Tuesday, March 3, 2009

Geeks Bearing Formulas

Among Warren Buffett’s talents is his quips about investing. “Be fearful when others are greedy, and greedy when others are fearful.” “You only find out who is swimming naked when the tide goes out.” And so on.

One of Buffett’s recent lines is, “Beware of geeks bearing formulas.” It’s a clever soundbite that already has more than a thousand Web pages quoting it, according to Google. But what does it mean? Are geeks with formulas the cause of the financial world’s havoc?

The media have been working this issue too. I’ve already covered The New York Times’ prosecution of Value at Risk, a widely used formula that could roll any collection of a firm’s risks into a single number. Among Value at Risk’s shortcomings was blindness to rare, extremely negative events. It was a known problem, but rather than compensating for it, firms often ignored it or, in some cases, exploited it in ways the geeks had not anticipated. For example, traders would take many positions with small upside in exchange for minuscule risk of massive downside—a move that made their Value at Risk look great, since it hid the small risk of catastrophe in the blind spot. Such positions helped fuel the meltdown when things went bad in 2008.

More recently, Wired magazine featured the Gaussian copula function as a public enemy. This formula was based on the relative value of credit default swaps, a type of financial derivative that emerged with the last housing boom. While times were good it was used to justify (among other things) “tranching” subprime mortgages into AAA assets. However, like Value at Risk, the Gaussian copula function had major sensitivities to negative events in which previously uncorrelated factors all went south together—like all those subprime mortgages blowing up when the housing bubble popped.

Yet for all the guilt by association the New York Times and Wired articles foisted upon the geeks, both articles said the geeks knew and communicated their formulas’ limitations. The problem was, there were few rewards for spoiling the party. The geeks’ formulas greased the rails for new ways of making money, and those betting the money—usually not the geeks—did not want to pull back if others were accelerating. If anything, not being aggressive enough was the main risk on many executives’ minds, since everybody else seemed to be crushing their numbers by pushing harder.

Now, back to Buffett: Although he originally made the “Beware of geeks” comment off-the-cuff in an interview, Buffett has since added context. In his 2009 letter to Berkshire Hathaway shareholders, he said:

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.

That sounds like a fairer assessment, where much of the blame goes to the investors and the middlemen who did not understand the game they were playing—or, in some cases, who cynically milked the game to the point of collapse.

The geeks deserve some of the blame too, but the root cause was the financial system’s tendency to feed on its own success, binging to the point of total disconnection from economic reality. As history has shown with past bubbles, that pattern happens whether or not geeks with fancy formulas are in the mix.

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