The Dismal Science

There are any number of discussions currently analysing economics or "the dismal science" as it is commonly referred to all in an attempt to try and explain why all the economists in the world got it wrong and missed the great crisis of '08-'09.

Now two things jump out at me on this account. The first is that not every economist missed it. Some like Dr Doom had been calling for catastrophe for the last decade. (Brings to mind the joke that economists got five out of the last two recessions right.) The second is that the crisis began in 2007, and the houses that made the most money up to 2008 were fully aware what was going on-it just never occurred to them that the fire they were playing with could get out of hand.

Take the "seminar" held in April '07 by a major international bank for its' hedge fund and proprietary trading clients. They spoke openly of their concerns surrounding the sub prime mortgage market and that they were actively building up a portfolio hedging their exposure to the mortgage market.

This was a meeting by traders for traders. The "real money" investor accounts of the bank were not invited. The host bank was however marketing mortgage CDO's to those "real money" investors-in fact one could go so far as to say that the investors were actually supplying the hedge for which the CDO traders were seeking.

In the summer of '07, a French firm packed with French mathematicians-its' Fixed Income Department had over 100 quants cranking out models for everything-suddenly announced that it could not value three of its' funds properly and so froze them.

I was always amused by this proclamation. It was almost as funny as the claim by another major French bank that the mass of models and risk management systems built by their French mathematicians-and theirs were the best- Polytechnique but of course-couldn't catch a rogue trader.

But I digress. I would suggest that it wasn't that they couldn't value the funds, but rather that they wouldn't. There was always an argument in the Street between the mark-to-market, and the mark-to-model. The difference often representing P&L. In this case the model and the market were both clearly suggesting that the value was ugly. To admit that would open up a can of worms. Their solution was to freeze the funds because they couldn't value them.

I believe this was the trigger which set the whole crisis in motion. I also believe that there were many-and I mean many bankers who were intelligent enough to understand what was happening. These were people involved in Derivative Sales, Trading and Structuring/Origination.

They had been playing with fire for over a decade and every time it got a little too hot at one house another one would jump into the fray and so the blow-ups were relatively small and self-contained. Ironically, many of those banks that would not get involved on the origination and distribution of these products were historically not comfortable with the concept of risk in their Sales and Trading Operations, but their Bank Treasuries came to be some of the largest buyers of these constructions.

No one seriously enters into banking without the hope/intent to make a lot of money. Financial Firms provide the opportunity to get rich-they are not charity organisations,are not for the faint hearted and the moral compass seldom points to money.

Firms were supposed to be structured such that Risk Management, Trading Management, Sales Management and Senior Management knew the risks they were running, and the profits they were generating. They were all expected to manage and understand this balance. Part of the problem however was that except for Risk they all had budgets, and even Risk was dependent upon those budgets to get paid. It was really in no one's interest to speak up and block what looked to be an extremely profitable proposition.

But back to the dismal science. Economists have always tried to get their subject into the hard sciences. They created first an extremely rational human nature that presumed the existence of a utility maximising automaton. This created one set of maxims generally under the rubric "rational and efficient" markets.

Then they got caught up in the fact that humans might not be totally rational. This created a new set of maxims such as "Random Walk" and "Chaos Theory".

They continued to develop and with the onslaught of math and physics brought the power of super-computers to crunch out statistics which would somehow divine the future path of economics/markets.

Now I understand that there is a movement to take some of the "hard" science out of economics and put it more into the realm of humanism.

This might be a good start- but I am concerned they will always want to start with the premise that there is an "ideal" circumstance. There is, but it is not the one they are imagining.

What they need to recognise is that the financial markets are actually run by a relatively small oligopoly. They are in a unique position to extract huge value from an activity that is intentionally opaque. Everyone clamors for transparency, but the combination of power and money makes it very difficult to effectively enforce.

The way to break it is to go after the money. That means regulation. I wouldn't bet on it.