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Lehman Bros ‘killed by complexity’

By Hamish Johnston

Have rocket scientists built ‘financial weapons of mass destruction’?…

The answer is yes — at least according to the investment guru Warren Buffett, who has been warning for some time that complex financial instruments such as ‘derivatives’ are far too complicated for mere mortals to understand. Indeed, five years ago Buffett described derivatives as a “financial weapons of mass destruction“.

Now that derivatives have apparently helped bring down one of the world’s largest investment banks, should the rest of us be blaming the rocket scientists — PhD physicists and other bright sparks — who helped develop these financial instruments and the mathematical algorithms needed to make sense of them?

In an 1999 editorial, then Physics World editor Peter Rodgers weighed the pros and cons of physicists abandoning careers in research for high-paying jobs in finance. Would the raised profile of physics in society offset the loss of talented people from academia?

What Peter didn’t ask was: “What if the rocket scientists make a mess of it?”.

Avarice, not algorithms, is of course to blame for the credit crunch, but one can’t help wondering if this is the end of the love affair between physics and finance?

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  1. Ender

    One might expect that if such “rocket scientists” were of any use, they’d have predicted the present crisis. Maybe they did, I’m not familiar.

  2. The problem is that they still try to apply conventional, “simplifying” (mechanistic) physics approach (including the scholar “complexity science” framework) to explicitly complex system analysis. One should not confuse mechanistic, dead (often artificial) “intricacy” (e.g. of usual science calculations) with genuine, dynamic complexity of real system behaviour. If despite its most “complicated” calculations, that official physics cannot explain elementary particle properties, behaviour and interactions (e.g. it postulates the super-natural “quantum mysteries”!), then how can one expect that it may be efficient in analysis of social system behaviour, where already each participating “element” (human being) is a practically infinite complexity source?!
    Therefore those “derivatives” may be externally “complicated” but always too simple with respect to real system dynamics. In particular, any efficient approach to any essentially human-driven system (e.g. economy) should take into account the relevant “human dimensions” (“avarice” including!), without their “statistical” simplification. It is quite possible, but within an essentially different, qualitatively extended approach necessarily able to solve the arbitrary many-body interaction problem (absent in usual science) and rigorously specify/analyse the result. And taking into account the full diversity of actually involved interactions, the related concept of complexity should necessarily be (provably) universal (as opposed to all its scholar imitations).
    It’s time to understand it now and urgently move towards that new kind of science, long-time “expected” by many (“systems science”, “cybernetics”, “dissipative structures”, etc.) but only now becoming indispensable. See , for a forthcoming conference and emerging interdisciplinary community of researchers that have understood that and are ready to apply their relevant experience and now-how to practical and fundamental problem solution (otherwise remaining “unsolvable”), from physics to economy and governance. It depends on a larger society attitude whether this real possibility of the necessary essential, qualitative upgrade of human knowledge will find support and application. In any case, it should be evident now, after all those strangely coinciding crises in very different fields, from cosmology and particle physics to ecology/climate and now economy/politics/governance (biology/medicine is coming!), that all versions of conventional, mechanistic science and way of thinking are absolutely practically inefficient and fundamentally insufficient for real, urgent and catastrophically accumulating problem solution. It’s time to move on or … disappear as a prosperous, progressing civilisation.

  3. biobot

    Cybernetics and systems theory make it abundantly clear that the more complex any system becomes the more controls (oversight in the financial/business/government world) is required.
    Proper use of modern tools like derivatives and forms of risk management are not to blame. It was a faulty belief system that we can have more complex systems with *less* oversight or controls that created this mess. This mess is the result of pure Republican “free market” dogma at its worst that we can thank for the meltdown.
    Rocket scientists on Wall Street did not create the problem. The challenge is in developing and implementing proper oversight and controls of extreme leverage (postive feedback loops) that are the real challenge when the controllers are politicians who not only do not understand science, but ridicule it.
    How can we expect proper oversight from numb-skulls who are still arguing over the validity of evolution?

  4. david

    i’d very much suspect the overpriced real estate market driven by greed and shortsightedness is the real cause of the current economic crisis.

  5. Ender

    The laws of gambling:
    1. You can’t win (akin to first law of thermodynamics),
    2. You can’t even tie (akin to second law of thermodynamics),
    3. You can’t leave the game :o)
    It doesn’t matter how you deal with complexity, you can’t beat thermodynamics. There is a level at which “rocket science” is irrelevant. For instance, you can’t pretend to get rich without producing, unless you’re taking advantege of someone else (conservation of energy?).

