Sorry but I am in Manhattan Market Overview high gear prep mode – the report will be published later this week – so I am pretty lame on the content side for Matrix at the moment.

One of my semi-regular podcast downloads is Russ Robert’s EconTalk. This week he interviews Nassim Taleb , the author of Fooled by Randomness and the Black Swan of a few years ago. I own the latter, but I think the former is over my head. I’ve never heard him speak before. I have now listened to this podcast 3 times already and thoroughly enjoyed it. Also make sure you read the slew of comments posted to their site.

Nassim Taleb talks about the financial crisis, how we misunderstand rare events, the fragility of the banking system, the moral hazard of government bailouts, the unprecedented nature of really, really bad events, the contribution of human psychology to misinterpreting probability and the dangers of hubris. The conversation closes with a discussion of religion and probability.

On one hand I am very leery of people who suggest they have all the answers to a problem but not the solutions – Nouriel Roubini is another example – but Taleb’s arguments are compelling. After all, I think we all want to understand how so many smart people could be so utterly stupid for so long. If it wasn’t mortgages as a vehicle, it would have been something else.

I loved the ten year flood example given in the notes of the interview:

A ten year flood has a higher probability than a 100 year flood, but the 100 year flood will be massively more consequential. You care about the probability times the size of the impact, the expectation of these events. Small-probability events can have in some domains, fat-tailed domains, a big impact and we don’t know how to estimate them.

Here’s the compensation scenario and moral hazard – notes from the interview:

Were heads of Bear Stearns and Lehman Brothers not aware of how much they were gambling or did they not care how much they were gambling? Combination. Three things: 1. fooling themselves, psychological dimension. 2. Had an interest in building huge risks and tail because if you blow up every 10 years, you will make 9 bonuses and the 10th year someone will pay the cost, not you. Vicious: taxpayers are paying retrospectively for the bonuses of the first 9 years. Banks are insolvent, have lost more than their capital base, but managers have kept their bonuses. Some of them have been wiped out because they went a little further than normal blow-up cycle. What about the ones who didn’t do it? Lower returns year after year; now should be doing extremely well, but now unable to buy up some of the firms that have made the mistakes because the government is propping them up.

Aside: Speaking of dumb, how about the new space station named “Colbert” and video. To see the vote page and the number one suggested name – go here.

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3 Responses to “The Black Swan and Really, Really Dumb Smart People”

  1. Anal_yst says:

    Some of the “smart” people saw the writing on the wall. Some didn’t have the cajones (or nest egg) to speak up and risk putting a stop to the gravy train. Just like everyone else, most people in Finance were just humming along doing their job, and in reality, few people had the authority and/or influence to sound the “full reverse” alarm, so-to-speak.

    If a publicly-traded iBank manager put the brakes on their securitization/structured finance practice in say 2006, their profitability would be far lower than their peers, the stock would tumble, and said manager’s head would end up on a stick in some Hedge Fund manager’s art collection.

    I’m just saying the issues are far more complicated than virtually everyone makes them out to be. For example, I don’t have a phD in Quantum Physics. I may understand the basics and some concepts, but I’m hardly qualified to discuss the finer points of quarks or neutrinos or whatever.

    Fortunately, we’ve yet to encounter a meltdown of the Quantum variety, and the Public goes its business blissfully ignorant of most things Quantum.

    However, if somehow crap did hit the fan, imagine the difficulty the global news media – even ones with fairly sophisticated readers/viewers – would have in accurately explaining the situation.

    While I’ve admittedly dabbled in some hyperbole, the point remains. Everyone wants to “know” what the heck went wrong, but very few, if any really do know, and even fewer can explain it to laypersons.

    Bit of a catch-22, eh?

  2. Jonathan J. Miller says:

    True and I can see the mob mentality angle too. When everyone is making money it’s tough up, especially when you don’t quite get what’s happening. The same logic applied to housing price trends when rising seemingly forever and was speculated to be a new demographic trend, a new phenomenon, etc. The pressure Appraisers were under to play ball was unreal. I remember talking about how illogical the whole thing was with others that were of like minds. We would feel like the wheels were coming off the wagon yet we only saw a small sliver. It never made sense why smart people would be so dumb. I suspect they only saw the sliver, coupled with greed, made for a “toxic” combination. Their “legacy” so to speak.

  3. Edd Gillespie says:

    “On one hand I am very leery of people who suggest they have all the answers to a problem but not the solutions…”

    That is the way a responsible person thinks. I, on the other hand, have been thinking about how much of market analysis involves economics and how economics, of course, is a study, like psychology or sociology, of human behavior in exchanging goods and services.

    Perhaps there is no solution to or for what people do, just history re-repeating on some kind of a trajectory to somewhere. When this is sorted out and explained by future generations it will no doubt have much in common with previous economic events.

    Odd how the appraisers saw it coming, or at least saw something wacko, but couldn’t or didn’t do one darned thing about it.

    The moral hazard is guaranteed, and free market advocate assertions notwithstanding, the government is not creating one by bailing or not bailing. We turn to it because we have to have a solution and can’t discover one.

    Any solution sequesters a moral hazard. It is the way of people. Doesn’t mean we shouldn’t try though. To not try hides yet another moral hazard.

    Maybe discussion is the best we have when we don’t understand what happened or what to do about it.

    One thing I learned. Reverse my thinking that the banks can be trusted to remain alert and stay on solid ground. I’ve tended to think that when banks fail it is due to victimization. Not so, they are just institutions concocted by people.