "how much money can I get in 3-4 months" not "how will i do in a year".

Lydy @#2:

The MBS markets were always a little sketchy I thought. The amount of money passing through those markets made it ripe for the bust that happened. I recall seeing Lehman and others go under and the markets scrambling to remove all their risk and positions related to those firms in like a 24 hour period before markets officially opened.

Returning to the original point, in the same article, Davies makes an argument that sometimes there aren't any numbers (see Davies' fn2) and the belief that there are leads to specious results; one ends up, like the Romney campaign, seeing one's own prejudices in random data.

As usual, there is an xkcd about this:

http://xkcd.com/904/

I have it all figured out, thanks to my science of Psychohistory - emphasis on 'psycho'.

Why the "Wall Street types" don't listen to their highly-paid, highly-trained, highly-intelligent quants is really quite beyond me.

I wonder if people still say that, and if they realize that this is also true of people who claim extraordinary expertise with the stock market and similar gambling entities.

Seriously, beta-testing your (complex, with a non-obvious UI) product on election day is just madness.

When the author of 'Outliers' was being interviewed a few years ago, the expatriate Brit doing the interview was incensed that he should claim that part of his succcess was due to luck. "I resent the idea that my success is due to luck. I came here," he said, "a man with a British accent, to become a television newscaster. Do you have any idea how risky a move that was?"

With no awareness of what he had just said.

I've read The Quants. You don't necessarily want someone who knows math but not the markets.

If the book is correct, there were too many guys (again mostly? entirely? guys) who thought you could bet on one thing going up and another thing that ought to go down if that first thing doesn't and look like a genius for a few years.... but then the market is weirder than you imagined and both your bets go wrong and you hemorrhage money.

Less giddily, Thorpe (the fellow who invented card-counting) had a gut level understanding that things could go wrong and the younger generation tried to coast on his ideas without really understanding them.

See also Goodhart's law: Any shortcuts to actually understanding what's going on (business people understand money! we can trust past results! we can trust credentials!) is likely to eventually get bitten by whatever was left out.

No, Wall Street financiers are not Masters of the Universe, no matter how easy it is for them to believe their own hype. Now, if only contemporary journalists could be persuaded to pay attention to the counter-narrative. Unfortunately, contemporary journalists appear to be extraordinarily gullible. Or perhaps it's just that they really really want the Wall Street mythology to be true, because the people who pay their salaries also really really want it to be true.

I suspect a lot of the gullibility of the "journalists" (they're really more like stenographers) who report on Wall Street stems from the unwillingness to do their own research; they get most of their information from interviews and press releases. This comes in part from the great stress placed on the press in general as newspapers and other traditional outlets downsize to cut costs as their readership declines; the more stories you can write in a given period of time the more competitive you are as a reporter and the more likely you are to keep your job, and research takes time.

I've had considerable dealings with industry analysts in the high tech sector over the last 20 years or so, and as far as I can tell, they have exactly the same failings as the brokers^$. They pick the companies and products they think will be winners based on gut feeling, and then find rationalizations to back up their guts^¥.

$ My first pass at typing that word came out "borkers" which I think is appropriate.
¥ Yes, entrail divination continues to be used in the modern world.

I feel like we need to start nailing some of these cowboys on failing in their duty of care to their clients and employers. And where they don't have a duty of care, we need to establish one. It won't help everything, but I feel like it might help limit the scope of the problem, which is significantly a problem of cultural tolerance.

Thank goodness for that. Some of them I'd rather not see garbed like Dolph Lundgren.

The markets, be they equities, fixed income, currency, or whatever are a mix of numbers and the human side. Problem is a lot of the people running it don't trust the technology for all sorts of reasons both right and wrong.

There's nothing wrong with making a risky bet, as long as you're willing to lose it. The Wall Street firms bet more than they could lose, and the government had to step in. Now, that said, the Wall Street bailout made a pretty profit for the Federal government, so it's not so clear-cut an issue as "the taxpayers ended up shouldering the debt with nothing to show for it".

Nancy Leibowitz @13: "Knowing the market" amounts to "gut instinct". Of course things could go wrong -- things could always go wrong. The problem is not that things went wrong, the problem is that when they did, they nearly took the country with them. "The housing market can never go down" wasn't driven by the quants, that was driven by "gut instinct".

As to gender balance on Wall Street -- among my friends (who are mostly back-office quant or tech types), at least, it's pretty even. Outside of my friends it probably skews male, but it's still not nearly the old Good Ol' Boy's club.

What's the right way to limit the risks banks take on while still allowing them to do their job (which is to take risks with a positive expected value overall)?

