Bail Out Miracle: How to fill a $500 trillion hole with a $2.5 trillion bailout

A leading Vatican Diplomat warned “that the current financial crisis could become a catastrophe unless solutions are found that respect ethics and invoke all levels of society.”  (Catholic News Service)  Archbishop Celestino Migliore, the Vatican’s nuncio to the United Nations, told attendees at a December conference on International Financing and Development that the problem is long-standing.  He noted that, “For some time we’ve found ourselves in the middle of a financial crisis that could (and has) become a catastrophe if its effects are allowed to impact other crisis: in economics, food and energy.” (CNS, 12-01-08)

True to that prediction, we are now looking at a world-wide economic catastrophe, a crisis which continues to be inflamed by an elite group of inside statisticians, economic war gamers, fund managers and modelers, who continue to be fueled by lack of regulation and oversight from a heretofore complicit government.  Having found gold in the statistical hills, their masters have urged them to even greater heights of quantitative alchemy.

One would think that with war drums humming, angry investors simmering and unemployed millions looking to land on someone as a scapegoat, that the field of financial engineering would be in disgrace, and its practitioners looking for a safe place to find a new batch of identity papers, but such is not the case.  If anything, the field has become more exciting and alluring.  Employers in insurance, banking, engineering and other statistics-driven businesses continue to advertise for financial engineers, or “quants.” 

Statistical modeling and financial forecasting have become such an integral part of finance that computer modeling has long since replaced human calculation. And yet, for all of its ability to generate untold zillions of decisions in a nano-second, computers and the human brain  share the same fault:  limitations in forecasting ability.

A recent industry conference noted the limitations of the human brain in probability forecasting, noting “…we had better make sure that we truly understand how probabilities are actually used in decision making – rather than how stylized hyperrational actions endowed with perfect God-given statistical information would reach these decisions.” http://www.battleofthequants.com

Nobody has “perfect statistical information”—we can’t supply all known variables, conditions, or permutations, even with our computers.  Garbage In, Garbage Out, remains an awful reminder of the limitations of statistics, algorithms and forecast modeling. In essence, as far as harm is concerned, the industry continues to rely on models that are inadequate for the task of predicting the unpredictable. In an interview, long-time trader, guru and industry critic Nassim Talib said:

"I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year. There is no way my experiences can be transmitted to the next generation because of these schools. We've had fiascoes in finance that they need to neglect because they contradict their models…"(Fortune magazine, “Fear of a Black Swan,” 4-3-08)

Referring to the world-wide financial meltdown which mismanaged derivatives generated, Robert Zoellick, the President of the World Bank warned that people around the world would respond to this economic downturn with anger and fear.  And, while various American politicians, financiers and bureaucrats seem to think the solution to the multi-trillion dollar crisis is to throw money at banks and failing financial institutions, we are looking at a possible $500 trillion in derivatives.

Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

1.       Sarbanes-Oxley increased corporate disclosures and government oversight

2.       Federal Reserve's cheap money policies created the subprime-housing boom

3.       War budgets burdened the U.S. Treasury and future entitlements programs

4.       Trade deficits with China and others destroyed the value of the U.S. dollar

5.      Oil and commodity rich nations demanding equity payments rather than debt

(Paul B. Ferrell , “Derivatives the new 'ticking bomb'”, Wall Street Journal, 3-10-08)

Even as the President and Congress try to create a Hail Mary pass with a financial rescue package, old habits never die.  Despite the fact that the current crop of poison exotic derivatives exceeds the annual value of the world economy,  financial engineers and quants continue to generate more derivatives to keep them company, ignoring the real world limitations of their models, putting economies at greater  risk.

“One of the problems with financial engineering is that there are no physical limits to new creations; a credit default swap can be replicated over and over (to $50 trillion dollars apparently.)  In real life, a design is bound by gravity, cost, and many other practical issues. (Ibid)

Financial engineering, modeling and computer-generated market forecasting have not lost their allure.  If anything, it seems that modelers, financial analysts, underwriters and quants are in even greater demand.  With the rest of Wall Street  laying off right and left, a financial engineer with 2 year’s experience can command a $300,000 salary as an electronic trader.

Despite the multi-billion dollar meltdown, Wall Street hasn’t lost its addiction to unreliable models. And we haven’t lost our addiction to government bailouts.

Monica Davis is a Midwest-based author, columnist, activist and public speaker.  Her articles have been used as research for legislation on the state and national level. Her book, Land, Legacy and Lynching: Building the Future for Black America is part of a museum exhibit on black farmers.  She is available for speaking engagements.