Relating to Understand

I realized relatively early on in my life that I most readily understand a concept only when I am able to relate it to something else with which I am familiar. If you've been reading this blog at all you'll notice that I'm constantly comparing one thing to another, comparing sports and modes of expression, strategy games and financial markets, love and a time of cholera (ok, not that, but I needed a third thing and that title has always stuck in my mind - not that I've read the book, although I hear good things). I'm currently reading through Michael Lewis' new book "Panic: The Story of Modern Financial Insanity". As I was reading I came to yet another semi-baked theory that I'd like to share with my massive readership.

First, a little about the book. I received it as a birthday present, and both the Official Giver of Gifts and I thought that the book was authored by Lewis. He is definitely one of the X amount of people I'd want to sit around a dinner table with, so anything he puts out will immediately draw my attention. I was a little disappointed when I saw "Edited By" above his name (and in very small print, trixy publishers!) on the cover, but I figured I'd give it a short read to see if I could learn anything. I was pleasantly surprised by how he structured the book - intros written to each section/financial panic, and those sections comprised of news stories written about said panic. It's an interesting way to get a sense of the mind set that goes into each of these "catastrophes".

In the section on the Asian crash of '97 he writes about the hedge fund Long-Term Capitol Management (LTCM). Starting the story back in the context of his initial book Liar's Poker (a mandatory read for just about anyone) he writes about the crash of '87 and how it marked a change in power on Wall Street. At the start of that book he describes the average trader as someone who traded more from his gut than his head, and at heart was a salesman - emotional intuition was more highly valued than rigorous analytics. In the anecdote from Panic he writes how in the '87 crash, in the midst of Black Monday (Oct 19, 1987, the biggest single day drop %-wise in the financial markets ever) John Merriweather and his group of "young professors" were able to realize a fundamental truth about the crash and everyone else's reaction to it.

Lewis describes how the emotionally effective traders had essentially (very much simplified for the sake of narrative) been using cheat sheets to determine what the prices of their bonds should be. The specific set of circumstances that arose on Oct 19th, 1987 was not covered on those cheat sheets. Lewis is a much better writer than I'll ever be, so I'll just quote his section here:

This brute with razor instincts, it turned out, relied on a cheat sheet that laid out the prices of old long bonds as the market moved. The move in the bond market during the panic had blown all these bonds right off his sheet. "he's moved beyond his intuition," one of the young professors thought. "He doesn't have the tools to cope. And if he doesn't have the tools, who does?" His confusion was an opportunity for the young professors to exploit.

In order to exploit that opportunity, the young professors developed a series of mathematical models that would allow them to accurately price those bonds in more extreme and increasingly exotic ways. They took an area of knowledge that could previously be condensed down to a cheat sheet and evolved it out to the point where people needed multiple Ph.D.s in order to follow the math. Along the way they made hundreds of millions of dollars and kinda-sorta inadvertently triggered a follow-on financial panic in '97 and can be round-aboutly blamed for the current financial fiasco in which we currently find ourselves.

Ok, now that you know wayyy more about esoteric financial details of the 80s and 90s I'll explain the revelation that made all of this make more sense to me.

The analogy that makes the most sense to me is to compare the evolution of the financial markets to post-Newtonian physics. The "brute with the razor instincts" from the above passage was working in the equivalent of a Newtonian version of physics. He was dealing with actions and reactions that he could experience in his daily life. Sure some of them were complicated - the equivalent of a dropping weight spinning a rod that pulls a string that's attached to another weight that's on an incline, and figuring out how fast the weight goes up the incline. There's a lot to that problem, but you can relatively easily build the system, and none of the math should be beyond a pretty smart high school student.

What the young professors did was invent the equivalent of Relativity Theory and Quantum Dynamics. These two theories work just the same as Newton’s theories in every day environments. It’s only when things start moving really Really REALLY fast or gets really Really REALLY small that Newton’s laws break down, and you need either Relativity or Quantum Dynamics to explain what is happening. Analogously (did I just make up a word there, not sure) the old bond pricing cheat sheets worked really well in most cases that would ever come up. However, when that 1 in 50 million situation occurred the cheat sheets were invalidated. You needed much more complicated equations, using wayyyy more Greek letters than most people would recognize to begin to make sense of what was going on.

The result of this evolution is that instead of anyone who was particularly smart in High School understanding exactly how the world around them works, only those who majored in physics in college would be able to accurately explain what’s really going on. Of course, just like with physics, the financial markets didn’t stop there. The young professors busted out in the late 90s, but instead of going back to the easier days of everything on a cheat sheet matters just got more complicated. Wall Street began courting people with degrees in advanced physics and mathematics even more strongly than they previously had, and these people did what they normally do – torture the numbers to try and understand reality.

If you’re as big of a lay physics geek as I am you’ll know that the current Holy Grail of physics is to unify Relativity with Quantum Dynamics – explain what happens to the really big and the really small with the same set of equations. This quest has lead to terms you might have heard: String Theory, M Theory, Brane Theory, the Multiverse, etc. While it is possible to have an extremely basic understanding of what all these theories suggest (Brian Greene is the author you’re looking for), there are probably 50 people in the whole world who could really keep up with the math that goes into it. Similarly, as financial matters have gotten more and more complex – credit default swaps, collateralized debt obligations and a host of other oddly named financial products – the amount of people who can intelligently comment on them have similarly shrunk. It got to the point where the people in charge of the big banks playing with the money didn’t totally understand the models that their decisions were made on.

Now, there are tons of different implications for this realization, and I’m sure I’ll happily digress onto many of them in the future, but I’m onto my third page of single spaced text and I’m sure no one is still interested in reading this. The take-away should be that there is an interesting and informative parallel between the growing complexity in our understanding of the physical universe and the growing complexity of our manipulation of the financial universe.

Hopefully this comparison can help others with their understanding of the world, and as always, I look forward to hearing your thoughts in the comments (I think I’m up to 4 total comments at this point! WOOT!)