ABSTRACT RISK

AND REAL DANGER

It is becoming increasingly clear that a major contributor to our economic meltdown was the cavilier way in which our financial institutions managed to get risk off their books — and out of their minds as well.  How did that happen?

Paul Wilmott has emerged as a vocal and active critic of the abstract economic models that lay behind this way of thinking — and  Nassim Taleb,  author of the bestseller The Black Swan, calls him the smartest quant in the world. “He’s the only one who truly understands what’s going on … the only quant who uses his own head and has any sense of ethics.”

Wilmott notes in Newsweek, Revenge of the Nerd:  “They built these things on false assumptions without testing them, and stuffed them full of trillions of dollars. How could anyone have thought that was a good idea?”  He adds, “We need to get back to testing models rather than revering them,” he says. “That’s hard work, but this idea that there are these great principles governing finance and that correlations can just be plucked out of the air is totally false.”

But what may be even more significant is Wilmott’s pessimism about change: “What I think is going to happen is that people will forget and we’ll just keep going on the way we have been with nothing really changing,” he says. Wilmott is encouraged by President Obama’s proposals to tighten regulation of derivatives; he thinks it’ll keep quants on a shorter leash. But he’s also stunned by the lack of outrage over the financial mess. The violence that erupted at this year’s G20 summit wasn’t anywhere near what he thought it should’ve been. “Where the hell was everybody? If people aren’t angry now, they’ll never be.”

So what explains the quants blindness to risk?  More importantly: why do the firms that employ them fail to learn from experience?  And, as Wilmott asks, “Where is the outrage?”  You might think that the battled scarred veterans of finance would be more skeptical about their clever quants, more tough-minded.  Why is it so hard to face  the reality of such risk?  What don’t they know they know?

I suspect it is about the immense competitive pressures that financial institutions feel to come up with investments yielding greater and greater returns.  In a society where all have become invested — through our  pensions, endowments, college funds, 401Ks, and savings —  finance has come to play the key role.   Financial returns from investments have become more important than productivity — or virtually anything else apart from national security.  The result is that the pressure within and between financial firms mounts.  Their competitive advantage  in the moment matters more than long range success, and risk of long term failure is downplayed.

To be sure, in the end the danger of financial collapse will spoil every other advantage, but the risk that the financial firms pay more attention to are the risks of failing to compete successfully with other firms to gain investments.  That risk casts all others into the shadows  — and makes it all too easy for investment managers to be seduced by the abstract reassurances of the quants.

And that is why Wilmott’s pessimism is justified.  People will forget because they will be intensely concentrated on the promise of gain and the competition with others.  In that situation, risk becomes a nuisance — and then it fades out of mind.