WHY DID THIS CRISIS HAPPEN?

Excellent summary of the crisis (and why we haven’t recovered) by Nassim Taleb here.  Unlike Taleb, I believe market participants can prepare themselves for black swans by properly identifying when risks are abnormally skewed.  Nonetheless, he makes some excellent points in reviewing this crisis and why we still haven’t solved our problems – the causes have not been resolved:

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

1) Increase in hidden 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 for the hiding of tail risks VaR and similar empirically and theoretically flawed methods promoted the hiding of tail risk, 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.

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 that the ENTIRE economics
establishment missed on the rise in tail risks, without incurring problems in credibility.

Who was responsible for the crisis?   Nassim mostly lists the power parties involved in the markets.  Personally, I think he misses a huge segment of the population in this section by ignoring the consumers who needed the newest McMansion, the latest Apple product, the newest flat screen TV and were willing to take on endless amounts of debt to achieve their goals:

RESPONSIBLE PARTIES

Government Officials of Both Administrations promoting blindness to tail risks and nonlinearities (e.g. Bernanke’s pronouncement of “great moderation”) and flawed tools in the hands of policymakers not making the distinction between different classes of randomness. Bankers/Company executives: The individuals had an incentive to hide tail risks as a safe strategy to collect bonuses.

Risk vendors and professional associations: CFA, IAFE promotion of portfolio theory and Value-at-risk methods.

Business schools and the economics establishment: They kept promoting and teaching portfolio theory and inadequate risk measurement methods on grounds that “we need to give students something” (arguments used by medieval
medicine). They still do.

Regulators: Promoted quantitative risk methods (VaR) over heuristics, use of flawed risk metrics (AAA), and
encouraged a certain class of risk taking. Bank of Sweden Prize, a.k.a. “Nobel” in Economics: gave the Nobel to empirically, mathematically, and scientifically invalid theories, such as portfolio theory.

Nassim’s remedy sounds very Austrian to me.  While I am not in favor of a full blown “take your medicine” approach I do believe there is a certain level of pain that must be associated with a sustainable recovery.  Capitalism without losers is like Catholocism without hell.  Thus far, we have tried to promote this “everyone can win” capitalist system in the USA.  It’s clearly not working.

SUGGESTED REMEDIES
As we saw with banks, Toyota, the BP oil spill, this economic system with a severe agency problem builds a tendency to push and hide risks in the tails. Risks keep growing in the tails; there is a need to break the moral hazard by making everyone accountable.

Captain goes down with the ship; all captains and all ships: making everyone involved in risk bearing accountable, no exception, none. Morally, legally, whatever can be done. That includes the Nobel (Bank of Sweden), the academic establishment, the rating agencies, forecasters, bank managers, etc. Time to realize that capitalism is not about free options. Note that organizations such as the CFA and American Finance Association, Rismetrics and such vendors, and
finance departments in business schools, those that promoted tools that blew up society do not seem concerned at all into changing their methods or accepting their role. They are still in the process of blowing up society

Source: Nassim Taleb