Thursday, August 26, 2010

Why Did the Crisis of 2008 Happen? - By Nassim Nicholas Taleb

Found via Farnam Street.

Summary of Causes: The interplay of the following five forces, all linked to the misperception, misunderstanding, and hiding of the risks of consequential low probability events (Black Swans).


1) Increase in hidden risks of low probability events (tail risks) across all aspects of economic life, not just banking; while tail risks are not possible to price, neither mathematically nor empirically. The same nonlinearity came from the increase in debt, operational leverage, and the use of complex derivatives.

2) Asymmetric and flawed incentives that favor risk hiding in the tails, two flaws in the compensation methods, based on cosmetic earnings not truly risk-adjusted ones a) asymmetric payoff: upside, never downside (free option); b) flawed frequency: annual compensation for risks that blow-up every few years, with absence of claw-back provisions.

3) Increased promotion of methods helping to hide of tail risks VaR and similar methods promoted tail risks. See my argument that information has harmful side effects as it does increase overconfidence and risk taking.

4) Increased role of tail events in economic life thanks to "complexification" by the internet and globalization, in addition to optimization of the systems.

5) Growing misunderstanding of tail risks Ironically while tail risks have increased, financial and economic theories that discount tail risks have been more vigorously promoted (while operators understood risks heuristically in the past), particularly after the crash of 1987, after the "Nobel" for makers of "portfolio theory". Note the outrageous fact that the entire economics establishment missed the rise in these risks, without incurring subsequent problems in credibility.