Rational Advisor

“beware of geeks…bearing formulas.” - Warren Buffett

And that summarizes the problems with these markets. Too many decisions on investing were made by super-brains and their computer generated modelling on what will work. Guess, what it didn’t.

There’s just too much reliance on the academic world and it’s a relentlessly popular and hopelessly arrogant delusion that human behavior can be reduced to formulas that others can or should rely on.

Economists, finance experts, hedge fund managers and even some investment managers are especially guilty in this respect, having dreamed up models that regularly fail to predict anything that might be of value to those who must make decisions about what the future holds.

These profs, PhDs and CFA’s have ruined rational investing. because they think it’s in some bunch of numbers that can be just cranked out. They created their hedge funds built on these black boxes, they stole people’s money with great stories, of how they could hedge risk and leverage returns. Well, I say BS. Investing is about emotions, it is about good businesses, and it’s about simplicity, not complexity. Not formulaes.

One of the funniest example of analytical incompetence is hearing some of these so-called experts explain away equity, commodity, credit and other bubbles as if they were “exceptions” — or didn’t really exist at all.

Along similar lines, Oct 31st Wall Street Journal features a report by Carrick Mollenkamp, Serena Ng, Liam Pleven and Randall Smith, entitled “Behind AIG’s Fall, Risk Models Failed to Pass Real-World Test,” that helps explain how dumb and stupid academics and their bogus theories contributed to the collapse of what was once the world’s largest insurer.

http://online.wsj.com/article/SB122538449722784635.html

Here’s a summary of the article

Gary Gorton, a 57-year-old finance professor is emerging as an unlikely central figure in the near-collapse of American International Group Inc.

Mr. Gorton, who teaches at Yale School of Management, is best known for his influential academic papers, which have been cited in speeches by Federal Reserve Chairman Ben Bernanke. But he also devises computer models used by the giant insurer to gauge risk in more than $400 billion of devilishly complicated deals called credit-default swaps.

AIG relied on those models to help figure out which swap deals were safe. But AIG didn’t anticipate how market forces and contract terms not weighed by the models would turn the swaps, over the short term, into huge financial liabilities. Those risks have cost AIG tens of billions of dollars and pushed the federal government to rescue the company in September.

A close look at AIG’s risk-management operations, and the rapid-fire chain of events that crippled the firm, raises questions about the run-up to the financial crisis: Did firms like AIG plunge into lucrative but perilous new markets without thoroughly understanding the pitfalls? Had the sheer complexity of the financial products made it all but impossible to fully calculate the risk? And did firms put too much faith in computer models to assess dangers?

The turmoil at AIG is likely to fan skepticism about the complicated, computer-driven modeling systems that many financial giants rely on to minimize risk. As chief executive of Berkshire Hathaway Inc., which owns insurance companies, Warren Buffett has been sounding the alarm about the issue for years. Recently, he told PBS interviewer Charlie Rose: “All I can say is, beware of geeks…bearing formulas.”

Last December, at a meeting with investors, Martin Sullivan, then AIG’s chief executive officer, told investors concerned about exposure to credit-default swaps that models helped give AIG “a very high level of comfort.” Mr. Gorton explained at the meeting that “no transaction is approved” by the chief of AIG’s financial-products unit “if it’s not based on a model that we built.”

Now, a federal criminal probe in Washington is examining whether AIG executives misled investors at that meeting, and whether any of its executives misled its outside auditor last fall. AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout — raising the specter that the government will eventually have to lend more taxpayer money to AIG.

Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.

Mr. Gorton, the son of a Phoenix psychiatrist, took a circuitous route to academia. He studied Mandarin, considered becoming an actor and briefly drove a cab in Cleveland, where he carried a gun for protection, he later told acquaintances. Eventually, he collected multiple degrees, including a Ph.D. in economics, and joined the faculty of the Wharton School of the University of Pennsylvania.

He was passionate about mathematics, engaging in late-night conversations with fellow teachers, says Ms. Bliss. One of his academic interests was how banks could unload risk and sell loans to investors.

