Picking a Lock with a Wet Herring

Will Shakespeare: “Words, words, words... Once, I had the gift. I could make love out of words as a potter makes cups out of clay; love that overthrows empires, love that binds two hearts together come hellfire and brimstone. For sixpence a line, I could cause a riot in a nunnery. But now...”
Dr. Moth: “And yet you tell me you lie with women? ... [consults notes] Black Sue, Fat Phoebe, Rosaline, Burbage’s seamstress; Aphrodite, who does it behind the Dog and—”
Will: “Aye, now and again, but what of it? I have lost my gift.”
Dr. Moth: “I am here to help you. Tell me in your own words.”
Will: “I have lost my gift. ... It’s as if my quill is broken. As if the organ of my imagination has dried up. As if the proud tower of my genius has collapsed.”
Dr. Moth: “Interesting.”
Will: “Nothing comes.”
Dr. Moth: “Most interesting.”
Will: “It is like trying to pick a lock with a wet herring.”
Dr. Moth: “... Tell me, are you lately humbled in the act of love? ... How long has it been?”
Will: “A goodly length in times past, but lately...”

— Shakespeare in Love

Apologies for the relatively lengthy hiatus, Dear Friends and Readers, but lately I have been sadly humbled in the act of writing. Specifically, I have been unable to post at this location for any number of reasons. Without boring you with particulars, these reasons include:

• Not having anything to say;
• Not being interested enough in anything happening in the world at large to write about it;
• Being exhausted with the neverending wrangling and partisan hackery which has taken over commentary on the financial system and its regulation;¹ and
• Finding no inspiration anywhere else.

The realization dawned on me this afternoon that I was in a pickle when I discovered I was about to post a poem on this site which I had already posted a year and a half ago. And it wasn’t even that great a poem. I was just desperate to post something.

My dilemma is exacerbated because I have barred myself from many reliable sources of stories, parables, and lessons learned, including those in my personal and professional life.² Unlike, say, Outer Life, who has penned some remarkably candid and wonderful pieces on his unfolding life story, I have chosen to mask my own identity beyond a limited number of superficial details and anecdotes. Notwithstanding the impression of most outsiders, Manhattan and Wall Street are each remarkably small places, and one too many details might allow a diligent person to triangulate my identity. This itself might not be so bad, but I would much prefer not to go to prison for the murder and dismemberment of any such misguided soul.

Likewise, my professional activities are off limits here. Not only because I do not want to tip my hand to eager enemies and competitors over clients and transactions I may be working on or have completed, but also because the SEC and even that toothless self-regulatory fossil FINRA would likely take an exceedingly dim view of such unapproved and noncompliant communications. This is not even to mention my duty of confidentiality, secrecy, and discretion to my clients and my colleagues which I—less unusual in this way among my industry peers than our haters and detractors (would prefer to) believe—defend and prosecute diligently.

* * *

So with this entry I have resorted to the last desperate act of a blocked writer: writing about writer’s block. A cheap and shameful maneuver. Fortunately for you, I have enough pride left that I will forgo any more posts on this selfsame topic for quite some time.

Now I truly have nothing left to write about. Enjoy the respite. You are welcome.

¹ Most tiresome and enervating of all is the sheer bloody-mindedness of most commentators and pundits in this regard. It’s as if nobody is actually interested in participating in a debate designed to reveal the truth about the problems and challenges facing us, but rather they are just interested in advancing their own one-note crackpot theories and agendas at as loud a volume as possible. That, and/or flog their books.
² This includes, for obvious reasons, the personal and professional stories of most people known to me.

© 2012 The Epicurean Dealmaker. All rights reserved.

Ready, Fire, Aim

So what I told you was true… from a certain point of view.

