Tactical, Operational & Strategic Analysis of Markets, Competitors & Industries
While McCain was widely ridiculed for putting much of the blame for the financial crisis on Christopher Cox, the chairman of the Securities and Exchange Commission, the NYT suggests today that the Republican candidate may have been on to something. The NYT says one of the root causes of the current crisis can be traced back to a brief meeting in 2004, where the big investment banks pushed the SEC to allow them to take on more debt. A few months later, "the net capital rule" was changed, and "the five big independent investment firms were unleashed." Although the new rules would allow the SEC to keep banks away from excessively risky activity, the agency essentially ended up "outsourcing the job of monitoring risk to the banks themselves." Cox came onboard a year later, but he made it clear from the outset that oversight of the banks was not an important priority, and regulators essentially ignored any problems that were discovered.
“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington. One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion. “We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”
Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.
... the martingale strategy doesn't eliminate risk—it just takes your risk and squeezes it all into one improbable but hideous scenario. The expected value computation is unforgiving. No matter what ultrasophisticated betting strategy you adopt, you can't expect to make money in the long run by flipping a fair coin. There's always a risk of loss—and the smaller the chance of losing, the uglier the potential loss becomes. The result is a kind of "upside-down lottery." If you play the Powerball, you'll probably lose the cost of a ticket, but you might win big. In the martingale, you'll probably win a little, but if all six numbered balls match your ticket, then the bank comes around and takes away everything you've got. You probably wouldn't sign up for that game. But the news of the last few weeks confirms that we've been playing it for years. And it looks like the balls just lined up. Oh, and there's one more difference between the thickly interwoven financial markets and the lottery: If one person wins the Powerball, just one person gets rich. If one massively leveraged financial firm loses while playing the martingale, it can bring the whole system down with it. The complex derivatives behind the current financial havoc aren't literally martingales, but what's wrong with the martingale is one of the things that's wrong with the derivatives. There's no question that you can reduce risk drastically by combining different investments in a single portfolio; that's what plain-Jane instruments like index funds do. What sounds an alarm is the claim that you can get low risk and high returns in the same happy package. "Once the limits of diversification have been reached," John Quiggin, an economist at the University of Queensland, told me, "rearranging the set of claims involved isn't going to reduce risk any further, so if all parties appear to be making risk-free profits, the risk must have been shifted to some low-probability, high-consequence event." In other words, if it sounds too good to be true, it's probably heading toward some outcome too bad to be borne. Or, as financial skeptic Nassim Nicholas Taleb wrote last week, "It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand."
The martingale's bad reputation is just about as old as the martingale itself; the word, which dates back almost five centuries, is said to come from the hinterland town of Martigues in southern France, whose residents weren't known for their gambling savvy. The quantitative superstars who inhabit the back offices of the financial industry, and the people who regulate them, are no star-struck hicks. So why did they fling themselves so boldly into martingale-style investments?
One way the banks got fooled was by convincing themselves that the coin wasn't really fair. The only way to make money in the long term by betting on coin flips is to have some reliable way of predicting the outcome—for example, if you know that a flipped coin will land on the side it was flipped from about 51 percent of the time. Not long ago, the credit market was convinced that the upward trajectory of house prices had reached some kind of escape velocity and that the usual laws of finance were powerless to bring prices back down. It was supposed to be like betting on a coin that was heads on both sides.