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Yves Smith “On Traders Behaving Badly and Cognitive Bias”

http://www.nakedcapitalis…-cognitive.html

Yves Smith of Naked Capitalism is doing “the Lord’s work” and asking for traders who have specifics on the various market manipulations shady trading behaviors perpetrated by Wall St. funds, banks, etc. to come forward and blow the whistle. The timing of her request is somewhat an effect of Jon Stewart’s recent battle with Cramer (See the more recent appearance and discussion from Jon Stewart vs Jim Cramer or the original Stewart spat against CNBC that started it all), which made very public an interview Cramer had done back in 2007 where he talks frankly (and yet not specifically enough as Smith points out below) about how funds would manipulate markets for profit.

Very interesting stuff, and since we’ve seen no successful persecution of this behavior, I have little reason to believe that future regulations will stop it. What does that mean? It means that investing in the markets is an incredibly risky business for laypeople as you are unavoidably swimming with the sharks.

The Jim Cramer chatter precipitated by his Daily Show appearance included some links to an infamous interview Cramer gave in 2007, where he discussed how he would, as a hedge fund manager, push the prices of stocks he was short down via the futures market. It was arguably a public admission of market manipulation.

What was most striking about this incident was how quickly it was forgotten.

Now, of course, one can cynically say, that’s what traders do. And there have been times when I’ve had the vast misfortune to be watching the ticks (I hate trading, I put on very few trades, and I sweat them all and second guess myself hugely) and have seen more than once some end of day action that was clearly tape painting (and my pro investor buddies saw it the same way).

But nobody seems offended at the notion that the markets aren’t safe for mere mortals, just the sharks, even the whole US investing mythology touts how transparent, open, and well policed US securities markets are.

That’s one level of heinousness.

As long as banks are playing with other people’s money, and the higher ups have plausible deniability, they have no incentive to rein this stuff in, save maybe a token case here and there so they can pretend they really were on top of things. And I’m being charitable and assuming the higher ups were not actively enabling it.

So why isn’t there more understanding of and outrage about this? After all, this is the heart of the looting that went on. If firms will tolerate (or even encourage) overly aggressive behavior that appears to generate profit, it isn’t just the nominal miscreants that are at fault, but the whole chain of command all the way to the top (after all, just as in the Jett case, they profited and therefore had reason not to probe too hard).

So here is my theory: the details are not specific enough for the public to see it as real. And if they can’t formulate a picture, they can’t believe it happens all that often (after all, if it did, surely it would be in the Wall Street Journal).

That is an example of a cognitive bias called the availability heuristic. If we can have examples, the more concrete the better, the more likely we are to believe that a phenomenon is valid (that is why anecdotal evidence is more persuasive than it ought to be).

Go back and look at the Cramer tape. It’s actually brilliant. He is not very specific! There is no “when I was short X stock in 2004, I did F, T, and H and the price fell by $Z and I made $100,000 in two days.” It’s all murky, to the point where Henry Blodgett, in parsing the transcript, had to insert words at quite a few junctures to make what Cramer say make sense to him (and note I in reading the transcript would have inserted different words). That’s why this incident never really stuck to Cramer. It all came off like knowing innuendo, but he didn’t present a smoking gun.

So unless we have a Pecora commission, or a lot of ex-traders and trading managers coming forth with particulars, the great unwashed public is not going to know enough of what happened to know where to direct its diffuse but well warranted anger over having been had.

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Paul Volcker: “Not an Ordinary Recession”

http://www.ritholtz.com/blog/2009/02/paul-volcker/

Paul Volcker recently gave a speech that has gotten a lot of replay action on the blogosphere. I believe most are saying that Volcker is calling for a return to “narrow banking” (see Jesse).

A lot of people listen to Volcker as he led the charge at the Fed over taming inflation back in the late 70s and early 80s. I wonder more if he wasn’t just at the right place at the right time, doing what had to be done — raising rates. I’m convinced that most people give entirely too much credit both on blame and accolades. Don’t get me wrong, the Fed has enormous power, but my estimation is that they are almost always messing things up. The Fed is reactionary always and almost always reacts too far.

Therein lies the problem. The Fed fails at regulating. Hardly surprising, really. Is it not a joke to pay lip service to free markets, which are incredibly dynamic decentralized systems, and then use a central body to regulate the blood of the system, money? It’s a sad joke.

I could go on, but I’ll hold off. There are two pieces of Volcker’s recent speech I want to quote and comment on briefly. First:

One of the saddest days of my life was when my grandson – and he’s a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, “I want to be a financial engineer.” My heart sank. Why was he going to waste his life on this profession?

A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn’t communicate with me very much. He sent me an email, “Grandpa, don’t blame it on us! We were just following the orders we were getting from our bosses.” The only thing I could do was send him back an email, “I will not accept the Nuremberg excuse.”

There was so much opaqueness, so many complications and misunderstandings involved in very complex financial engineering by people who, in my opinion, did not know financial markets. They knew mathematics. They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events only happen once every hundred years. But we have “once every hundred years” events happening every year or two, which tells me something is the matter with the analysis.

So I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken.

The system is broken. The system was too opaque. Finance is incredibly complex. It is here where I actually started wondering if Volcker “gets it” as far as understanding that our system is far from robust as centrally controlled and designed. As it is, Nassim Taleb is the only person I’ve seen who seems to glimpse the complexity of the financial system. However, I’ve seen even Taleb defer in theory to people “who saw this coming,” like Nouriel Roubini, for potential ways to “fix” the system.

Volcker’s comment about his grandson also hits home with me as I went into finance/accounting. When everyone you know is running into a field, that may be cause to rethink your choice of education (Everyone I knew in college was getting into Real Estate — this was back in 2001). Then again, I still wish I had gone and pursued computer science, but the dotcom crash (2000) scared me away.

More from Volcker:

What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system. …

What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.

So just as soon as I thought maybe Volcker “gets it,” he goes and says we should have a strong core (read: centralized) system of banking that is heavily regulated. He wants this core to be firewalled from entrepreneurial finance to eliminate conflicts of interest.

I’ll be brief. Regulation has failed. The Federal Reserve is a monstrous regulatory body that has repeatedly exemplified failure, and I’ve already mentioned its innate centralization. The SEC? Failure at every turn. More regulation? More centralization? How many examples do we need whereby larger organizations display a need for more regulation, and when more regulation is presented, said regulatory agency is either captured by the body it intends to regulate or is inept?

What we need are decentralized banking systems that are free enough and unencumbered enough to fix themselves or self-destruct without taking down the entire network.

The great centralization experiment has failed. Let’s move on (and follow the example of the internet, which exemplifies the power of decentralization).

Enough for now.

Update 2/24/09: Saw a youtube clip of Volcker’s speech. Wanted to get this quote down:

The description of a fat tail reflects a kind of analysis that isn’t appropriate. They think that financial markets follow normal distributions. pattern like the law of physics. The one remark I’ll leave with you: if you think the financial world follows a normal distribution pattern like the laws of physics. If you think that you’re a financial engineer but you’re not a very good financial analyst.

So he recognizes how inherently unpredictable financial markets are but then goes on to suggest that the Federal Reserve can fix imbalances that present themselves.

Cognitive dissonance.

[video:youtube:O3ROf8ln9rg]

@ http://www.youtube.com/watch?v=O3ROf8ln9rg