— Obi-Wan Kenobi, Star Wars Episode VI: Return of the Jedi

The news out of Old Blighty this morning that Bob Diamond, CEO of Barclays, has resigned under pressure seems to indicate the ongoing LIBOR fixing scandal is finally gaining enough momentum to fly off the rails. The current rumblings are that Mervyn King, Governor of the Bank of England, wiggled his stately eyebrows disapprovingly and conveyed, with the minimum regulatory fuss, that, yes, indeed, he would be exceedingly obliged if the presumptuous Mr. Diamond were encouraged to remove himself forthwith to a less embarrassing locale. Like, say, Inner Mongolia. Perhaps unfortunately for Mr. King, Lord Turner of the FSA, and their minions, however, Mr. Diamond is scheduled to testify in front of a Treasury Select Committee tomorrow. Current odds in the interbank lending market are 5 to 3 that Mr. Diamond will celebrate Independence Day by setting off a few hundred fireworks under his former overlords’ derrieres. Honi soit qui mal y pense.

Increasingly lost in the hubbub surrounding this folderol is the nature of the offense. Diamond himself admitted that Barclays did two things wrong. First, certain traders within the bank apparently cajoled, wheedled, and perhaps even bribed the employees charged with submitting Barclay’s LIBOR fixing over a period of several years in order to book profits or reduce losses on their own proprietary positions. While this manipulation may have benefited these individual traders, it is not at all clear that it benefited the bank as a whole. As a huge global commercial and investment bank, Barclays stands on the paying and receiving end of tens if not hundreds of thousands of financial contracts indexed to LIBOR, which is the base rate underlying hundreds of trillions of dollars of loans, mortgages, derivatives, and other financial contracts around the world. On many of these contracts, Barclays pays interest calculated as a spread to LIBOR, and on many others it receives the same. As a whole, one would only be able to determine Barclays’ exposure to LIBOR if one summed up all these obligations to determine its net exposure. It is an empirical question. If one takes the theoretical position that a huge bank like Barclays as a whole should normally be structurally short floating rates—that is, is a net short-term borrower which pays floating rate interest—then one can say an artificial reduction in LIBOR should in fact benefit it by reducing its borrowing costs.¹

But that was not the intent of the individual traders and submitters manipulating Barclay’s fixings. They were just trying to pad their own P&Ls and apparently didn’t give a fig for their employer’s overall profitability. This was sheer individual profiteering, and the fact that it occurred repeatedly demonstrates that Barclays was riddled with lousy controls, inadequate supervision, and a culture of individual profiteering run amok. It is not an indictment of banking in general, it is an indictment of what a crappy bank Barclays was.²

On the other hand, Bob Diamond also admitted that, beginning around the time of the financial crisis, Barclays began to systematically underreport its LIBOR fixings to the BBA. It did this, he claims, because executives began to notice its self-reported rates were higher than those of its global peers, which seemed unrealistically low. Because Barclays began to fear that reporting higher LIBOR rates than its peers would undermine the perception of its creditworthiness in the marketplace, it guided its submitters down to the new, improved “market” levels. For what it is worth, Gillian Tett of the Financial Times and others at The Wall Street Journal had begun to report as early as the Fall of 2007 that something was rotten in the state of LIBOR. It seems that every major bank in 2007 and 2008 was submitting bogus LIBOR fixings with the intent to persuade the market all was well (when it most distinctly was not). The kicker is that Barclays now claims its ermine-cloaked stewards at the Bank of England strongly encouraged it to get in line.

Oops.

* * *

Of course the real question in this kerfuffle is whether this gross, sustained, systematic and perhaps regulator-sanctioned manipulation of base rates used to calculate payments due under hundreds of trillions of dollars of financial contracts worldwide—which I think we can safely say did in fact occur—actually claimed any victims. Certainly not among the banks, who neither could nor would lend or borrow at LIBOR rates from their peers during the financial crisis. Certainly not obviously among the myriad of borrowers who had borrowed at or swapped back into fixed rates, and who happily motored along paying their nice level payments without regard for the shenanigans in the floating rate market. Not obviously among the investment banks, hedge funds, and other active market participants and intermediaries who regularly transacted on both sides of the floating rate ledger either. Perhaps those parties who borrowed on a floating rate basis during the period of artificially low benchmark rates benefited, and the counterparties who loaned to them suffered?

But here’s the rub: virtually nobody borrows at LIBOR. Entities borrow from and lend to each other at LIBOR plus a spread, which is negotiated between the parties at the commencement of the contract. It is the spread which reflects the negotiated price for credit risk undertaken by the lender. Spreads are the true market price of credit. LIBOR is just a number pulled from a page on a Reuters or Telerate terminal.