I expect there are people who could look at the quants' math, and those people's guts would go "ow-ow-ow" because their gut feelings would react immediately to the lack of concern for things going wrong. Unfortunately, the math was so complex and the idea of hiring mathematicians and physicists was so shiny that the few people with the right instincts didn't have enough authority to deal with the problem.

Another wanted to go become an actual physics professor; the first job he applied for, he was one of the top three of 600 applicants for a job at a small state college, and the next year he actually got that job after the top guy bailed on them. Physicists don't become quants just because they want the money and excitement of Wall Street, it's where they go slumming if there aren't academic jobs around.

And one of the big reasons that "knowing the market, not just the numbers" matters is that the models all rely on independence or correlation of events, and the numbers don't always reflect the underlying correlation of events except in rare circumstances, e.g. mortgages failing are pretty much independent noise as long as the average housing price doesn't drop more than 20%, but if it does you find that there's a strong correlation between all of them, so that tranche that Moody's rated as AAA is really just as junky as the tranche they rated Junk--. So if they're just following the numbers, quants can make a reasonable profit on the not-quite-random fluctuations, unless the bottom falls out of the whole game.

So far as I know, the entire quantitative establishment has ignored his work, on the theory that he didn't know what he was talking about. Even if he was wrong, that's hardly a rational way to analyze conclusions which, if true, can have serious consequences for the global economy.

All it takes is one bug, or even just an incompatibility between the algorithms of two different traders to create unstable market behavior. You may remember that in August what was supposed to be a limited beta test of a high-frequency trading system slipped its leash and ended up costing the company running it over $400 million.

Understanding things is a skill. Convincing people to believe you is another skill. Real life isn't like a completely balanced point-based RPG, but still, time spent developing one skill is not spent developing the other.

On top of that, if you understand things thoroughly enough to make qualified and hedged rather than sweeping and absolute statements, to some people that makes you *less* convincing.

they’re closer to being professional gamblers than mathematical scientists.

Actually, I would bet (ha!) that of Wall Street brokers, professional gamblers, and mathematicians, the Wall Street brokers are the least like the other two. Although it may depend on what you're gambling on.

We had a functional answer to that during the decades between 1930 and 1980, in the existence of banking regulations which pretty solidly prescribed the amount and types of risk a bank could take on, and yet the banks flourished.* Those regulations were systematically demolished between 1980 and 2000, with results which should have been entirely predictable. Deregulation is what got us into this mess, and yet Wall Street continues to yell for more deregulation as a solution. To which I say, the hell with that -- let's see some RE-regulation!

* We also had Savings & Loan Associations -- remember those? They were deregulated starting in 1978, and it took about a decade for the entire industry to go glub, at a hefty cost to the taxpayers. You'd think someone would have taken the warning to heart.

I get it. But it's the difference between taking stupid risks and taking informed risks. And an informed risk isn't just "this seems like a pretty good gamble and I think it will probably pay off," but includes "and it's within my client's risk tolerances, which may or may not allow for a high degree of uncertainty."

Put it another way - you can make conservative bets or risky bets, or mix it up. But when people assume it's all gambling, and start taking lots of really risky bets because "it's all the same" and when nobody's paying attention to the odds because they're too focused on the high payouts at the other end of a long shot? That's a problem. A duty of care would require folks to pay attention to the odds, and also to their client's specific circumstances, before deciding what bets to place. When their professional licenses are on the line, people pay attention to that sort of thing.

We had a functional answer to that during the decades between 1930 and 1980...

This is just fractally wrong. With stable inflation, and stable exchange rates, the 3/6/3 rule worked fine. It stopped working when inflation rates started rising in the early 70's; the late 70's deregulation was an an attempt to cope with the resulting mess.

Venture capital is a whole different kind of investing -- statistics of large numbers don't really apply. (Or that's how it seems to me, anyway. Not a finance expert here.)

In my time I've seen it's less a distrust of the math but more a "i know better" thing. For all the risk taking unless something is happening they think will make them money they will ignore it at best. I've seen this a lot with new tech or tech that is hard to understand.

If it's good enough for Alan Greenspan, it's good enough for me.

It's a pdf, but I think this history from the FDIC is a good summary.

Is there anyone who doesn't have Acrobat reader on their computer?

This is why I see no reason not to regulate the hell out of banks, and to severely confine their business. There are a lot of good operators, and then there are those like the Levitts who were beyond what parody could possibly dare to depict. The collateral damage of letting the market deal with the latter is simply too high.

In general, bailouts imply strict regulation, if you don't want to run a system where the taxpayers cover the bad bets of the bankers from time to time. And the deposit insurance stuff worked okay in the financial meltdown, right? I mean, the big problem was not with banks collapsing and taking their customers' money with them, but rather with very large and shaky banks/financial companies having large and hard-to-assess exposures to other shaky banks, so that it was hard to decide whether a given bank was safe to lend money to. The biggest banks/financial companies in the crisis were given overt and hidden bailouts, under the "too big to fail" theory.

