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The 300 Optimists.

G. K. Chesterton, demonstrating his genius at the art of paradox, once referred to optimism as "morbid." Since the moment I read that (it appears in the second chapter of The Everlasting Man), I have felt in my bones that it is true, and have accordingly nurtured a healthy repugnance for the braggarts of optimism. But as with many paradoxes, it is difficult to explain without vitiating its power to surprise and thus enlighten. A true paradox is not a mere turn of phrase, a linguistic subtlety. It is attempt to fill a gap in man's power of understanding. It is a rhetorical reach, a heuristic device to explain what is in the end a mystery to our meager powers of mind. The paradox is a human reflection of the mystery of being.

So in the hands of a master like Chesterton, the paradox becomes an instrument of extraordinary explanatory power. It can show us, as in a flash, a principle or precept which might by other means require hours of lecture to impart. (There is an obscure masterpiece, long out of print, called Paradox in Chesterton, by a critic named Hugh Kenner, which lays all this out with great elegance. It ends with the astonishing claim for GKC that he be called a Doctor of the Church; and more astonishing still, the reader finds himself convinced.)

In this case of the problem of optimism, Chesterton's paradox opened my mind's eye to the surprising truth that optimism, being so engrossed with the potential for good things, courts ruin and despair by minimizing bad things -- or, in the parlance of finance, by minimizing the downside risk. Especially when abetted by the modern doctrine of progress, optimism is morbid because of its tendency to induce blindness concerning man's limitations.

Now I have a concrete, factual illustration of the problem of optimism, right in front of everyone's eyes.

As I understand it, AIG was basically ruined by the wild bets of a 300-man unit out of London, the Financial Products office. This 300-man operation lost the equivalent of a big state's budget and more, all by themselves. We now have a partial counterparty list since the federal bailout in September. Forced out into the open by congressional pressure this letter reveals that the AIGFP London office paid roughly $22 billion in straight collateral on credit default swaps; and then on top of that, another $27 billion used to purchase underlying bonds, and thereby cancel the swaps associated with them. (This latter course of action to extinguish these toxic assets was a project undertaken along with an entity confected by the New York Federal Reserve Bank called "Maiden Lane III," which is said to be the holding company of AIG's bailout.)

300 hundred men -- a single office -- wrote contracts forcing an otherwise profitable company to pay out sums huge enough to bring down the entire 100,000-man firm.

And let's not forget that you don't have to hold the underlying debt to buy the swaps. You can just short-sell and speculate with it. Michael Lewis' piece some months back in Portfolio described exactly such an operation: a bunch of doomsayers who, fiercely disbelieving the reckless optimism, used CDS to short-sell durn near everything in the mortgage-bond market. They short-sold the whole shadow banking system itself, on the grounds that it was unreal: a web of hedging and counter-hedging, of selling risk out the front door and buying it from the back.

What AIG did was sell insurance on Lehman and other banks' bonds with feverish abandon, then package new securities from that insurance-premium revenue stream, and unleash these engineered monstrosities on everyone else. They passed around financial timing grenades with the pins pulled. This was Zippy's "horizontal" Ponzi scheme.

Was this an act of fraud? I say usury is a better word for it, because we're lacking the element of malicious intent. Instead we have optimism.

The means of this usury was the extraordinarily reliance upon mathematical abstraction for financial performance, and the blindness was ubiquitous assumption that real estate would appreciate forever. By analogy this was a kind of sophistry which played on the audience's trust, and the performer's talent, to erect a great pretense, a facade, a house of cards, an illusion that bedeviled performer and audience alike. The poor mesmerized Optimists -- they thought Lehman could never fall! it had been on the Exchange since before the Civil War! It was reckless optimism that ruined them. It was, as Chesterton put it, morbidity of optimism.

In short, the whole financial world was brought to its knees, in the Great Usury Crisis, by the 300 Optimists, the Morbid Optimists of London.

Comments (17)

Morbid optimism?

I just had to deal with a new financial adviser after our last one cost us half our money. (I said sell when the market was highest. He said I would be foolish to do so. I took his bad advice twice.)

Our new guy, Bill, told me the Bull was on its way any day now. The market is a great place to be. He told me I was letting fear dictate to me.

No. It isn't fear. I know inflation is coming. I know Obama will ruin things for awhile, and then I know that everything guys like Bill have told me about the stock market was a load of bull, indeed.

I found Bill's optimism exactly morbid. It wasn't fear that troubled me. It was my experience. Thus far I've been screwed by the market every single time I bought into the idea that the market always grows.

So now I'll take some bonds and some gold stocks, thank you. My wife and I are reconciled to the fact that we'll never earn anything in the market. Why? Because everything is timing. The long term doesn't work since everyone's long term is between 20-30 years. Bad if your 30 years just landed this year, isn't it?

