Wednesday, March 7, 2012

Lombard Street On Computer Models Versus Looking At The Facts

"The map is not the territory"...

Korzybski said that in a different context but it is so appropriate to modeling of all sorts, climate, finance, economics etc. that I put it up top on almost every modeling post.*
 Via ZeroHedge:
This is Part 1 of a series from Lombard Street titled "Last Spin Of The Wheel For Europe's Banks." As the title indicates, Lombard Street is hardly bullish on Europe's chances to avoid a fate that was described earlier by the IIF, only this time instead of just €1 trillion which would be the cost of a Greek disorderly default, the final tally will be many orders of magnitude higher and will also drag down the ECB, and the world with it.
Computer models versus looking at the facts
In 1974, Hyman Minsky explained the unfolding of credit cycles with his Financial Instability Hypothesis. It identifies three types of debt financing: hedge (borrowers can pay principal and interest from income, so risk is minimal); speculative (borrowers can pay interest from income, but need liquid financial markets to refinance the principal at maturity, so defaults rise when liquidity is impaired); and Ponzi (borrowers can’t pay either interest or principal out of income, so need the price of the asset to rise to service their debts and defaults soar when asset prices stop rising). Confidence rises over a prolonged period of prosperity, so a capitalist economy moves from hedge finance dominating its financial structure to increasing domination by speculative and Ponzi finance.

Financial markets and the economy are relatively stable when hedge financing dominates, but become ever more unstable as the proportions of speculative and Ponzi finance rise. The rising instability causes cycles of increasing severity until fear takes over and financial markets suffer a self-reinforcing spiral downward. Banks are the core of the financial system, so Minsky correctly says bank balance sheets deteriorate until inability to  service liabilities causes a ‘Minsky Moment’ – a debt crisis that forces bloated asset prices down to levels that are appropriate to the real economy of  production and income.

The questionable lending practices and the banking business models that caused the 2007–08 banking crisis and Great Recession certainly fit Minsky’s definition of Ponzi finance. That ‘Minsky Moment’ was a major turning point in global financial and economic history. It began the correction of all the imbalances that have accrued since the last major turning point – the huge monetary stimulation in response to the Penn Central non-bailout in 1970. (It changed the focus of most central banks from guarding against inflation to protecting banks from everything.)

Many analysts ignore financial debt when computing debt to GDP ratios – odd because financial debt is always a factor in financial crises. Financial debt in the US has fallen 20% from its high at the end of 2008, but is up 10% in Europe, shifting the locus of the banking crisis to Europe, where the quality of sovereign debt has fallen as financial debt has risen. Moreover, bankers on both sides of the Atlantic are continuing two serious errors that were major factors causing the last banking crisis;
  1. putting more reliance on computer models than common sense and
  2. failing to purge their balance sheets of failing assets due to inadequate net tangible equity to absorb the losses.
Contrary to the hype, computer models are very fallible. As predicted in February 2007, they greatly underestimated financial risk by failing to incorporate obvious correlations as well as being responsible for rating securities based on home equity loans and sub-prime mortgages AAA. Reliance on computer models also explains the failure to spot turning points. Only external shocks divert models from moving towards the equilibrium position, so all forecasts tend to be straight lines. Computer models don’t, and probably never will, identify turning points....MORE 
*We have so many posts on models and modeling that it is easiest to just give you the Google search results:  models
Here is a taste of some of the topics we've looked at:
How Models Caused the Credit Crisis
Quants Lose that Old Black (Box) Magic
Finance: "Blame the models"
Climate Models Overheat Antarctica, New Study Finds
Climate modeling to require new breed of supercomputer
Computer Models: Climate scientists call for their own 'Manhattan Project'
Computer Models: " Misuse of Models" and "No model for policymaking"
Climate prediction: No model for success
Climate Models and Modeling
Based on Our Proprietary "What's on T.V." Timing Model...
How many Nobel Laureates Does it Take to Make Change...And: End of the Universe Puts
The New Math (Quant Funds)
Modeling*: The Map is Not the Territory
Inside Wall Street's Black Hole
The computer model that once explained the British economy (and the new one that explains the world)
"Airspace Closure Was Exacerbated by Too Much Modeling, Too Little Research
Insurance: Is the industry too reliant on models? (BRK.B)
Insurance: "CEO FORUM: Gen Re's Tad Montross on model dependency" (BRK.A)
and many, many more. One that is definitely worth a deeper dive:
Computer Models: " Misuse of Models" and "No model for policymaking"
I'm going to bring out the big guns.

I read a book last year, Useless Arithmetic: Why Environmental Scientists Can't Predict the Future, that, while a bit light on the 'whys', packs more understanding of computer modeling into230 pages than you are likely to find anywhere else.

The author, Orrin H. Pilkey is Emeritus Professor of Geology at Duke.
The first review I'm going to link to appeared in American Scientist. The reviewer is Carl Wunsch, Carl and Ida Green Professor of Physical Oceanography in the Department of Earth, Atmospheric and Planetary Sciences at the Massachusetts Institute of Technology....
 Obama: Swedish Model Would Be Impossible Here
From ClusterStock:
Eventually the government might be forced to nationalize a large swath of the banking sector, but they'll be dragged kicking and screaming. Yesterday's non-bailout announcement aimed to preserve the status quo, and Obama himself dismissed the idea that the US could adopt the Swedish model in an interview with ABC...

The Swedish Model