I’ve been getting grief from a few people about the haphazard manner in which this blog is updated. I couldn’t agree more. Any successful media source relies on creating expectations and then meeting those expectations. So, my New Years Resolution will be to keep this blog updated regularly and full of fresh content.

In the meantime, here’s my latest Big Idea from ROB Magazine.

Wisdom of crowds

In the era of Google and 24-hour news, there is no shortage of expert opinion. Too often, the wrong ones prevail

KEN HUNT

December 16, 2008 at 7:00 AM EST

Things were going amazingly well. In 2007, AIG Inc. was one of the 10 largest companies in the world, and the unri­valled king of insurance. It had over 110,000 employees and operations in 130 countries. But much of the real action was happening in one little office called AIG Financial Products, ensconced in London’s exclusive Mayfair district. The branch had fewer than 400 employees, but between 1999 and 2005 this cabal of hard-core egghead quants took AIGFP from revenues of $737 million to $3.26 billion (all currency in U.S. dollars), largely by issuing credit default swaps on blue-chip corporate debt. Joseph Cassano, the leader of AIGFP at the time, was so confident in their business model that, as late as August, 2007, he was quoted as saying, “It is hard for us, and without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions”

It wasn’t long after that it all came crashing down. The credit default swaps they issued added up to guarantees on nearly half a trillion dollars worth of debt, and none of that risk was hedged. When the underlying debt started to sour, thanks to a downturn in the housing market, AIG’s business swiftly crumbled and threatened to take down everyone who had purchased their products with them, including many of the world’s largest banks. Within six months of Cassano’s “one dollar” statement, his operation had lost $11 billion and triggered a U.S. government bailout that has since climbed north of $150 billion. So, where did these millionaire geniuses go wrong? Why didn’t they see this coming, and how could Cassano have been so extravagantly confident and oblivious? The answer to these questions lies in the fact that they were working from financial models built by the greatest minds in modern economics. They trusted these models, and everything in them pointed to a safe and steady stream of profits. Those models just happened to be dead wrong.

When Alan Greenspan was called before the House Committee on Oversight and Government Reform to explain the current mess, he pointed directly at the failure of the reigning computer models, saying that some time last summer, the whole modern risk management paradigm simply collapsed. “I was shocked,” Greenspan said, “because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.” Common sense, however, should have tipped off the financial world that the party couldn’t last forever: Housing prices had been known to crash before, lending standards on many subprime mortgages were absurd, and the notion that anyone could make billions of dollars a year risk-free sounds as naive as a Nigerian e-mail scam. The manner in which financial wizards were blindly trusting their risk models was akin to the truck drivers who had become so reliant on their GPS systems that they followed them into rivers and through farmers’ fields. Harvard Business School professor Niall Ferguson put it best when he wrote: “Those whom the gods want to destroy they first teach math.”

Farhad Manjoo, technology columnist for the online magazine Slate, is curious why we pay attention to some sources of information and blissfully ignore others.
big idea

His book, True Enough: Learning to Live in a Post-Fact Society, explores the way our personal ideology affects the way we interpret the world. According to Manjoo, “facts no longer matter.” These days, we simply decide how we want to see the world and then go out and find experts and evidence that back up our beliefs. Meanwhile, we have a tendency to dismiss those who are not onside, sometimes with devastating consequences.

In the case of AIG, and all the others who contributed to our faltering economy, those who should have known better, who were in the best positions to see the risks of subprime lending and the unfettered and unregulated use of high-risk derivatives, ignored the disease as it was spreading.

In the classic 1972 book Groupthink, Yale psychology professor Irving Janis showed just how a panel of experts can come to a consensus that is wildly incorrect. Experts worry about their status in the community. They fear veering too far away from the others, because if they do, they risk becoming irrelevant. Even the most well-informed or cynical experts can find themselves censoring their viewpoints and even actively changing their deeply held beliefs in order to remain in line with what they perceive to be the beliefs of the group as a whole.

In AIG’s case, it’s not as if there were no experts out there warning of the dangerous direction in which the economy was heading. One YouTube video making the rounds recently shows Peter Schiff, president of Euro Pacific Capital, touring cable television’s financial shows in 2006 and 2007. More than anything else, these appearances show exactly how uncomfortable it can be for a single person to speak up against the consensus of his peer group. On each program, Schiff warned that the economy was headed for a major meltdown, one that would extend far beyond the subprime mortgage market and would eventually cause markets—financial stocks, in particular—to plummet. During one debate on Fox News in May, 2006, four panellists in a row were given the opportunity to summarize their positions toward U.S. housing markets: Each one said, “The worst is over.” Turn to Schiff: “The worst is yet to come.” There were bursts of laughter, followed by assurances that nothing of the sort was likely, or even possible. As he cut to a commercial, Fox News anchor Neil Cavuto segued, “All right, Peter, I wish we had more time with you. I know you want to continue that exposé on Santa Claus.”

Given Schiff’s treatment, it’s little wonder that other experts weren’t lining up to contradict popular opinion. One great thing about the economy, though, is that the truth always comes out eventually. No model is so compelling, no bubble so exuberant, that it can beat market fundamentals in the long run.

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