But he showed me stats! In 2003 the market rose 28%. "We were in the market in 2003," I said, "and we never saw that increase."

"You must have had the wrong mutual funds."

It was a diversified portfolio. So much for stats.

Personal trust is an essential relational good that's missing from these kind of financial relationships where traders in super-specialized, bureaucratic organizations are so distanced from the source of the resources they are handling that it becomes abstracted out of human lives. They say that such distance is necessary for efficiency, which is to say it's necessary for traders to act as if they were machines. I think Wendell Berry makes a similar point concerning how people buying food from supermarkets are so distanced from the source of the food that they are easily alienated not simply from farmers but from the earth.

Optimism, in the sense you're using it, Paul, is morbid at least in part because it is so abstracted out of the reality of human life and, as you say, creational limits.

to act as if they were machines

If they were working well as machines, they wouldn't get over-optimistic. It seems to me that if the abstraction does anything, it makes them irrational. That seems to be the burden of Paul's post.

Mark:

Careful with those bonds. When inflation spikes, so will interest rates. When that happens, all else equal, bonds will plummet in relative terms. You might want to stick with inflation-indexed treasuries, which have a better shot at maintaining their principal value at such times.

Careful with that gold. It's trading these days at about $900, up from about $400 in 2005. Look at a chart of its prices since 2000, and you'll see that buying gold right now is sort of like buying the Dow Jones 30 in November 2007.

It sounds like both you and your new advisor might be engaging in data mining. Not surprising, really: learning from experience just is data mining. But it's a good idea to admit into your calculus the experience of others, at other times and in other places and situations. That's what the stats are. No guarantee that the stats will be a sure guide; if you are looking for a guarantee, you won't find it in this heaven. Relying on stats is like relying on any other work of man, such as aircraft. Is it morbid optimism to climb on a plane or start your car? Somehow that seems like a stretch.

Your new advisor may have a valid point when he surmises that you owned the wrong mutual funds. It's no good to hope for market returns from a fund that owns anything less than the market. In my experience, most people who think they own diversified portfolios have used 5 or 6 funds to invest most of their money in the same 20 stocks. I.e., most people are very poorly diversified.

Here's an interesting question: One view of probability theory is that a person's probabilities for various propositions simply are the relative bets (the odds) he would be willing to place on those various probabilities. I don't accept this as an analysis of probabilities, because I'm not a behaviorist. However, I think it can be a good _indicator_ of a person's probabilities. Now, one important point is that you are definitely irrational if someone can Dutch-book you. You must then have incoherent probabilities. I wonder if anyone has analyzed these credit-default swap thingies to see if the "bets" being placed can be accurately modeled as representing an incoherent probability function so that the people making them could be Dutch-booked.

Kristor,

I tried to think of everything including treasuries. Gold is for inflation. Bonds are for some earning even though inflation will hurt; whereas stocks are useless now and will be for awhile. There's just no winning in all of this. I'm just trying a different strategy.

But as I said, I'm rather reconciled to the fact that the market is a con game for small fry like me. Real money is made (and lost) in taking greater risks.

If they were working well as machines, they wouldn't get over-optimistic. It seems to me that if the abstraction does anything, it makes them irrational. That seems to be the burden of Paul's post.
Lydia, traders certainly would act "over-optimistic" if they were "built" that way. And they are "built" that way by the particular business model of a large investment bank which distances traders from the people who provide them their money and turns them into money-manipulating machines that simply cannot take relational goods into account in their actual business environment. This causes something more like a-rationality than irrationality because for them as for machines, certain goods do not even come to mind. It is not bad thinking, but non-existent thinking.

I apologize for the unclear analogy; I can see why it would be difficult to trace my link between "optimism" and "machine." The key is to understand that the critical flaw of "optimism" has less to do with irrational feelings (that machines admittedly cannot have) than an incapacity to perceive and operate outside of a reductively defined paradigm.

I'm not quite sure I understand. Even supposing that we leave "relational goods" out of the whole thing, it isn't exactly a stellar _financial_ success if your company comes crashing down and has to plead with the government to be bailed out. It would look even worse from just a crass, non-relational, materialistic, money-making point of view if the government _refused_ to bail you out. And bringing the whole economy down is surely materialistically bad. So it still seems to me that my point stands. If the "little machines" really were programed accurately to make lots of money without killing the goose that lays the golden eggs--which seems only reasonable from a money-making perspective--they wouldn't do stupid things like this.