Now, IMO, too big to fail means either too big to exist, or so big and systemically important that it should be taken over by the government and run as a public utility. I'm no expert, but I do not understand why Citibank and Goldman and the rest get to continue doing business with a de facto US government guarantee on their debts, but without enormously tighter regulation. Indeed, it seems to me we'd be better off breaking those huge banks up and using antitrust or financial laws to keep them from re-forming.

Usenet has a lot to answer for.

Friend of a friend back in the '80s played the stock market very successfully. He had a very simple algorithm:

1. What are the possible gains?
2. What are the possible losses?
3. Can you afford the losses?

If the answer to 3 is 'no', you don't bet. The answer to 3 is NOT "can't possibly lose!"

They don't beat the market either -- as a class. Some get lucky, beat the market and get on the cover of adoring business magazines. Thousands go bankrupt in obscurity and shift the real costs of their operations onto their innocent counterparties. All hail the awesome power of the free market.

I'm not on dialup, but I find them annoying because I need to confirm the download, and then take the extra step of figuring out whether to keep or delete them. It's just more cognitive effort than opening and closing tabs.

More generally, I try to cater to other people's dislikes without necessarily trying to adjudicate whether they're reasonable or not. I don't know if you were intending to come across as judgmental (rather than simply curious) in your comment, but that's the effect your comment had on me.

Additionally, PDFs can be used as a vector for attacking peoples' computers. I gather this is not all that uncommon when you're trying to selectively install keyloggers or other malware on activists' computers--put out a PDF with some kind of payload that takes over Acrobat Reader and then installs the keylogger, and you magically get to spy on the computers of a whole bunch of people who are downloading documents on Chinese human rights abuses in Tibet or something.

The annoying thing about this is that PDF files are the standard way to transfer big documents around, despite the exploits. However, it's not a bad idea to find an alternative PDF viewer instead of counting on Acrobat Reader, and it's a very good idea IMO to set your browser to download PDF files, rather than opening them automatically.

It also makes it plain that what happened wasn't, "Banking" so much as bilking. The "banks" weren't making money on putting money to work, they were making money on sales.

Anyone who was paying attention should have known there was a disaster coming. I did, back in 2005. If I'd had a small fortune, and known about things like, "default swaps", etc. I could have made a big fortune.

Because I saw a television ad. From that ad (telling people the way to get out of renting was to buy a negative amortization loan, with a three year lag time to the ARM phase), and from Alan Greenspan touting ARMs, I knew 1: there were a lot of loans guaranteed to fail and 2: the "numbers guys" were clueless, and possibly had ill intent.

Sam Chevre: It's possible that the deregulatory waves in the 70s/80s were attempts to deal with some systemic problems, the evidence on the ground is the solution was worse.

The problem with such things is the experiments can't have a control negative. We don't know what doing nothing, or doing something else would have done.

I do know that when the parallel sort of deregulating was done, a fairly similar metastasis of the banking sector; to what happened in the S&L sector, took place.

A type of failure which hadn't been seen in the time of the regulation. I know (because I was alive in them. I recall lending rates in the 17-21 percent range. My family bought a house in 1976), that I think the solution is worse than the problem; esp. with the "austerity" being touted to fix the fallout.

I would absolutely agree.

I disagree with "we had a working system"; I don't at all disagree that "once we messed with it, it was even worse."

Was the banking system too inelastic? I don't know, but I do know the deregulation of banks (not S&Ls) didn't really take off until Clinton (and the repeal of Glass-Stegal), so it's hard for me to say, "It was broken", when it recovered before the tinkering; and exploded afterwards.

Esp. because there are extant historical examples of that same pattern, Holland, in the time of Tulips, and then England in the latter Victorian era. Their markets went from making/selling THINGS, to selling "investments", and then they collapsed.

I wish I could remember the book which was detailing it (No, it wasn't McCauley).

"I disagree with "we had a working system"; I don't at all disagree that "once we messed with it, it was even worse.""

I would assert that, at least in the S&L fiasco.

From my understanding, the problem in the late 1970's (before deregulation) was that the inflation of the late 60's onwards had killed many S&L's, through no fault of their own. The business of an S&L was to loan money at fixed nominal rates over long terms, while taking in deposits which were withdrawable upon demand. Let's say that a S&L had loaned out their deposits at 5% for 20 or 30 year mortgages, while paying 3% on those deposits. When an inflationary period hits, their real loan rate could be negative, and people withdrew their money to invest in things paying over 3% nominal (such as real estate).