And consider this: Since no bank believed either their own or any other bank’s LIBOR number back in 2007 or 2008—to the extent that many (most? all?) even refused to lend to each other at those rates—do you think it likely they did not incorporate that knowledge into the market price of credit they offered each other and every other potential counterparty? Do you really think commercial and investment banks did not at least implicitly add 25, 50, or even 100 basis points to their normalized credit spread in each and every deal to compensate for the bullshit discount priced into the reference rate? Do you really think every sophisticated investor and participant in the fixed income and derivatives markets—who could and did compare posted LIBOR rates with the banks’ real market borrowing costs displayed real time in credit default swap and other credit markets—was unaware of this dislocation, and did not price it into their own transactions? Let me suggest an answer to you: of course they did.

In fact, I suspect the only participants who obviously benefited from the systematic manipulation of LIBOR were those who had entered into contracts priced before that manipulation began. In other words, a counterparty who borrowed at LIBOR + 600 bps in 2005 definitely benefited from the fact that they only had to pay 600 basis points in 2007 and 2008, when the correct price may have been closer to 700 bps or more.³ Even banks and other entities which were structurally net short floating rates during this period were unlikely to have benefited fully from the implicit LIBOR discount, because their obligations rolled over on a short-term, almost continuous basis, as is the wont for active financial intermediaries. Each time a bank borrowed money or reset a credit spread during that period, you can be certain its lenders priced the loan at true credit market rates, unconstrained by whatever straw man the banks and their regulators had agreed to put on the Reuters and Telerate pages.

* * *

So, despite the huge numbers involved and its pervasiveness throughout the global financial infrastructure, it is far from clear to me that banks’s systematic manipulation of LIBOR led to vast wealth transfers from one set of market participants to another. No, the real damage this practice caused is what we are witnessing now. The current scandal is the last nail in the coffin of whatever trustworthiness banks may have had left after five years of crapping the bed.

Sure, nobody (or very few people) may actually have been ripped off by this behavior. Sure, systematic lying by banks about their creditworthiness during the financial crisis may have lulled the public into not panicking and triggering a wholesale global financial collapse. (Which most assuredly would have been A Bad Thing.) It may have even helped in more systemic ways.

But I think bankers must now get used to staying in the doghouse for a very long time. It might even be time to pick out curtains.

Related reading:
Donald MacKenzie, What’s in a Number? (London Review of Books, September 25, 2008)
Ryan Chittum, The Libor lie unravels (Columbia Journalism Review, June 28, 2012)
Matt Levine, Libor Can Be Whatever You Want It to Be (Dealbreaker, June 26, 2012)


¹ Think of a simple example: Bank A borrows a million dollars in the interbank market on a floating rate basis at 3-month US dollar LIBOR. It then turns around and lends you a million dollar adjustable rate mortgage indexed to 3-month LIBOR plus a spread. Assuming no timing differences in the reset calculation of LIBOR on either “leg” of this transaction, Bank A’s net exposure to LIBOR in this example is exactly zero. LIBOR could be 10% or it could be 2%; it wouldn’t affect Bank A in the slightest. Now sum this up over hundreds of thousands of mortgages, tens of thousands of corporate loans, and tens if not hundreds of thousands of interest rate swaps and other derivative transactions. Good luck figuring that out.
² And perhaps an indictment of how ineffective or inattentive its regulators were, too?
³ Note, if you retain a shred of charity toward the banks at this point, that many if not most of the people who bought houses with adjustable rate mortgages in the run up to the crisis fall into this category of clear beneficiaries. I can assure you the banks did not intend it to happen this way.

© 2012 The Epicurean Dealmaker. All rights reserved.

Turn the Page

Truckin’, like the Do-Dah man.
Once told me you’ve got to play your hand
Sometimes your cards ain’t worth a damn
If you don’t lay ‘em down.

Sometimes the light’s all shinin’ on me;
Other times I can barely see.
Lately it occurs to me
What a long, strange trip it’s been.

