Thursday, August 28, 2008

Taleb Calls Fannie Mae

Portfolio.com has an interview with my favorite flaneur, Nassim Taleb. He notes that he called the Fannie Mae meltdown, citing a footnote on page 225 of the Black Swan that

Likewise, the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry, their large staff of scientists deem these events 'unlikely.'"

He notes he wrote this in 2003, after talking with Alex Berenson about a NYTimes article on Fannie Mae's risk. But the article, and Nassim's comments in that article, are all about interest rate risk. Fannie Mae's current problem was adjusting the criteria of the underwriting--with the explicit goal of increasing home ownership of minorities--which increased their credit risk. For a guy who spends a lot of time discussing how fraudulent experts and forecasters are because of their hindsight bias, and lack of candor and honest evaluation, he seems to be speaking from first-hand knowledge. Being right for he wrong reason, is not trenchant. And being right when one makes many blanket statements, and calls multiple disasters, is not impressive, because it neglects all the disasters that did not happen: the general strategy of being a chicken little, buying out-of-the-money puts, is a bad general strategy, as Taleb discovered. You aren't evaluated on you best calls you are evaluated on your portfolio. Taleb basically said you might want to short these 50 stocks, and when 1 goes down 90%, says, 'told you so'! Sounds like a lot a brokers I know.

Priorities are essential when talking about risk, because simply listing all the things that can happen, or that 'you should check your assumptions', or that 'you could be wrong', gives one no sense of importance. If Taleb was hired by Fannie Mae to run their Risk Management in 2003, and they adjusted the interest rate risk management as a result, it would not have mattered. As one who criticized economists for not having been traders, he should be wary of criticizing risk management never having been a risk manager (except in the broad sense that everyone, at some level, is a risk manager). A risk manager has to do specific things: generate methods for monitoring risk, limits, reports. What, pray tell, would he do, just write 'shit happens--don't say I didn't tell you!', shut his door and browse the internet?

Trivially, everything is possible, and so we cannot insulate against everything, but you have to do something, and this is based on probabilities and payoffs. Simply listing 50 things or companies that can blow up because anything can happen, and then when one of them blows up, saying 'aha!', highlights the depth of Taleb's understanding of risk, because this vague statement was not actionable. What about all those companies or scenarios that did not happen, what would have happened if you retreated there as well. You can't mention lots of disasters, in no particular order, with no specifics about nature of the risks, and then when something happens claim one was prescient. Further, logically certain statements like 'something unexpected and important will happen' are incapable of being wrong and therefore meaningless. It's like saying, there will be a humanitarian crisis in the Third World next year unless we act now! Of course, we won't, because one needs to be more specific, and something will go wrong, it always does.

The Talebs and David Smicks and Kevin Phillips of the world are all very loud, certain they know something really really important, viz, the world is complicated, and many things can go wrong, or right, in unpredictable ways, and it is getting more so. Now, except for the latter point, this is all indubitibly true, but that observation is not useful to anyone, nor interesting to me.

15 comments:

Anonymous said...

nasim the dream! don't hate the playa hate the game. he made fuck you money in '87.
true story, swear to g.o.d. : I got taleb's swan audiobook off the torrents about 2 weeks ago (can't afford to strain my eyes on this/don't pay for content out of principle). every night before bed I press play and can't make it past the first chapter. i discovered the cure for insomnia. big pharma might be interested.

that being said, you still stand behind your fannie call? don't see how the merton model can work in the real world.

Eric Falkenstein said...

Obviously, I'd wish I'd bought Fannie at current levels. But I think it was a good ex ante call. You don' evaluate a call by itself, any more than you evaluate a rule by how it works in any one case. The rule for Fannie was/is: with 890MM is assets and nearly that in liabilities, the option value makes it worth >$40B even if it probably fails.

Anonymous said...

If what taleb's saying about the bank profit is true, then his risk mgmt advice would be not to be involved in the lending business in the first place. The statement about all bank profits being wiped out in the S&L crises and again with the subprime mess, should be easily verifiable. You could calculate earnings/capital gains and writedowns for the financial sector from compustat. I don't know what the answer is, and I'd be curios to know if Taleb is full of BS on this one.

