Lies, Damn Lies, & Statistics, or: Things That Weren’t The Cause of The Financial Crisis

25 Jan

Ever heard the joke “How many European Economists does it take to come to the wrong conclusion about the cause(s) of the American housing crisis?”  No?  Really? Well, anyway, the answer, it seems, is three:

For many, the US housing market was the epicentre of the global crisis. This column suggests that the US bankruptcy code, which in some cases protects a large section of the individual’s house, leads to overinvestment in housing – a bias that may have helped massage the US housing bubble in the decade preceding the global crisis.

The authors of this article would be well-served to spend an afternoon overhearing conversations in the food court of one of our many thousands of shopping malls (or maybe worse, Walmarts).  Were they to do so, methinks they’d quickly re-examine their thesis, methodology, and conclusions.  The average American knows about as much about state bankruptcy law as they do about quantum computing.

Maybe some Lawyers consider the worst-case financial scenario of personal bankruptcy when buying/paying for a home, but Lawyers account for less than 1% of employees (if not much less), and I find it extremely hard to believe many others even consider such an unpleasant outcome.

This leads us to a larger and far more important lesson:

I’ve been saying for years (as have many others) that quant types (traders, economists, structured finance peeps, etc) who seldom left the confines of their cubicles were instrumental in enabling if not causing the bubble that lead to the financial crisis.  If some of my recent reading is any indication, these mathletes – despite scoring off the charts on every test they’ve ever taken – still haven’t gotten it through their thick skulls that even the most complex analytical techniques are useless if not harmful when they ignore the fundamental reality behind the data.

It doesn’t matter how many degrees you have, how “complete” your data sets are, or how theoretically rigorous your approach/analysis may be.  Numbers lie.  Always have, always will.

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Michael Burry (and those who followed his thesis like John Paulson) became unbelievably wealthy because instead of holing-up in their offices on Wall Street, The City (or wherever) running numbers, they looked at the underlying fundamentals.  To the quant-types at banks, hedge funds, and institutional asset managers, home prices were not and would not become significantly geographically correlated, that just wasn’t possible or even likely.

To investors like Burry who saw the groupthink and herd-behavior within the mortgage finance industry and on Wall Street, this mentality was absurd given what he saw both on the front lines and within the thousands of pages of MBS (etc) prospectuses he read.  Lo and behold, when the proverbial excrement hit the fan, Burry made a fortune while Wall Street collectively barely survived intact, and only after extraordinary bailouts and other forms of Government assistance.

Surely there were other dynamics involved (competitive pressure faced by bank management to meet quarterly performance numbers, regulatory and ratings agency-enabled short-term goals, captured/ignored auditors/lawyers, etc), but as Burry and others have explained for the past few years, all the signs of the impending housing collapse were there to see for anyone who wanted to look at them.

In closing: be wary of nerds* bearing numbers.  Remember, there are three types of lies: Lies, damn lies, and (most dangerous of all) statistics…

* Many of my friends are nerds (as am I, to a point) and very few of them are of the arrogant, economy-destroying type.

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One Response to “Lies, Damn Lies, & Statistics, or: Things That Weren’t The Cause of The Financial Crisis”

  1. Tim January 26, 2011 at 2:33 pm #

    Ah yes, the balance of street smarts and book smarts….too much of one, not enough of the other.

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