Early on, Mr. Gorton billed AIG about $250 an hour, which likely would have netted him about $200,000 a year, says a former senior executive at the unit. Eventually, his pay was far greater; another former colleague estimates it at $1 million a year.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano chead of AIG Financial credited Mr. Gorton with “developing the intuition” that he and another top executive had “relied on in a great deal of the modeling that we’ve done and the business that we’ve created.”

AIG began selling credit-default swaps around 1998. Mr. Gorton’s work “helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money” because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton’s work didn’t address the potential write-downs or collateral payments to trading partners.

In his presentation to investors, held at New York’s Metropolitan Club, in 2006 Mr. Sullivan then head of AIG praised the unit’s models as “very reliable” in analyzing many mortgages, saying they had helped give AIG “a very high level of comfort.”

Mr. Gorton was introduced. “The models are all extremely simple,” he said. “They’re highly data intensive.” He said he didn’t rely on the default-risk predictions of credit-rating services, and instead came up with his own estimates of what was safe enough for AIG to insure.

Mr. Cassano, the unit’s head, told investors: “We believe this is a money-good portfolio….As Gary said, the models we use are simple, they’re specific and they’re highly conservative.”

In February 2008, AIG disclosed that Pricewaterhouse had found a “material weakness” in its accounting controls. Late that month, AIG announced a $5.3 billion fourth-quarter loss, its largest ever, driven largely by write-downs on the swaps. It also said it was “possible” that actual losses on the swaps could be material.

Mr. Sullivan told investors that Mr. Cassano, the unit’s head, was retiring. He remained a consultant, receiving, until recently, $1 million a month, according to a document later released by Congress.

In May, AIG announced another record quarterly loss, of $7.8 billion, largely driven by write-downs of the value of the swaps. That same month, Yale’s School of Management announced it had hired Mr. Gorton away from Wharton.

Mr. Sullivan was ousted in June. As of July 31, AIG had handed over $16.5 billion in collateral on its swaps, according to a regulatory filing.

By August, AIG had increased its estimates for what it might ultimately lose on the swaps in the case of defaults to as high as $8.5 billion. (The estimates are distinct from potential losses on write-downs and collateral calls.) That same month, Mr. Gorton attended the Federal Reserve Bank of Kansas City’s annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, “The Panic of 2007,” which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. “It is difficult to convey,” he wrote, “the ferocity of the fights over collateral.”

Credit markets worsened in late August and September, and AIG’s trading partners demanded additional collateral. When Lehman Brothers Holdings Inc. filed for bankruptcy protection on Sept. 15, bond markets essentially froze. That same day, rating agencies slashed AIG’s credit ratings. Company executives figured the downgrade would require AIG to post more than $18 billion in additional collateral to its trading partners, according to a person familiar with the matter. Worried that a bankruptcy filing could roil markets world-wide, the government stepped in with a bailout.

The rescue didn’t stop the collateral calls, which have eaten up much of the government’s initial $85 billion loan commitment, which on Oct. 8 it boosted to $123 billion.

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

My comments

Geek, idiot, imbecile, over-paid bozo, misleading liar, LaLa land guru, Larry, Curly & Moe all rolled into one, moron with a degree, Menace to society - teaching future menace’s to society, and more…

Personally, I feel this guy was so dumb, that they should have watered him twice a week.

Yep, It’s hard to believe that people can rely in computer models to detemine anything. So when someone talks about Efficeint frontier, Capital Asset Pricing Model, Black-Scholes, Nobel Prize winning theories, Black Box, for your sanity - please tune them out!

Remember the more formulaes - the more BS

it’s really simple and hasn’t changed since the beginning of trade, a company sells a good for more than it cost to make it - that’s profit. A share of that profit given to the companies partners is called Dividends! No Sales, No Profits, No Dividends.

Read the “Richest Man in Baylon” written in 1926, the best $10 bucks you’ll spend

http://en.wikipedia.org/wiki/The_Richest_Man_in_Babylon_(book)

Remember

Beware of geeks bearing formulas

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