— Grateful Dead, “Truckin’”

Well, ladies and gentlemen, it was bound to happen. Sometime around midday on this hot, quiet summer Saturday, some poor befuddled soul clicked a link that brought him or her to this site, thereby registering the one millionth visit to Your Humble Bloggist’s opinion emporium. The Earth continued to spin in its orbit, the sun continued to track across the sky, and—to the best of my knowledge—nobody reported hearing trumpet blasts signalling the beginning of the Interregnum. From these signs, I will venture to conclude that Life, indeed, Goes On.

It was slightly less than five and one-half years ago that your Masked Opinioneer first planted his standard in the sand of this new yet unapproachable internet. What began as a lark, a way to practice writing unrelated to my daily duties, and an editor- and copywriter-free zone for me to inflict my ideas and beliefs upon an unsuspecting world morphed into... well, frankly, not much more than that. Over the intervening years, the tone, topics, and breadth of material I have addressed here have changed, sometimes notably. But I still write because it is fun, I occasionally feel I have something useful to add, and to-date nobody has found an effective way to stop me.

Writing here has also opened me up to a broader range of insights and influences than I would otherwise have enjoyed as a blinkered member of the relatively cloistered and inbred society which comprises my personal and professional milieu. I have begun correspondence with a few individuals of apparent genius, whose knowledge and occasional wisdom has deeply enriched my own. And I am not reluctant to admit I have established a few close friendships as well, all with people whom I have never met in the flesh and likely never will.

* * *

What you, O Dear and Long-Suffering Readers, have gleaned from my self-indulgence is harder for me to discern. I hope I have contributed some valuable insights into the actual and proper functioning of the global financial system (two different things, sadly). I also hope I have introduced some of you to the work of writers, artists, and poets whom I find important touchstones and inspirations in my life. And finally I hope I have made some of you think a little more deeply about subjects outside of finance and markets with my occasional forays into more speculative and wider-ranging topics. Only you can decide whether I have succeeded in any or all of these objectives.

I do not kid myself that 1,000,000 visits over five and one-half years represents anything remotely approaching what a normal person would consider “popular,” or even influential.¹ This has been a cottage blog site for me and my readers. However, I do take comfort that more than half of you have visited here more than once over the intervening years. Either I have offered something worth a return visit or two, or you have appallingly short memories for the distress I may have caused you in the past. Either way, I will take the credit.

What I cannot take credit for, however, are the vast waves of traffic which have been sent my direction by far more popular and influential writers and aggregators than me. My writing is difficult, obscure, tendentious, and exceedingly long—not to mention frequently plain wrong—so it is with gratitude that I acknowledge the generosity of such titans of the econoblogosphere as Felix Salmon of Reuters, Tadas Viskanta of Abnormal Returns, and Josh Brown of The Reformed Broker. They, along with far too many others to properly mention, have been the original and ongoing sources of the majority of traffic and regular readers I have gained over the years. Thank you.

And thank you, O Dearest and Most Misguided of All Readers, for flattering my self-indulgence with your attention over the months and years. While it may do no credit to your judgment that you actually read my scribblings, it reflects a naïve generosity of spirit and charming gullibility which is all the more valuable for being so rare in today’s cynical, hyper-sophisticated, and charmless world.

In closing, I am reminded of David Niven’s reaction at the 1974 Academy Awards when his introduction of Elizabeth Taylor was interrupted by a man streaking naked across the stage behind him:

“... isn’t it fascinating to think that probably the only laugh that man will ever get in his life is by stripping off and showing his shortcomings?”

If I have done nothing more than make you laugh at my shortcomings, Dear Reader, I will be a happy man.

Ta for now.

Related reading:
And in the spirit of self-indulgence, I have collected a few pieces on cognate topics below—some obscure, some less so—which you may find amusing, informative, or both. If you do not, feel free to leave your criticisms and suggestions in the Comments section following. (Oops.)

On pseudonymity: Do You Trust Me? (February 23, 2011)
On my writing habits and philosophy: Fragments (February 26, 2010)
On my appalling wordiness: A Tedious Argument of Insidious Intent (May 6, 2007)
On this blog’s founding mythos: Molon Labe (September 1, 2008)
On my occasional descent into naughty language: Not Safe for Work (April 25, 2008)
On everything else not elsewhere categorized: Welcome to Duloc! (April 21, 2009)


¹ Editorial addendum by Mrs. Dealmaker: “Only five years? It seems like ten.” Everybody’s a critic.^2
2 Perhaps now you understand why I prohibit comments on this site. Mrs. D does not need any help.

