Why don’t we build models to output an expected range of values with a confidence interval (rather than a single value)?  Yes it’s more complex, but not much more than the multivariate models used throughout the business world today.  It makes the uncertainty much more transparent than anything widely used today.

Maybe the convention of using single values is a big part in much of the bad risk taking going on.

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On Capitalism:

To understand the shape of our response to the crisis, we must understand the crisis itself. We have experienced a failure of capitalism–not the failure of capitalism. We know markets are still the best way to allocate resources and to set prices and wages. But the first and essential corollary to any theory of markets should hold that they are fragile and must be protected. No matter how frequently large swaths of the world loudly shout, “We love the market!,” virtually nobody does. In the absence of rigorous enforcement of rules, market players seek monopoly power and unfair advantages; they take risks at the undisclosed expense of others, or violate fiduciary duty. None of this means these actors are “evil” or “immoral.” But their actions demonstrate that self-interest, unbridled by enforcement of rules, will destroy the very market so many people so ostentatiously claim to adore.

Take that Michael Moore – I know a movie with this viewpoint wouldn’t sell as many tickets but keep crusading.  This South Park clip is about Rob Reiner, but I always think of Michael Moore when I watch it.

On Government:

Our market has been–and will continue to be–undermined by regulators who are intellectually or ideologically unwilling to confront powerful market players. Too many of our regulators have been tarnished by the culture of Washington, where the constant movement between government and the private sector has created a fear of disrupting the status quo. It is an environment where stringent enforcement–the very type we needed–jeopardizes future confirmations, alienates potential clients, and engenders social ire. This cozy world isn’t exactly corrupt. Rather, it perpetuates an insidious process of socializing the regulators and the regulated alike. Everyone emerges accepting a way of doing business that ultimately fails the public and the economy. Groupthink has prevailed, leading to an ideological conformity that forecloses challenges and alternative theories.

On Corporate Governance

But, once again, we’re missing the opportunity. Instead of adding bureaucracy, we should be using the government to help invigorate shareholders to police companies. They should be empowered to control executive compensation, eliminating all the conflicts that now encumber those decisions.

Yes, this is an opinion piece by Elliot Spitzer, and I think he is guilty of some of the worst excesses of government along with the rest.  He doesn’t go nearly far enough into addressing why the Washington culture is so ineffective, or into bad governmentpolicies taht led us down this road.  But I think he is on the right track about what reform needs to look like.

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It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

via Traders Profit With Computers Set at High Speed – NYTimes.com.

As a whole I have no prblem with this technology, traders provided an innovation that makes the market place better, and over time, everyone will trade faster, dividing the gains from faster trading to more hands while still  providing the added liquidity and price setting benefits for all.

However, flash orders, the ones that let high frequency traders see what slower traders are doing just before they do it, should be shut down.  It is one thing to palce smaller orders to learn when others are willing to trade, but to see something before eveyone else is an unfair advantage.  Financial Advisor’s are not allowed to trade n front of their clients (front running), for the same reasons: seeing others orders gives you an advantage over them and allows you to profit at their expense.

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While we are rebuilding our financial system and restructuring our economy and health care system, we need to remember that there will always be a big bad wolf around the corner waiting to blow our house down (and even if we take shelter in the house of brick, earthquakes can quickly bring that house down). There is no final answer or perfect structure – every possible method of organization will entail some risk.  The key is to find a way to successfully manage the day to day risks while leaving the flexibility and ability to recover and rebuild quickly after the big bad wolf comes a’knockin.

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Another gem about why banks were so unprepared for a catastrophic economic situation:

The individuals who were running large financial institutions had an opportunity to pursue strategies that resembled, in terms of their reward structures, going short on extreme market volatility. Those strategies paid off for years but ended in disaster. Until the volatility actually arrives, this trading position will appear to yield supernormal profits, and indeed, the financial sector was enormously profitable until the asset-pricing bubbles burst.

From a publication by economist/blogger Tyler Cowen.   See the full article here.

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McKinsey analysis of what’s happened to banking so far and what’s in store for the future.  The pain may not be over…

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Arguably, better matching pay with value created is ideal, but it is also difficult to measure, which is why we rewrite the rules of financial services compensation every 15 years or so.  Creating new regulations and better modeling risk both have the same problem: how do you accurately identify and measure risk?  If you subscribe to murphy’s law (maybe it should be renamed Taleb’s law), you will take on too little risk.  If you use the computer programs of recent years, you will obviously take on too much.

I think the best solution will be the one that fights complexity with simplicity.  If banks are required to hold a percentage of the assets they generate, they will be much more invested in generating quality assets.   If non-bank financial institutions are allowed to do the same things as banks, why are they regulated differently?  All of the slicing and dicing of securities combined with the insuring and reinsuring created a tangle beyond comprehension of any participant, let alone risk management (this might be pushing it, but all these agreements remind of the secret alliances that were a part of making world war I a world war – no one knew enough about everyone else’s commitments to take appropriate action).

Financial innovation will always outpace regulation because there is money to be made, but smart regulations will make the system simpler and clearer, rather than adding pages and pages of new rules to administer and loopholes to exploit.  Although, all those regulations and loopholes do make for big business…

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