Taleb Fooled by Leverage

Tom Keene did two must-listen podcasts this week:

  • Fisher Says Consumption Slowdown May Cause Bond Defaults
    Peter Fisher, managing director and co-head of fixed income at BlackRock Inc., talks with Bloomberg’s Tom Keene about the Federal Reserve’s relationship with the U.S. Treasury, assumption of the Treasury’s distressed pool of assets onto the Fed’s central bank balance sheet and the potential impact of an economic slowdown on bond default rates.
  • Taleb Says Crisis Continues Until Banks’ Management Changes
    Nassim Taleb, author of “The Black Swan: The Impact of the Highly Improbable,” talks with Bloomberg’s Tom Keene about the globalization of financial markets, the credit crisis and banks’ risk management.

Five minutes into the tape, Taleb tells Keene that banks should “fire all their quantitative risk managers”. Seven minutes into it, Keene asks him if the debacle was a fault within the mathematics or if it was the greed factor, leveraging up relatively good math, to which Taleb replied, “the math itself is broken”. He went on to announce that he has trouble with students (who, gasp!, want answers!) and that he would never teach again (except at $4,000 Wilmott weekend seminars, of course). Oh, PUH-lease, spare me the hubris!
In contrast, Peter Fisher was a breath of fresh air when Keene asked him a similar question seven minutes into the interview:

We’ve got to think harder about all the embedded leverage. I mean, it’s a little shocking that not more people understood that if you take a 30:1 levered, structured product and you put it on a 30:1 levered balance sheet, you’re not talking about 30:1 leverage. You’re talking about 900:1 leverage and you can magnify gains and losses pretty dramatically when you do that. So the risk management system, the capital rules just haven’t kept up with the instrument innovations–another decade has gone by.

The bottom line? The math is good enough. We know shit happens — best if it doesn’t hit the leverage fan at 900:1.

Thoughts on Bubbles

For more thought-provoking insight, check out comments made by Harrison Hong and two colleagues and Bernanke advisors on the commodity markets in a conversation with Charlie Rose.


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  1. I routinely set my TV’s DVR to record the Charlie Rose show. I found this show particularly thought provoking on the success or failure of economic/market models. There has been a failure to integrate “friction” (variables) and the use of over leverage. The questions were asked: Why is there so much disagreement? How is the ongoing housing bubble going to deflate? What will be the human behavior in perceived good times and bad?

  2. Did you notice at the end there where the guys told Charlie that understanding psychology probably trumps everything else? It always goes back to that, does it?

  3. “I’m not a monster. I’m just ahead of the curve.” –- The Joker in the Dark Knight
    To murder yet another metaphor, heavy is the head that wears the crown — of insight. Enlightenment/insight/perspective is perhaps the greatest contributing skill to the success of any trader. When I first read the legendary interview of William Eckhardt in Market Wizards I especially made note of the section where he notes that intelligence in and of itself is not a prized skill. There was hope for me yet since I’m not that smart! However, I was smart enough to read that interview over and over again until the truth of it became self evident.
    Not until very recently have I discovered the downside of enlightenment. This weekend I formulated (yet) another mantra to keep me grounded rather than succumbing to my own supposed brilliance. “Just because you know what’s going on in the market doesn’t mean you always need to be leveraged to take advantage.” This is a good mantra for me in that it is subjective enough to allow me to actually participate in trades should conditions warrant. Later I may address the other psychological shortcoming this statement reveals –- why am I so compelled to always take advantage? I do need to work harder on reining in this burgeoning ego created by the very insight that got me to this place of proper perspective.
    Alas, I have discovered yet another inherent paradox in the world of financial markets! How does one maintain the requisite humility to not succumb to hubris while still putting in the work required to stay ahead of the curve? Ah psychology! Who knew this would be the salvation to rise out of the quant universe?
    I was quite happy to learn that the mantra I formulated this weekend will not need to undergo a full revision upon hearing those two podcasts from Bloomberg. In fact, they confirm it in much the same matter as a mathematical thesis.
    From the comments on Bloomberg, Mr. Taleb does indeed sound like a man who has spent far too much time far out in front of one of those Gaussian distributions he likes to mock so much. Never let it be said that I don’t greatly appreciate the huge amount of work he has done to create a view of risk management where all the black swans, randomness, and inherent dangers are all accounted for as much as they can be. However, just as I cannot and should not use my market insight to state where the market is going rather than just to take the best advantage of any movement, Mr. Taleb should not impose his comprehensive view to explain everything going on both now and the doomed future should not these ignorant masses heed his advice.
    I agree with you when you chastised him about that ‘math is broken’ comment. He knows the difference between criticizing the math and criticizing the model. I did like his analogy for his upcoming book about the history of medicine where he notes that the medical approach historically has been to keep giving different kinds of medicine to alleviate the symptoms when often the best thing to do is nothing at all. All of my biggest mistakes I’ve ever made in the market could have been easily avoided if I had just kept my ego in check and instead done nothing at all.
    Most of your better superhero movies of the last ten years or so have addressed the issue of power and responsibility. The great frustration for those of us who are not superheroes is to figure this out on our own without the convenient foil of an arch villain. If only the markets acted in an obvious and evil manner, the traders of a noble nature would rise up to save the day when the threat was the greatest while remaining shrouded in tranquil anonymity the rest of the time. Maybe Mr. Taleb needs to start writing screenplays once he’s done completely figuring out how the world works.

  4. As I have always said, we don’t need to know the future to make money in the market. We just need to know what it’s doing now, something that still seems to defy most observers. 😉

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