March 3rd, 2009

(no subject)

"You should change your model to fit reality rather than casting out data points until your model works."

You'd think this would be a fairly simple concept, but you'd be surprised how often and in how many ways people violate something this basic.

I spent a lot of my life with some exceptionally broken mental models: about money and work on the one hand, and about relationships on the other*. It wasn't until I started adjusting them that I started having more success in either field.

We can't get along without models of reality. Reality is just too complex for our limited brains, and models are a useful construct to allow our brains to make some kind of decision given complex reality. (Jonah Lehrer talked yesterday on Fresh Air about how people are overwhelmed by excessive complexity when trying to make decisions.)

My mental models still have a lot of issues, and I do have some concern that I may run into the problem Taleb keeps talking about, where your model is good enough in the current circumstances but may somehow be prone to abrupt and catastrophic failure when conditions you have assumed not to ever be worth worrying about turn out to be much more common than you expect. Then they blow up. (The model, your relationship, the financial markets, whatever.)

*I'll be glad to discuss these, of course, but this post was just about adjusting models to fit reality rather than rewriting reality to fit an existing model, as opposed to what the model itself is.

Oh, so about AIG...

...remember them? We the taxpayer bailed them out back in September, in order to save the financial system from itself, and we've been throwing money ($160 billion, so far) at them ever since. Well, they had a conference call yesterday to discuss their Q4 results. Here's what Floyd Norris of the NYTimes had to say about that call:
The chief executive, Edward Liddy, seemed a little defensive, and for good reason.

In the fourth quarter, A.I.G. said it lost $61.7 billion.

That amounts to $465,421 a minute. To put that in perspective, every six seconds it loses enough to pay full tuition for a year at Harvard.

How long will this go on? Will the government ever stop having to pour money into this black hole? Mr. Liddy ducks that question, explaining: “The marketplace is a pretty crummy place to be right now. When the world catches pneumonia, we get it too.”

He does not mention that A.I.G.’s financial irresponsibility was a major cause of the epidemic.

The government is committing another $30 billion to keep A.I.G. afloat. It also is allowing A.I.G. to pay less for the capital that the government already put up.

Mr. Liddy at one point refers to “our partners in the government.”

One analyst asks what A.I.G. will look like in five years. Mr. Liddy does not know, but let’s hope it is only a bad memory by then.
In case it isn't obvious, that's our money they're losing at nearly eight thousand dollars a second.

Matthew Yglesias adds:
But the long and short of it is that all this money we’re giving “to AIG” isn’t really going to AIG, it goes to AIG’s counterparties. These are mostly banks (many of them abroad) who bought insurance from AIG against the possibility of a global financial meltdown. It turns out that AIG can’t actually pay all the insurance claims. So were AIG to go down, all these firms who thought they were at least partially insured against catastrophe would find out that they’ve got nothing and they, in turn, would go under. Hence, the government is stepping in to, in effect, pay off AIG’s debts.

That seems reasonable enough. But the retrospective look at things is truly outrageous. The whole idea of the insurance industry is that if I buy insurance from you, you pay off the claims. Absent ability to pay claims, there’s no business there at all. It’s just fraud. Whether or not it meets the legal standard for fraud, I couldn’t say. But in ordinary language sense, it’s a fraud—you’re selling a service you have no capacity to deliver. And AIG executives made a bunch of money engaged in it.
And, as a matter of fact, it's important to remember that the entire CDO market was exempted from the normal reserve requirements insurers actually have to follow. From Barb Arrigo's editorial blog in the Detroit Free Press:
Reality stinks, as the saying sort of goes. And there’s a lot of painful reality in the news that AIG needs even more of our potential tax money to stay afloat – and that we have to keep AIG afloat because the entire financial system would come crashing down if we don’t.

“Banks relied on AIG’s financial products unit to back about $298 billion of assets through derivative contracts at year-end, making the company a ’systemically significant failing institution’ that has to be propped up, according to the Treasury.” – Bloomberg News

As best I understand them, these derivative contracts often were treated as if they were insurance products, but without the rules regular insurers have to follow about keeping reserves on hand. In effect, they just became a way to hedge/bet, mostly on mortgage backed securities and other credit products.

So while the housing market was going gangbusters, places like AIG were more than happy to sell gobs of derivatives because they never ever had to pay out any money on them. Apparently the worst outcome anyone even contemplated was that one part of the country might have a housing slowdown, but it could never happen nationwide or worldwide.

So, yeah, now it has happened. And if AIG doesn’t back up all the bets it took, every other financial institution in the country will probably be insolvent (not that they’re doing that well anyway).
Oh well, at least Ben Bernanke is angry about it. From
Ben Bernanke, known for his sober and professorial demeanor, railed against American International Group Inc. and told lawmakers he’s “very angry” about the company’s circumstances.

The Federal Reserve chairman, at a Senate Budget Committee hearing, faced repeated questions about the insurance giant a day after it reported a $61.7 billion loss while in the government’s hands. Lawmakers had enough anger in them; Mr. Bernanke appeared to up the ante.

“If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG,” he said. “AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses. There was no regulatory oversight because there was a gap in the system.”

Lawmakers appeared to be somewhat receptive to his comments.
Well, that's all right, then.