Why did the 2008 Financial Crisis Happen?

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August 26, 2010

Nassim Taleb writes in a new essay:

The interplay of the following five forces, all linked to the misperception, misunderstanding, and hiding of the risks of consequential low probability events (Black Swans).

Increase in hidden risks of low probability events (tail risks) across all aspects of economic life, not just banking; while tail risks are not possible to price, neither mathematically nor empirically. The same nonlinearity came from the increase in debt, operational leverage, and the use of complex derivatives.

Asymmetric and flawed incentives that favor risk hiding in the tails, two flaws in the compensation methods, based on cosmetic earnings not truly risk-adjusted ones a) asymmetric payoff: upside, never downside (free option); b) flawed frequency: annual compensation for risks that blow-up every few years, with absence of

claw-back provisions.

Increased promotion of methods helping to hide of tail risks VaR and similar methods

promoted tail risks. See my argument that information has harmful side effects as it does increase overconfidence and risk taking.

Increased role of tail events in economic life thanks to “complexification” by the internet and globalization, in addition to optimization of the systems.

Growing misunderstanding of tail risks Ironically while tail risks have increased, financial and economic theories that discount tail risks have been more vigorously promoted (while operators understood risks heuristically in the past3), particularly after the crash of 1987, after the “Nobel” for makers of “portfolio theory”. Note the outrageous fact that the entire economics establishment missed the rise in these risks, without incurring subsequent problems in credibility.

Taleb goes on to point out the responsible parties and suggested remedies. Read the rest .

Nassim Taleb, author of many books—The Black Swan , Fooled By Randomness. and The Bed of Procrustes —is in the process of writing a new book.

Source: www.farnamstreetblog.com

Category: Personal Finance

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