Wednesday, November 12, 2008

Money men congressional testimony

Five big hedgies testified today before Congress, including Paulson, Griffin, Soros and Simons. Simons gave a very succinct and accurate summary of the causes of the current crisis.

Mr. Simons, the founder of Renaissance Technologies and a former mathematics professor who devises complex computer models to predict market moves, says there is plenty of blame to go around for the current financial crisis.

“In my view, the crisis has many causes: The regulators who took a hands-off position on investment bank leverage and credit default swaps; everyone along the mortgage-backed securities chain who should have blown a whistle rather than passing the problem on; and, in my opinion the most culpable, the rating agencies, which allowed sows’ ears to be sold as silk purses,” Mr. Simons says.

See my talk for related comments.

Before the money men testified, four finance professors had their say. From Andy Lo's (MIT Sloan School) testimony:

...[Government funding for training quants!]

6. All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely. In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology.

...[Behavioral finance!]

Economists do not naturally gravitate toward behavioral explanations of economic phenomena, preferring, instead, the framework of rational deliberation by optimizing agents in a free-market context. And the ineluctable logic of neoclassical economics is difficult to challenge. However, recent research in the cognitive neurosciences has provided equally compelling experimental evidence that human decisionmaking consists of a complex blend of logical calculation and emotional response (see, for example, Damaso, 1994, Lo and Repin, 2002, and Lo, Repin, and Steenbarger, 2005). Under normal circumstances, that blend typically leads to decisions that work well in free markets. However, under extreme conditions, the balance between logic and emotion can shift, leading to extreme behavior such as the recent gyrations in stock markets around the world in September and October 2008.

This new perspective implies that preferences may not be stable through time or over circumstances, but are likely to be shaped by a number of factors, both internal and external to the individual, i.e., factors related to the individual's personality, and factors related to specific environmental conditions in which the individual is currently situated. When environmental conditions shift, we should expect behavior to change in response, both through learning and, over time, through changes in preferences via the forces of natural selection. These evolutionary underpinnings are more than simple speculation in the context of financial market participants. The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the “fittest” traders suggest that Darwinian selection is at work in determining the typical profile of the successful investor. After all, unsuccessful market participants are eventually eliminated from the population after suffering a certain level of losses. For this reason, the hedge-fund industry is the Galapagos Islands of the financial system in that the forces of competition, innovation, natural selection are so clearly discernible in that industry.

This new perspective also yields a broader interpretation of free-market economics (see, for example, Lo, 2004, 2005), and presents a new rationale for regulatory oversight. Left to their own devices, market forces generally yield economically efficient outcomes under normal market conditions, and regulatory intervention is not only unnecessary but often counter-productive. However, under atypical market conditions—prolonged periods of prosperity, or episodes of great uncertainty—market forces cannot be trusted to yield the most desirable outcomes, which motivates the need for regulation. Of course, the traditional motivation for regulation—market failures due to externalities, natural monopolies, and public-goods characteristics—is no less compelling, and the desire to prevent sub-optimal behavior under these conditions provides yet another role for government intervention.

A simple example of this dynamic is the existence of fire codes enacted by federal, state, and local governments requiring all public buildings to have a minimum number of exits, well-lit exit signs, a maximum occupancy, and certain types of sprinklers, smoke detectors, and fire alarms. Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition— after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire.5 In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

1 comment:

gs said...

From Andrew Lo's testimony: In the interest of full disclosure, I wish to inform the committee that I am a principal investigator in a project funded by the National Science Foundation, and in addition to my academic position at MIT, I am affiliated with an asset management company that manages several hedge funds and mutual funds.

I was surprised he didn't specify his own hedge fund. It turns out that he sold it. About the same time, the first draft of Khandani and Lo's "What Happened to the Quants in August 2007?" (referenced in his testimony) was posted.

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