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Giacomo John Roma pointed me to an interesting article by Taleb & Spitznagel as part of the LinkedIn discussion and here are my thoughts on this and the related discussion.

I infer that Taleb’s primary concern is leverage. Debt provides leverage, and unconstrained debt provides unconstrained leverage. That is the lesson of 2008. Taleb wants us to reduce the extent of the leverage in our economy, because debt has a property that affects our perception of risk, i.e. debt hides volatility.

Regarding VaR:

(1) If you examine the historical data, outside of social sciences and quality control, there are very few thing that are Normally distributed. Taleb’s point here is that much of the mathematics that is used in finance and economics is based strongly on the assumptions of normality, and therefore, are not good forecasters of their metrics. They only appear to work when the law of large numbers can be applied. Therefore Taleb is recommending that a lot of these mathematics and their resulting analytical tools are erroneous in the long run.

(2) There are serious problems with VaR even without the normality assumption. In my experiece (I never assume normality) with years of building econometric CMBS loss and default models I found that VaR would consistently underestimate losses in the first 3 to 5 years of the loan.

Black Swans are a real problem in mortgages. The historical data shows that they are real. Just look at 2008. My own estimates are that Black Swans in CMBS bonds are on the order of 20% to 80%.

I also found that the only realistic way to handle undisciplined leverage was to implement non-linear economic or risk capital controls. This comes back to Taleb’s point on non-linearity.

Non-linearity is not new. Credit card companies use non-linearity a lot. They impose 2x and even 3x or 30% rates on delinquent card holders. Try imposing that on institutions, and all hell breaks loose. This is the power of buyers and sellers at play, not mathematics and not finance.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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As simple as it will sound there is a fourth requirement for good regulation that we always overlook in the heat of formulating regulation.

The fourth requirement of good regulation is that it needs to facilitate market forces.

This is not as easy to do as it sounds. Take for example currency bands. Once a country set currency band limits, than all a currency investors has to do is buy low and sell high. How quickly you get rich depends on how quickly you can move the currency across the band.

Where does the investor’s profits come from? From the taxpayers of the currency-banded country as their government tries to prevent the currency moving outside the band. Currency bands are wealth pumps siphoning wealth out of a country.

So the lesson here is that good regulation fosters economic forces while reducing the potential for market players to game the system.

Benjamin t Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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