© 2012 The Epicurean Dealmaker. All rights reserved.

Breakfast in Fur

The Cereus, which only blossoms for a night, withers away without any admiration from another in the wilderness of the southern forests; and these forests, receptacles themselves of the most beautiful and luxuriant vegetation, with the richest and most aromatic perfumes, perish and collapse in like manner unenjoyed. The work of art has no such naïve and independent being. It is essentially a question, an address to the responding soul of man, an appeal to affections and intelligence.

— G.W.F. Hegel, The Philosophy of Fine Art¹

Peter Aspden has written a piece in the Financial Times which I am still struggling to get my head around. It largely seems to be an unstructured lament about the corruption of art by commerce, but he does make the counterargument that the marketing of consumer goods emblazoned with the words and works of live and dead artists can somehow “be seen as an act of revenge by art on society.” Huh? This seems desperately, even comically wrong to me.

It is true that a number of artists he mentions by name—Jeff Koons, Damien Hirst, etc.—and many he does not have made careers which seem nothing less than performance pieces commenting on the dominance, allure, and corruption of commerce, money, and fame in contemporary society. Their work, and their lives, are grounded in ironic commentary on the place of wealth in society and its effect on the production and consumption of art, mediated through alternately hostile scorn for and obsequious subservience to it. It is a clever and potentially subversive program which I would find more entertaining if the basic subject matter—money, the people who have it, and how they spend it—were less mind-crushingly banal. I would also find its subversiveness more compelling were its practitioners less patently desperate to join the ranks of the plutocracy they mock.

But Mr. Aspden is exactly wrong if he thinks these court jesters are exacting some sort of revenge on commerce or that they are controlling it in any way. No, they have embraced the Great Whore of Babylon wholeheartedly, and they indulge themselves and their audience with ironic detachment and sarcastic mockery of the creature while they take her coin and enjoy her favors unshamefacedly. They are prostitutes who wink at the spectators while they take their customers’ money. They are in control of their own corruption, no more.

* * *

And commerce has been beating at the doors of art for, oh, approximately forever. Fine artists used to be simple craftsmen, of relatively low social status, who worked for those who could afford to pay them for decorative, nonutilitarian luxury baubles; namely, the rich. Only in relatively recent times did a myth emerge of the artist as some sort of tortured Prometheus, braving Olympian disapproval to bring the fire of wisdom and meaning to the huddled masses. But even then, and even now, fine art only exists at the sufferance of people with so much surplus wealth they can afford to throw it away on rotting shark carcasses and gilded sculptures of Michael Jackson with his chimpanzee.

And the common folk and bourgeoisie have always wanted a little taste of artistic glory too, even if it was no more that a poorly registered print of the Mona Lisa on a postcard. Mr. Aspden himself notes that museums have been selling reproductions of the works of dead artists for decades. Whom does this benefit? Certainly not Leonardo da Vinci or Vincent van Gogh.

As best I can tell, Mr. Aspden seems most upset that the estate of Francis Bacon—another dead artist, natch—is profiting from the sale of his wit and work on cashmere throws and coffee cups.

I’m not so sure about Bacon, though. His work was of a different order, and if we are to regard him as a masterly commentator on existential isolation and mortality, we are surely traducing his work by spreading it so thinly, on mugs, towels, silk scarves. We may live in a cheerfully ironic age, but there are limits. Bacon was trying to say something important about the human condition in his work. He struggled to say it, and we are captivated by the romance of that struggle. But the minute that the results appear on a kitchen tray, some of that subtle alchemical reaction between artist and spectator cannot help but be altered. We have lost something. The descent into kitsch is a one-way street and there is no turning back.

Really? I fail to see how the endless reproduction by museums and purely commercial enterprises of artistic masterpieces on postcards, cheap prints, coffee cups, neckties, and tote bags has done anything to cheapen the content or import of artists far more talented that Mr. Bacon. Do we value Botticelli or Bernini any less because their works have been reproduced on jigsaw puzzles? Of course not.

