The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Sunday, January 27, 2008

Smoke & Mirrors (or What The Pink Panther Can Teach Us About the Market Meltdown)

What a week! Last week began with an almost unprecedented plunge in global stockmarkets that stretched from Hong Kong to Frankfurt (and places in between) that led to the sharpest interest rate cut in the history of the US Federal Reserve (21 - 22 January 2008). The week finished with the venerable French bank, Societe Generale, announcing that it had lost $7.2 billion -- a figure that easily exceeds the GDP of several countries and rivals Harvard's endowment -- because of the actions of a 'rogue trader,' Monsieur Jerome Kerviel. (Aside: The two events may have been related.)

So how do we make sense of these events? For that matter, how do we get our minds around the whole credit crisis and its messy consequences? The answer: Think of the Pink Panther.

For those of you who are not cinephiles (movie lovers), The Pink Panther (the original version and not the one with Steve Martin) was a 1963 movie starring David Niven as the brilliant jewel thief, Sir Charles Lytton, a.k.a. 'the Phantom,' who planned on stealing a rare diamond, named the Pink Panther. His nemesis was one Inspector Jacques Clouseau, played by the late, great British comedic actor Peter Sellers.

Originally, The Pink Panther was suppose to be a star vehicle for David Niven's character, the Phantom. The Phantom was supposed to be the criminal version of James Bond who would have a movie franchise built around his criminal exploits. In reality, what happened was that Peter Sellers' brilliant performance as the bumbling but preternaturally lucky Inspector Clouseau was so popular that subsequent movies in the Pink Panther series was built around his character. Inspector Clouseau -- rather than the Phantom -- became a household name, recognized by people who have never seen the movies, and became a near universal cultural reference.

And that's the problem. The problem that we are having in analyzing what is happening to the markets during this credit crisis and general collapse of confidence in financial markets is that we are focusing in on the Inspector Clouseaus rather than the Phantoms.

People -- especially during the annual meeting of financial, economic, and political 'luvies' at Davos, Switzerland -- have expressed incredulity at how Jerome Kerviel could have lost the equivalent of the GDP of several countries through bad trades and outright fraud. Some of the thoughts that have been expressed from Wall Street and the City (of London) to the ski slopes of Switzerland include: 'He couldn't have acted alone.' 'How much has he socked away?' 'He didn't even attend a Grandes Ecoles!'

My thoughts on these displays of incredulity are this: He probably did act alone. That is not to absolve the guilt of the Mandarins who did attend the Grandes Ecoles and run SocGen and much of France ... they fell asleep at the helm. But Jerome Kerviel probably knew enough about gaming the system from his experience with back-office work with processing and auditing trades to get away with it as long as he did.

I also believe that he didn't gain much financially from his endeavors. After all, if he did stash away billions (or even millions) of Euros from his fraudulent trades, then why didn't he run off to some exotic locale with an ex-model turned chanteusse in the style of another Frenchmen who's been in the news? His motivation was probably to cover up the fact that he made losing bets on the direction of equity futures. It probably had more to do with ego rather than financial gain. (Some insights into this was given by another infamous 'rogue trader,' Nick Leeson -- the man who brought down the venerable British bank, Barings -- during a recent interview with the BBC that was surprisingly candid and detailed.)

As for the final point, it's true that he didn't attend a Grandes Ecoles, but this brings us to what I call the Pink Panther problem. By focusing on the admitedly tantalizing narrative of some 'rogue trader' bumbling away billions of Euros, Pounds, Dollars, etc., we are missing what ought to be far more disturbing aspects of what is happening to us because of the crisis in the financial markets.

No, Jerome Kerviel didn't attend fancy schools and wasn't a member of the power elite. But what is the responsibility of those who have fancy credentials and connections in the current economic mess? It's easy to scapegoat some low-level employee in a trading outfit or some lowly mortgage broker or realtor straight out of Glengarry Glen Ross for the current troubles, but what about the higher-ups who are pocketing huge bonuses and/or severance packages and will land on their feet despite fubar-ing away billions if not trillions of dollars (all the while people are losing jobs and losing their homes)?

What about all of the supposedly non-rogue traders and derivatives salesmen who made decisions that were far more reprehensible and stupid than what Jerome Kerviel allegedly did? Those people aren't being arrested ... no, they're the ones who are running off to exotic locales with trophy wives/mistresses while they leave behind a trail of victims that lost a substantial chunk of what little they had.

What about the sanctimonious cheiftains of investment banks, hedge funds, etc., that ridicule single mothers, the lost youth of the inner cities and the countryside, and others who are less fortunate than they when they sincerely need help all the while these captains of industry are going around panhandling for money from goverment backed investment vehicles?

What about the politicians that looked the other way when all of this was going on? They weren't being wined and dined by the Jerome Kerviels of the world nor were they concerned about what would happen to ordinary Joes and Joannes that voted for them when the supposedly non-rogue, but (in some ways) far more crazy financial dealings of those who were wining and dining officials blew up. No, it was the business-world's equivalents of 'Sir Charles Lytton' that did attend the Grandes Ecoles, the Ivy Leagues, etc., that got our leaders and regulators to look the other way.

And looking the other way is at the heart of our crisis. One of the basic tricks of magicians is to use devices that distract the audiences' attention from what they should be focused in on in order to not get tricked ... smoke and mirrors. A good magician knows that human beings are more likely to be interested in the stumbling and bumbling Inspector Clouseau rather than the coldly calculating Phantom.

The mess that we are in is because we believed in a mirage, a possibility suggested in an excellent article by David Leonhardt of the New York Times. Just as Inspector Clouseau repeatedly escaped death by pure dumb luck, we had managed to escape financial disaster (until now that is) by Clouseau-esque good fortune. Sadly, Peter Sellers is no longer with us, and it is obvious now that the economy is also mortal.

People thought that the "spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis" (from David Leonhardt's article). Quite the contrary, it is the spreading of financial risk that has led to the spreading of the crisis. Just as infectious diseases become more contagious when a virus or a bacteria takes advantage of the network effects of the interlinked relationships between their human hosts, financial contagion can now spread through more channels than in the past.

We were told that financial derivatives is another way of taming risk. Although derivatives can be validly used in risk and investment management, there are those who want to -- in the infamous, quasi-fictional words of Satyajit Das' 'Nero Tulip' -- lever up as much as possible via ever dizzying combinations of options, swaps, futures, special purpose entities, etc. In the recent past, we were lucky on a Clouseau-esque level to not have had all this 'hidden' leverage blow-up on us. Our luck ran out.

Risk can't be tamed. It can't be controled in some simplisitic, mechanstic way. That's the mirage we believed in. We put our faith in the good fortune of Jacques Clouseau all the while missing the thieves getting way with the loot.

Risk can't be waved away with a magic wand nor can we shuffle it off somewhere without it feeding back on us. Scapegoating some low-level flunky misses the point ... although there are plenty of villains (including, allegedly, Mr. Kerviel) ... because the really reprehensible characters will probably get away with it.

We can respect risk. We may be able to understand it on some level (although I doubt we can fully unravel its mysteries). But risk isn't subject to us, we are subject to it.

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