Sunday, March 8, 2009

Bubble Fuel

As a postscript to Geeks Bearing Formulas, I liked Semyon Dukach’s explanation of the financial crisis. In summary, there are many ways of goosing near-term returns in exchange for risk of ruin later. Investors will pass if the risk is obvious. However, many investors can’t resist the attraction of higher returns if the extra risk is not obvious. Ponzi schemes have this property because they intentionally hide their unsustainability. This hiding amounts to fraud, and thus Ponzi schemes are illegal.

Whereas a Ponzi scheme has a mastermind who understands the con, the reckless use of credit default swaps emerged by itself. The financial instruments were complex, and their use was largely out of public view. However, they appeared to work legitimately, which was all most participants wanted to know. Even money managers who were uneasy joined the crowd, fearing their own returns would suffer in comparison. Fueled by and feeding back into the housing boom, the party kept heating up and up, until it melted down.

In some respects, this explanation seems like a familiar take on why bubbles occur. The thing that interested me was the necessary role of complexity.

As long as the mathematical analysis of the risk of ruin lies beyond the understanding of the CEOs, the money managing organizations can stay competitive by employing their latest version of a return-boosting [gimmick], without admitting to themselves or to others that they have been peer-pressured into the financial equivalent of selling their soul to the Devil.

Put another way, credit default swaps were successful as bubble fuel largely because of their inscrutability. This made them easy to abuse because their catastrophic risk was diffused and obscured among a huge web of complex, private trades. With the risk hidden and the returns good, it was easy for the market, as a system, to con itself.

So, going back to the responsibilities of “geeks bearing formulas,” a key responsibility is to know that the market would rather use a formula for bubble fuel than truth. When the latter supposedly correlates with the former, be wary indeed.

[Dukach’s post put this topic in terms of the gambling system called Martingale, in which the gambler keeps doubling down until recovering with a win—that is, until a statistically inevitable string of losses busts the gambler before the recovery win can occur. It’s definitely worth a read for that angle, which I omitted for simplicity.]

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