I always understood Chesterton's comment to be directed at those with a persistent vague trust in the future: that as a species, humanity is progressing (and we all know how Chesterton felt about "progressives") towards what is ultimately good. But as Benjamin Franklin noted, the only certain things in life are death and taxes. The assumption that what is to come is better than the present or the past isn't only crass futurism, it's an embrace of the Curse. What comes in the future with certainty is death, and as such an optimist doesn't say "the world sucks, but I believe in the hope of God", but rather "I rush forward to my own doom with open arms, for it is ultimately better than what is in the now." Such an attitude also explains the actions of the 300, and the arrogance of those who do not recognize human depravity persistent in all areas of life.

Very well said, Michael.

Hi Lydia. Suppose I have a hole-digging machine. It's very good at digging holes. Unfortunately, due to its reductively-defined paradigm (being a machine rather than a wise human with a broader perspective), it doesn't realize that if it digs too well, it'll break through the planet's crust and lava will fill the hole it made and destroy the machine. And so it does.

Nevertheless we would still understand that it is, or was, an excellent hole-digging machine, even if the end result is a destroyed machine and a lot of igneous rock rather than a hole.

Similarly, our trader machines are very good at doing what they do. Unfortunately, being a machine is not always enough because machines, being human inventions, have reductively-defined paradigms which preclude certain realities and certain goods such as relational goods. It is unfortunate that human traders operating in investment banking environments became more like machines in their disregard for certain realities and goods, because this led to a metaphorical digging into magma. This is why I understand "optimism" in this financial context--maybe optimism simply isn't the right concept to use--to be less about irrational feelings than about a worldview that simply doesn't even allow one to see the reductions that lead to tragedy.

In your parlance, the trader machines simply behaved, optimistically, as if the goose could not die. I know you're stuck on the idea that machines could have been better programmed (so, my hole-digging machines were, in your way of looking at it, actually bad at digging holes) but this idea fails to capture the texture of the events. A better description would say that the hole-digging machines were really, truly quite good at digging holes, but their reductive vision failed to apprehend critical realities that ended up destroying their work.

Analogously, I think it's more helpful to see stock traders as effective machines doomed by their reductive, anti-relational view of finance, than to say they were simply un-effective machines.

Lydia, consider the relational question in the light of what has come to be known as a Taleb distribution, meaning, an investment strategy that has a low probability of blowing up 9 years out of 10, delivering astronomical returns, but a high probability of blowing up 1 year out of 10. Investment bankers, hedge fund managers, and traders in larger firms will pursue these strategies without regard to their long-term untenability, precisely because, by the time the collapse occurs, they will have banked years of lucrative management fees, bonuses, and commissions, notwithstanding the fact that such strategies will eventually decimate the capital of their clients. In effect, they will have done little more than redistribute to themselves, over time, a portion of their clients' capital, destined largely to vanish. And one can accomplish this if and only if one effects a psychological distancing from the people one is ostensibly serving, focusing upon one's own participation in what amounts to a glorified status competition, ala Veblen's Theory of the Leisure Class.

By analogy this was a kind of sophistry which played on the audience's trust, and the performer's talent, to erect a great pretense, a facade, a house of cards, an illusion that bedeviled performer and audience alike. The poor mesmerized Optimists -- they thought Lehman could never fall! it had been on the Exchange since before the Civil War!

Was this an act of fraud? I say usury is a better word for it, because we're lacking the element of malicious intent.

But Paul, your description of what these blind weasels crafted is precisely the description of a Ponzi scheme. A Ponzi scheme is exactly a "house of cards" that looks great until it crashes down, an illusion of a profit making machine.

A Ponzi scheme doesn't have to be fraudulent by the leaders and marketers. If semi-sophisticated players invent a really complex scheme that they think

is real, but it is so complex that they lost the threads of the assumptions built in and it is really an illusion, their lack of fraudulent intent does not get rid of the Ponzi character of the scheme. That's what happened here.

Though, I dare say that at least a few of the 300 knew darn well that there were risks to the whole market in what they were doing, and they chose to minimize those risks (probably in their own minds, certainly in discussion with their peers) not in honest belief, but in hope of extra profit. This surely walks the edge of fraud, morally even if not legally.

Maximos, I see the point you are making, but here's what I keep thinking: We've been told that the _whole economy_ was in danger of collapsing, with riots and stuff, maybe war with China, everybody's stocks and money just disappearing. Now, if these guys did what you said, then the money they had redistributed to themselves could have all disappeared, too. I mean, they weren't turning it into gold bullion and banking it under the floors of their houses. So they were taking a huge risk for themselves as well, and no doubt suffered even as things are a lot of loss of the value of that money they made themselves, too.