The way that I heard it was that in 1980 this was estimated to need a 50-70 billion $ FDIC bailout of depositors. The Reagan administration decided that the way to cure that was to deregulate, and let S&L's move into higher-yielding investments to make up their losses. Apparantly there is no risk-reward trade-off in right-wing economics.

Two of the effects were (a) riskier investments sometimes led to serious losses, putting the FDIC deeper into the hole, and (b) the deregulation include (probably deliberately) looser ownership restrictions, allowing real estate investors to own S&L's, which they promptly looted to fund real estate games.

This took a $50-70 billion problem and turned it into at least a $250 billion problem.

The usual quote used to respond to that idea comes from Keynes: "Markets can remain irrational a lot longer than you and I can remain solvent."

That is, many people can see that a bubble is inflating, but that doesn't mean that you know when or how the bubble will deflate. Sometimes it can go on for a very long time overinflated, while you lose money betting against it time and again.

Some aspects of deregulation I think were OK and even necessary. There was no way that the banks could have survived the Fed's interest rate hikes without more flexibility in setting interest rates than they had. (One can question whether those hikes were a good idea, but that's a separate issue.) OTOH the removal of the wall between retail and investment banking was and is a big problem. One of the points of that barrier was, after all, that an investment bank that went bad could be left to fail without involving the FDIC. And surely one of the lessons here is that forcing the banks to do ordinary business simply both makes supervision both less of a burden and more effective.

I am convinced at this point that there's going to be a crisis, who knows how many years off, revolving around student loans. The only thing that makes it not as bad is that it seems to be free from the "get rich quick through wheeling and dealing" curse, so the money doesn't pour into in with the same abandon. But there is no way that the current pattern is sustainable, and the perpetual indenturement of current loans can't last. And when it pops, the college costs bubble will have to pop with it.

Back in the 90s, Acrobat Reader would pretty often crash Windows machines, in my experience. It was a reliably buggy program back then. I always figured that's why people started warning for PDF download links.

I think the habit's stuck around because it's nice to know in advance that the link you're clicking on is a link to download a file, for workflow reasons (as abi mentions) if nothing else.

I did some reading on the people who made money on the crash... The leverage of being on the winning side of a CDS, or the more insance CDO (which were just bundled CDS) was in the range of orders of magnitude, for a fixed annual cost.

So for a 3 tenths of a percent you could be entitled to all the insured funds. All you needed was the couple of million a year to pay the rate. A fund that had a couple of billion could do that, so long as the investors were willing to take the up-front losses.

And by 2005, anyone who was looking at the details (as I was seeing the big picture) could have seen the writing on the wall. A few did. They made tens of billions on a couple of hundred mill.

If you are rich, you can make a fortune.

I'd push that "1980" back to "1940" for a small consideration, and back to 1900 for a larger one. The Modern Firsts market is a classic bubble.

My rule about collectibles: "Never spend more for something than you'll get back from the pleasure of owning it." That's the only way I know of not to lose. The art lies in predicting the pleasure/cost ratio.

If you are rich, you can make a fortune.

If you are rich and have better sense and more information than most of the people around you, you can make a fortune. In other words, you probably won't.

I still think he didn't need to write any more books in the series after the first (which I said before the second was published). Everything I needed to know was in the first one. But -- I still wanted to read more. I just wish he'd done a better job with the "more".

IIRC, some people did, but they were sneered at, and in some cases fired, for their negative attitude.

IMO, the first lesson of the crisis should be: Never demand a positive attitude from someone whose job is prediction. If a disaster really is coming you need to know about it and shooting the messenger is suicidally stupid.

The man who doesn't believe in bears will be the first one mauled. Ditto bear markets.

But that would be a good thing, right? Us J. Random Populace who refuse to get student loans could maybe afford a college education again? Or would it just mean that the universities' financing would collapse?

The first point I recall was that until the 1960s, the UCs were essentially free (they charged no tuition, and only minimal fees). Pretty much anyone who got accepted could afford to attend. Apparently Governor Reagan didn't like the problems caused by Berkeley students (and faculty), and so did all he could to reduce state funding to the UCs. Today, the UC "fees" have risen to rival tuition at private universities.

The second point was that one of the Regents of the UC system is also one of the largest investors in the Apollo Group, the largest for-profit higher-education company, owner of Phoenix University among others.

I don't expect the coming changes in higher education when the student loan bubble pops to be good for society as a whole.

The article for your first point might have been this article that I Parheliated last month.

It makes no mention of the Apollo Group, however. So maybe not.

I apologize for (unintentionally, but sloppily) propagating misinformation.

Education for the children of the 1%? Not sure how that's a good thing...

-- I don't see your remark either in the moderation queue or in the spam bucket, so I think your remark is pining for the fjords.