In a previous life, for a project, I had to calculate economic capital and RAROC numbers for corporate loans. Risk adjsuted return numbers were always negative for most ratings. The risk return relationship did not make a whole lot of sense for large corporate loans, even if you were to account for other 'relationship' revenue. But it's hard to imagine retail lending being not profitable at least before the subprime mess.

Anonymous said...

i understand the arithmetics behind it, but can't see why the rule would work outside of the safe environment of a derivatives exchange where contracts are always cleared. companies can go bankrupt suddenly/delisted etc. in the real world. has this been tested/can you recommend a paper to read on it?

Jeha said...

Mr. Falkenstein,

Your obsession with Taleb is very interesting and appears to be pathological. I see a lot of "motivation" and little substance behind your eloquence.

Eric Falkenstein said...

jehe: heh. Taleb is often highly strident in his denunciations of others. That he and his acolytes are so thin skinned, is consistent with his hypocrisy. Name me an empirical implication from Taleb's thesis? What, should one do? He is like Smick and Phillips, a set of facts does not make a theory, any more than a set of stones makes a house.

Anonymous said...

John Hempton at Bronte Capital was similarly worried about FNM and FRE, and, like Taleb, was concerned about interest rate risk. Hempton, however, has the humility to acknowledge his mistake, i.e. overlooking credit risk.

Anonymous said...

"Name me an empirical implication from Taleb's thesis? What, should one do? He is like Smick and Phillips, a set of facts does not make a theory, any more than a set of stones makes a house."

But I think that is actually Taleb's schtick. Empirical Skepticism means operating without theory. It's all the Black Swan.

Anonymous said...

Outside the Platonic world of financial models, assuming the underlying distribution is a scalable "power law", we are unable to find a consequential difference between finite and infinite variance models - a central distinction emphasized in the econophysics literature and the financial economics tradition. While distributions with power law tail exponents ±>2 are held to be amenable to Gaussian tools, owing to their "finite variance", we fail to understand the difference in the application with other power laws (1<±<2) held to belong to the Pareto-Lévy-Mandelbrot stable regime. The problem invalidates derivatives theory (dynamic hedging arguments) and portfolio construction based on mean-variance. This paper discusses methods to deal with the implications of the point in a real world setting.

Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance

Eric Falkenstein said...

There are hundreds if not thousands of published papers on 'relaxing' the assumptions of Black-Scholes, most have not caught on because they add more parameters that necessitate some theory or intuition. This is in that category, though Taleb uses the over-the-top idea that his assumption adjustment 'invalidates derivatives theory'. No where does he show that his alternative would be better, just that theoretically, it could be more 'realistic'.

This is like saying that the assumption of perfect information invalidates microeconomics, and one needs to model imperfect information. OK, how? What evidence suggests it is better?

Anonymous said...

Actually I think Taleb isn't merely relaxing the assumptions of the Black-Scholes, as it is he doesn't view the use of variance as a useful measure in both derivative and portfolio managemet.

There is an odd quality in Taleb's writing where he can come off sounding extremely arrogant but a dash of unexpected humility. In the last section of his paper linked above, it seems he's confirming exactly what you're questioning: he doesn't have any real answers, but neither does current orthodox thinking on these matters.

Eric Falkenstein said...

Well, that's it isn't it. To note something is imperfect because it makes some unrealistic assumptions (as all models must), yet not generating a better alternative, is not helpful. Criticism is only interesting if you have a better way.

theguywiththepaper said...

f**k taleb. why would the equity-as-a-call-option work? these are real companies not contracts cleared on an exchange. what vol would one use for the enterprise? this is nuts.
has any research tested this, or is just a 'that's how it should work stupid' thing?

Anonymous said...

well?

Anonymous said...

Fannie Mae got wiped out because they tried to compete with Wall Street. They weren't wiped out because they were altruistic and trying to help minorities.