For surely the value of great art is in an important way orthogonal to the socioeconomic matrix in which it is produced and experienced. It cannot be tamed in the form of consumer goods. Likewise, kitsch cannot demean or degrade the message of Hamlet or the beauty of van Gogh’s irises. Kitsch can only demean and degrade bad or mediocre art, of which we will always have more than enough. Some bad art itself takes the form and essence of kitsch, like the immensely popular images of LeRoy Nieman or Thomas Kinkade. Popularity does not mean art is great, or lasting, or meaningful, but neither does popularity signal great art’s death knell. If Francis Bacon’s art really has something meaningful to say, I am sure it will withstand a few cashmere throws draped around the upwardly mobile living rooms of London.

Surely the socially aspirational deserve the right to signal their sophistication and taste as much as the wealthy, no? ² Besides, I very much doubt the ladies who lunch will start stocking their tea caddies with reproductions of Méret Oppenheim’s ode to oral sex.

Related reading:
L.H.O.O.Q. (July 29, 2007)


¹ As quoted in A. Hofstadter and R. Kuhns, Philosophies of Art and Beauty: Selected Readings in Aesthetics from Plato to Heidegger, 1964 edition, pp. 426–427 (as remembered). Emphasis mine. I have what I may presume is T.M. Knox’s more accurate translation of Hegel’s Aesthetics at hand, but I have always preferred Hofstadter and Kuhns’ more flowery translation of this passage, to which I was exposed in my halcyon youth. So sue me.
² Of which this blog, too, is another example. Yes, I partake of the condition of modern art: I am self-aware, and my subject is mostly myself. You people aren’t doing anything to entertain me.

© 2012 The Epicurean Dealmaker. All rights reserved.

50 Ways to Leave Your Lover

She said it’s really not my habit to intrude
Furthermore, I hope my meaning
Won’t be lost or misconstrued
But I’ll repeat myself
At the risk of being crude
There must be
Fifty ways to leave your lover
Fifty ways to leave your lover

— Paul Simon, “Fifty Ways to Leave Your Lover”

In the unlikely event Your Humble Blogosopher were ever called upon, O Indulgent Ones, to develop a required reading syllabus on risk management for senior executives and government regulators of financial institutions, I am untroubled to admit I would fail to include even one textbook or how-to manual of the mathematical ilk which purport to convey the principles of that noble calling. There are plenty of such already to be found on the bookshelves of industry practitioners and regulators, replete with concise derivations of Itō’s lemma, elegant mathematical notation, and perfunctory handwaving about the real behavior of real human beings in real market contexts. As I am not eager to advance the wisdom common to most of this literature—that greed, fear, and other messy human behaviors can be ignored in favor of a market model based on the diffusion of gas molecules in a box—I would search for inspiration elsewhere.

Instead, I would be much more interested in collating writings and writers who I feel might inculcate a healthy fear of hubris, an aversion to overconfidence, and a deeply uncertain view of the ontological underpinnings of our epistemological beliefs. In other words, Dear Readers, I would like to scare the everlovin’ bejesus out of anyone who has the presumption to be a risk manager.

Leading candidates for my syllabus would include cautionary authors and works like David Hume, Oedipus Rex, War and Peace, and anything by Montaigne. And, I am pleased to say, this little gem of a commencement address by Atul Gawande:

Scientists have given a new name to the deaths that occur in surgery after something goes wrong—whether it is an infection or some bizarre twist of the stomach. They call them a “failure to rescue.” More than anything, this is what distinguished the great from the mediocre. They didn’t fail less. They rescued more.

This may in fact be the real story of human and societal improvement. We talk a lot about “risk management”—a nice hygienic phrase. But in the end, risk is necessary. Things can and will go wrong. Yet some have a better capacity to prepare for the possibility, to limit the damage, and to sometimes even retrieve success from failure.

When things go wrong, there seem to be three main pitfalls to avoid, three ways to fail to rescue. You could choose a wrong plan, an inadequate plan, or no plan at all. Say you’re cooking and you inadvertently set a grease pan on fire. Throwing gasoline on the fire would be a completely wrong plan. Trying to blow the fire out would be inadequate. And ignoring it—“Fire? What fire?”—would be no plan at all.