  6. WKrasl

    Well, having listened to all the Bailout news the last couple days, including Bush’s national address, and having Googled for clarity, I’ve come to the conclusion that we definitely need to rethink our economic models in Quantum Mechanics terms.
    For example, “Liar Loans” sound a lot like the sudden appearance and disappearance of income and assets (as in Stated Income / Stated Assets), much like the appearance and disappearance of virtual energy and particles. The math might be very similar.
    I’m looking forward to tossing $700B into the economic landscape, and assume it will have the same effect as tossing 700 billion Higgs Bosons into CERN’s lap. If we watch the effects (of either of these) rather closely, we might learn something valuable, hopefully also getting a real return on this risky investment.

  7. Ender

    I was listening to an economist yesterday, and he was explaining there are at least two aspects to the present financial crisis: a liquidity crisis, and a transparency crisis. He blamed the latter on the derivatives market, in which there are too many unknowns due to its complexity. I guess that’s where our fellow “rocket scientists” are to blame.

  8. As a physicist who has spent quite a few years working in that field, I can jump in.
    The truth is that there are several distinct issues.
    One is that many physics-trained so-called “financial engineers” have entered the field with very little understanding of the underlying Economics. They used their mathematical skills (i.e. PDE’s and their stochastic counterparts), as well as, perhaps more importantly their skill at modeling complex systems to price increasingly complex derivatives while completely losing sight of that fact that the “underlyer” i.e. the securities those derivatives were based on, were in fact tied to actual individuals paying off their mortgages or other obligations in time. Ultimately this linked back to Economics, or more accurately, to the economy, and therefore to the welfare of those souls who ultimately had to pay those bills. The formalism lost touch of the true economic equation and the model became divorced from the underlying reality. Moreover, while the pricing models themselves became completely divorced from reality, the modeling itself became so complex that even getting the data necessary to go back to a more realistic type of pricing became next to impossible. The models were difficult to “calibrate” – which made a more meaningful type of pricing a huge challenge. When a single security is so complex it in fact is correlated with a huge number of intertwined mechanisms modeling it based on economically meaningful numbers i.e. unemployment, income, taxation etc. becomes an issue. So the models and their data were divorced from the economic reality.
    Truthfully, modelers, while often well-paid (though not as well as some would have us believe – analysts were never in the same leagues as hedge fund owners, CEOs etc. and they were the first to get booted, usually with little to no severance), often were paid to build models of increasing mathematical and formal sophistication, while seldom truly having any incentives to link those models back to more intuitively meaningful quantities. One of the reasons was that those securities were meant to be “traded” i.e. short-term precision in a normal market environment was of greater value than a more accurate longer-term model that would have been better able to link back those security prices to the longer-term macro environment.
    A further issue is precisely the misalignment of incentives in that business.
    No real though was given to a longer-term perspective since precisely, no-one expected to keep those securities on their books long enough for those issues to become relevant. The game became one of musical chairs, with the caveat that when the music stopped (due to the real economy finally showing its face), there were few chairs left to sit on. Everyone had those securities on their books, and no-one was willing to accept the buck at this stage.
    This finally takes us back to the final disincentive issue: those securities were very profitable to issue, to trade, and to hold. They were highly “rated” so they required very little capital and allowed for significant leverage, and treasuries and other truly high-quality issues were depressed as a result of poor macro policy in the last decade or so – in particular to the flood of “liquidity”. In other words, the only was to generate enough return on savings for financial institutions was to hold, or issue such securities either directly or through high-level derivatives. Not dealing in such securities became suicidal – one’s assets were basically eaten away by inflation. The cause of that was really bad economic policy.
    To conclude, the brighter experts in risk management, as well as many high-caliber academic economists (Krugman, Roubini) fully understood, and had for a number of years, what was about to happen and how. The real issue was again one of incentives – a long-term, prudential, perspective was strongly discouraged in comparison with the alternative – that of the aforementioned “Russian Roulette”. Being right would lead you right out of business while being wrong could earn you much profit, and social recognition.
    Ultimately the question is not one of the quants (i.e. quantitatively trained financiers) being just “wrong” it was one of poor macro policies and dearth of sensible regulation leading those folks to behave “sensibly” for them and their employers in the short term, but not in society’s best interest.
    When one person does something stupid, you can assume they’re just being incompetent, when two do, it well, there may be more at play. When everybody does the same thing you probably have to look for more fundamental reasons. And the fundamental reason is usually either poor legislation, or lack thereof.
    Fixing this will be hard and expensive, but doing so will prove as futile (though much more costly) as it did in 98 (LTCM, Asian crisis), 2000 (Tech bubble) etc unless we look deeper down, but that requires political courage, not just a PhD in physics.