Oh, and another thing: Wasn't their job, even considered as little money-making bots, supposed to be to make money for their _companies_, to work to the benefit of their _companies_? But in that case, since they appear to have driven their companies to the brink of ruin--staved off for the time being only by massive government intervention which might not have happened--they were hardly working well for the benefit of their companies.

Now, if these guys did what you said, then the money they had redistributed to themselves could have all disappeared, too.

Lydia, I think you're making the mistake of assuming that the actions of these traders and speculators must be subsumed under some model of rationality, when the lesson of this entire crisis is precisely that market actors are often - I would say more often than not - irrational, and that, in consequence (though the causation on this point is more complex, involving also the inherent incompleteness of price signals - prices do not incorporate all relevant information, as should be obvious from contemplation of the housing bubble and collapse) market efficiency in the allocation of capital will never, ever approach the fantasies of the textbooks and econometric models. Capital is always squandered to one degree or another, are there is no reason, in principle, why this could not extend to that of irrational traders, albeit unintentionally. Moreover, we don't see that many of these ethically-challenged traders are exactly suffering, so they evidently possessed some means of preserving large percentages of their gains by transferring them from the unstable investments that garnered them, or by depositing them in institutions and investments with little or no exposure to such dodgy instruments.

Wasn't their job, even considered as little money-making bots, supposed to be to make money for their _companies_, to work to the benefit of their _companies_?

There are enormous agency problems inherent in the compensation schemes employed by the majority of financial firms, as implied by my previous comment. Compensation is awarded up front, on the basis of the nominal value of the trades, itself a function of the implied/projected maturity value, which may well be the product of nothing more substantial than mark-to-fantasy accounting. Ideally, the interests of the traders should be aligned with those of the depositors and investors, which would suggest that compensation should be integrally linked with the long-term stability and growth of productive investments; as the crisis demonstrates, this is manifestly not the case, from which it follows that, objectively speaking, these traders were not labouring to benefit their employers and those who invested in those firms, but rather themselves, in what amounts to a sort of status competition in conspicuous compensation and consumption. In certain instances, there may not have been any such subjective intent - in other words, traders may have had sincere belief in the quants' models projecting indefinite growth in asset valuations, with a minimal probability of defaults - but the absence of such intent doesn't alter the objective facts, namely, that the ostensible investment strategies promised the impossible.

Compensation is awarded up front, on the basis of the nominal value of the trades, itself a function of the implied/projected maturity value, which may well be the product of nothing more substantial than mark-to-fantasy accounting.
Absolutely true of traders, who are basically there just to fill orders. A trader is kind of like a McDonalds drive through attendant, except that he says "would you like a thousand shares of GE with that" instead of "would you like fries with that".

I have no idea how the 300 optimists were compensated, but the typical hedge fund compensation structure (at least pre-crisis) is 2-and-20: 2% of the present value of the account annually, plus 20% of the profit above and beyond the initial investment. That is typical for venture capital and private equity as well. Those compensation structures are under pressure for the hedgies because of all the massive recent redemptions. The "insider" terminology is to talk about money "invested in your name". A hedge fund manager will get 20% of the profits from the $5 billion he has invested, so he has $1 billion (of other peoples' money) invested "in his name" -- that is, he gets any profits on that $1 billion. In the downside scenario, where the fund makes no money, he is stuck with just the 2% in management fees: a paltry $100 million per year in the case of our $5 billion dollar man. It is good work if you can get it.

FWIW, the hedge funds I am in have done exactly what they were designed to do. Contrary to popular perception, a hedge fund in the 'traditional' sense is not supposed to generate massive returns from speculation: it is supposed to be "hedged", that is, it is supposed to use options and other strategies in order to stay uncorrelated to equities, commodities, and other asset classes. The idea is that you still have pretty good upside, though not as much as individual equities, but your downside is hedged; so it makes a good piece of the pie in a well diversified portfolio. I own shares in somewhere in the vicinity of 40 or 50 different hedge funds (I own them through funds-of-funds) and they have done pretty much exactly what they are advertised to do. They are down because of all the redemption pressure (some of the funds-of-funds have had 70%+ redemptions), but they aren't down nearly as much as equities; they track equities pretty well to the upside, though equities do better if all you look at is the upswings.

Of course nowadays the term "hedge fund" has come to mean pretty much any investment vehicle for accredited investors only (not Mom and Pop, because from a regulatory standpoint allowing Mom and Pop to invest in a hedge fund would be legal suicide) with a flexible investment charter and a 2-and-20 (or the like) compensation structure. There have doubtless been plenty of shenanigans in hedge funds loosely construed, but these 300 AIG employees are/were not a hedge fund even in the loosest sense of the term. They were a bunch of derivative speculators internal to AIG, AFAIK.

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