March 27, 2009
A Cultural Problem
Today Greenspan writes an op-ed in the Financial Times that recognizes that Markowitz has failed us. I also lay the blame at Markowitz's feet. But Greenspan's conclusion that we just need to "increase the financial cushion" misses the problem.
The Problem is Cultural, Not Numerical
The problem is not with regulatory boundaries, but of culture. It is a problem with how we educate our financiers and economists.
Wall Street must get away from the idea that it can always put itself on the winning side. Wall Street must be willing to make real bets and take real risks. It needs to end the flawed and useless concept that risks are unsystematic and unknowable and that a bank's primary mission is to hedge them away.
Wall Street has been running their businesses like the Las Vegas casinos do. A casino knows that there are no good bets or bad bets - the only way to make money is to obey their mechanical models of risk, and blur together millions of gambler's plays. The only business plan in the casino world is to repackage and bundle forever bigger piles of randomness, and to resell it at a markup. There is no insight, no skill - the Blackjack dealer plays by mechanical rules. It is a volume business.
Blame Sharpe Too
The meme that "you can't beat the market" on Wall Street treats ordinary investments like pure gambling.
That idea, which has its roots in Markowitz's Nobel-winning work, is delivered to us ordinary investors using wise words like "indexing", "diversification", and "efficient markets." A generation of sages like William Sharpe have preached that it is futile to invest according to fundamentals, because we can never be smarter than the market in the long run. The best we can do, says this viral meme, is measure risk and diversify it away.
While that may be sound advice for the casual investor, the crime - and the crash - occurs when all participants in the market believe in this Markowitz thread. Once everybody believes you can't beat the market, the market becomes stupid. That is what happened to the market for mortgage CDOs.
Diversification is a disease of intellectual laziness.
Wall Street has been castrated
In a sense, Wall Street has lost its ego: the banks have lost the idea that they can identify sound businesses and genius ideas better than their peers.
Over the decades Wall Street has outsourced on-the-ground gruntwork to credit agencies, mortgage brokers, and VC funds. To the extent that there might be some inaccuracies in their suppliers of numerical data, they dive into their statistical textbooks and hedge it away. Do you get respect on Wall Street by actually talking to the people that you invest in? Pshaw, says the culture of 2008: that is such a small-money idea. That would be like trying to talk with a roulette table.
Wall Street is no longer a business about insight and assessment: it has become a stupid volume business, like Las Vegas.
Instead of doing actual banking, Wall Street has enslaved itself to Markowitz's theory that its role is to bundle huge numbers of bets and repackage risk.
Alan, the real problem is that Wall Street's culture is in tatters.
The world needs a post-Markowitz framework for finance.Posted by David at March 27, 2009 11:30 AM
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