the ladybug and the lion

The SEC.

It is not that they failed to uncover my fraud, it is the fact that for their entire existence they have spent their time and resources on the petty problems of small firms and refuse to deal with the obvious problems and outright violations of the large investment banks who had free reign to cause the eventual destruction of the financial markets. This mentality is still in evidence today.

—Bernie Madoff

Full story at the NYT.

Complexity And Warfare.

If the time frame is long enough to allow reaction within the "rules" of the existing system, we have gaming. If it allows for the rules to be changed, we have something more akin to warfare. In war itself, changes of this sort can occur very quickly, because the key to victory is creating both change and the tight coupling that prevents adjustment to that change. In finance, changes also can occur quickly, because finance has no physical plant to alter, is designed for innovations, and largely works in the close to instantaneous realm of information flows and trading. When we move to the macro sphere, the changes of this type take longer, because they require time for institutional and political shifts. But the objective remains the same: move to unanticipated new environments, thereby creating endogenous uncertainty.

Full story. It's worth reading.

(via The Browser)

Friends Don't Let Friends Get Into Finance.

Fewer people are being added to industry employment, but they are coming from new and narrower places. The financial services industry used to consider it a point of pride to hire hungry and eager young high school and college graduates, planning to train them on the job in sales, trading, research, and investment banking. While that practice continues, even if in smaller numbers, the difference now is that most of the industry's profits come from the creation, sales, and trading of complex products, like the collateralized debt obligations (CDOs) that played a central role in the recent financial crisis. These new products require significant financial engineering, often entailing the recruitment of master's- and doctoral-level new graduates of science, engineering, math, and physics programs. Their talents have made them well-suited to the design of these complex instruments, in return for which they often make starting salaries five times or more what their salaries would have been had they stayed in their own fields and pursued employment with more tangible societal benefits.

An analysis of MIT's graduate-employment data shows that the financial sector increased its hiring from 18 percent of its graduates in 2003 to 25 percent in 2006. So not only are the investment banks siphoning off hundreds of billions of dollars from our economy with financial gimmicks like CDOs; they are using our best engineering graduates to help them do it. This is the talent that our country has invested so much resource in producing.

When most sectors of the economy grow, new companies are created. The authors found, however, that the finance sector is not driving firm formation; it is cannibalizing entrepreneurship in the U.S. economy by offering wage and skill premiums to individuals who might otherwise have started companies. It is also causing far greater volatility among publicly traded firms and a reduction in the quality of businesses started.

The report concludes that a shrinking finance sector will likely lead to a higher entrepreneurship rate and the creation of companies with greater social value, and still provide the financial intermediation services that are most important to young companies. So that's what we need in order to save this empire: to tame this beast.

Full story from TechCrunch.

The Risks In Risk Modelling.

We will succeed in managing financial risk better only when we come to recognise the limitations of formal modelling. Control of risk is almost entirely a matter of management competence, well-crafted incentives, robust structures and systems, and simplicity and transparency of design.

A great article from John Kay at the FT.

Insider Trading.

"Given the scope of the allegations to date, we are not talking simply about the occasional corrupt individual; we're talking about something verging on a corrupt business model," Preet Bharara, the U.S. attorney for the Southern District of New York, said in a statement.

More on the federal investigation into insider trading from WashPo.

Inequality And The Crisis.

So you feel inequality is central to what has gone on and that we really need to address that?

Yes – and there is very little concrete talk about addressing it. It’s a very difficult problem. You might think that in a system of majority voting, the middle class and the poor would dominate and would prevent this kind of inequality from developing. But it hasn’t been that way – it’s been even less so that way lately, especially in the US. And once again, we have to attribute that to some change in our zeitgeist, in our way of thinking about what people view as important.

Robert Shiller at FiveBooks.

Bigger And Bigger.

In other industrialized countries, central banks are at least beginning to confront the ideology that supports the unfettered and undercapitalized growth of big banks.

In the United States, the Treasury, the Federal Reserve and now the Financial Stability Oversight Council are distorting the evidence to accommodate the views of Jamie Dimon of JPMorgan Chase; William M. Daley, President Obama’s newly appointed chief of staff, and other executives who want to build bigger, increasingly global, highly leveraged – and much more dangerous – banks.

Simon Johnson, former chief economist at the IMF, criticizes the assessment released by the Financial Stability Oversight Committee on the costs and benefits of limiting bank size.

Musical Fed.

Mr. Frost and his team work out of a small, beige corner office with arched windows that used to be a library. There, at about 10:15 most workday mornings, one of them pushes a button on a computer. Across Wall Street, three musical notes — an F, an E and a D — sound on trading terminals, alerting traders that the Fed is in the market.

Full article from the NYT.

(via MR)

Quotes I Like.

Life always has a fat tail.

—Eugene Fama.

Complexity.

Our problem is that the scientific desire to simplify has taken over, something that Einstein warned against when he paraphrased Occam: “Everything should be made as simple as possible, but not simpler.” Thinking of natural and economic systems as essentially stable and decomposable into parts is a good initial hypothesis, current observations and measurements do not support that hypothesis—hence our continual surprise. Just as we like the idea of constancy, we are stubborn to change. The 19th century American humorist Josh Billings, perhaps, put it best: “It ain’t what we don’t know that gives us trouble, it’s what we know that just ain’t so.”

So how do we proceed? There are a number of ways to approach this tactically, including new data-intensive techniques that model each system uniquely but look for common characteristics. However, a more strategic approach is to study these systems at their most generic level, to identify universal principles that are independent of the specific details that distinguish each system. This is the domain of complexity theory.

Full article by theoretical biologist George Sugihara. It's worth reading.

(via The Browser)