  9. In response to WKrasl’s comment on the relevance of the QM and QFT formalisms in finance, work has actually been done on this, although it had borne relatively little fruit. People like Ilinski and Baaquie have described financial systems by means of gauge transformations. I have not seen those models bear much fruit, but they are certainly interesting and elegant.

  10. Ender

    Quoting Patrick Amon:
    “Ultimately this linked back to Economics, or more accurately, to the economy, and therefore to the welfare of those souls who ultimately had to pay those bills.”
    Which makes me wonder: Aren’t these people the ones who should be bailed out? They were lured to buy and then made hostages of mounting interest rates. Many of them lost what they had made through honest productive work, not speculation.
    Thank you very much for your insightful comment Patrick.

  11. David Asgeirsson

    A couple of comments to add here.
    First of all, I believe it was Clinton the democrat who appointed the “wizard” chairman of the Federal Reserve, Greenspan, who is responsible for the macroeconomic policies mentioned above as driving the dependence on overly leveraged paper. It was also Clinton and the Democrats who repealled the Glass-Steagall act of the 1930s which prevented chartered banks from dealing in insurance, securities and other financial products, originally in place to ensure the stability of the banks by creating a firewall between them and the exchanges.
    Secondly, while many people might feel sorry for the “average person” who defaults on their mortgage, these average people are just as guilty of the same greedy speculation as occurred on Wall Street. Anyone who buys real estate that they can’t afford ( see for example 0 down mortgages) based on the premise of continually rising prices is “playing” the real estate market, in the same way that brokerages “play” the stock market. Now they learn that the fine print “prices may go up or down” really was true.

  12. Thanks to all for the comments relative to my posting. I’m not sure this is the ideal forum for a debate on the respective political responsibilities of each side, so I’ll just stick to clarifying a few historical points:
    The repeal of Glass-Steagal was implemented in the form of an act, the Gramm-Leach-Bliley act, which was voted largely along partisan lines in 1999 in both a GOP-controled house and senate, by a veto-proof majority.
    Nevertheless, while Gramm-Leach-Bliley eased the overall contamination of the financial sector, and ultimately the cost of fixing this, it is only part of the issue, but not the whole issue.
    The political context was complicated — it dates in some ways back to the ratcheting up of interest rates in 1994 which led to some unease on the legislative side about the Fed’s much-vaunted political independence (and it potential impact on financial markets if it decided to tighten monetary policy aggressively as it did in 1994), and it was certainly affected by the ongoing Citi-Travelers merger which was very difficult to pull off legally under Glass-Steagal.
    The merger gave further impetus for a legislative overhaul.
    The Democrats certainly do share some of the blame – home ownership was certainly seen as socially desirable by both parties, leading to a loosening of some prudential rules, but again they were arguably bit-players in this crisis.
    For the record, a further point worth mentioning is that Fannie and Freddie, sometimes seen to have benefited from Democratic support (although this is arguable) were in fact bit players at best. Much of the funding, in particular that most in trouble now, i.e. subprime, came not from them but from third-party financial institutions.
    The truth is rather complicated – there’s plenty of blame to go around, but not equally. It’s difficult not to be drawn into politics in this crisis, for politics is hugely relevant to the legislative context that allowed this to happen. But perhaps there are indeed better forums than this one to discuss politics.
    In response to Ender’s comment (thanks for the kind words, by the way): there is serious debate about actually bailing out actual home-owners instead of the banks (call it “trickle-up” if you will). Some serious economists believe it is likely to be both “fairer” and more effective. It might happen at some point in the near future, in fact.
    For what it’s worth I personally believe that it would be a better approach, but whether or not it happens is likely to once again be a function of what happens in November…
    Politics once again…

  13. Lewis D Miller

    To further correct the earlier post, it was Ronald Reagan, not Bill Clinton, who appointed Greenspan Chairman of the FED.

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