There is fourth major pitfall, one which Mr. Gawande is perhaps too diplomatic to mention: insisting, in the face of incontrovertible evidence to the contrary, that the something going wrong is only doing so because other people (or things) are not acting according to plan. The common corollary to this position is that it is not your theory which is wrong, but nature is behaving unexpectedly or people are acting “irrationally.” We have seen this video before, and it wasn’t convincing the first time.

* * *

As the cleverer among you might suspect, I have said similar things at this location in the past. The point of risk management is not to prevent failure, for that is impossible. The point is to have a plan ready to manage and control failure when it inevitably comes.

It is my belief that many quants, hedge fund managers, and investment bankers came to believe—consciously or not—that, by explicitly embracing and accounting for chance, they had tamed it. They spent countless millions of man hours designing and implementing elaborate mathematical models and risk control systems based on aleatory principles that could predict, with remarkable accuracy, the variation in return and behavior of securities and derivatives under normal circumstances. They spoke confidently about “value at risk” and “maximum expected daily trading loss” as if they knew what they were talking about. As if those terms actually meant anything. And then they trotted off to their bank, or their prime broker, or the Discount Window to borrow a couple more turns of leverage against their proprietary positions.

But you cannot tame chance. That is what makes it chance. At base, implicitly attributing the kind of predictability these individuals seemed to ascribe to chance was a fundamental error, a category-mistake.

To use an example from the not-so-distant past, could the principals at now-defunct hedge fund Long Term Capital not see that pegging the odds of losing all their capital in one year at 10²⁴-to-1 against was ludicrous on its face? (And I am not arguing that Myron Scholes and the other LTCM propeller heads picked the wrong distribution for their probability estimates, as if settling on a Levy skew alpha-stable distribution with α = 1.8 and β = 0.931 would have been more accurate than a lognormal one.) In all intellectual honesty, how could they possibly know? Hubris, yes, but more importantly epistemic blindness was at play here.

For even if you have guessed (or calculated) the probabilities correctly, giving one-in-ten-million odds that a life-destroying asteroid will hit Earth in the next ten years does you no good when a Manhattan-sized meteorite is discovered hurtling toward Rio de Janeiro the following day. In retrospect, it seems pretty clear that it is far more important to plan how you intend to deal with an unlikely event when and if it does happen than to shrug and say it will probably never happen. Disaster planning and scenario testing are far more valuable risk management practices than fine-tuning the estimated volatility inputs to your CDO trading model.

Doctors like Mr. Gawande seem to have an instinctive handle on how to cope with the unexpected, probably in large part because they have seen or heard of so many “impossible” complications arising in a hospital context. They have a healthy respect for the unpredictability of the human body, and a healthy appreciation of the limits of their own knowledge and ability to predict its behavior. In one respect they benefit from a larger dataset of experiences to call upon than financial risk managers: people have heart attacks, surgical complications, and rare diseases with much higher frequency than we suffer from globe-rattling financial collapses. But the so-called Masters of the Universe could learn a lot from the humility of doctors, not only about how to prevent disasters from occurring, but more importantly how to recover from them when they do.

... we need to rediscover a little more respect (and fear) for the ineluctable and irreducible operations of chance in our lives, including in the markets. We need to keep reminding ourselves that having a 95% confidence level that our hedge fund will not lose more than 100 million dollars in a day does not mean it won’t lose $500 million tomorrow, or $75 million a day for ten days in a row. We need to rediscover that well-understood probabilities are usually more stable in the long run, so the whipsaw of short term events doesn’t blow us up before we can profit on our longer-term investments.

And it’s a good idea to have a plan, a direction in which you’d like to go. But it’s always a better idea to have back-up plans as well, alternate routes you have mapped out in case your main chance doesn’t work out as expected. Keep those in your back pocket, so you don’t frighten the Congressmen or limited partners you rely on into paralyzed immobility. But keep them nevertheless.

We probably have more than enough risk managers in the global financial system nowadays.

But we sure as hell need a lot more risk doctors.

Related reading:
Why So Serious? (December 10, 2008)
Nobody Expects the Spanish Inquisition (May 24, 2007)
P(x) = 1/1,000,000,000,000,000,000,000,000 (May 9, 2007)


© 2012 The Epicurean Dealmaker. All rights reserved.