by: Sigurd Rinde

Or why the situation is not about Black Swans, it's about Plain Geese.

Heard of Special Purpose Vehicles, a rather grim game of "hide and seek"? Seen this amateurish gaming of stock prices on the last day of last quarter? Ever wondered what a Structured Investment Vehicle is trying to hide? From "Hide and seek" to virtual poker games with real money, where does the games end and where does reality set in?

In order to understand, simulate and reproduce any natural phenomena we need a model, a theory. With that established, simulation can happen, understanding of cause and effect may occur.

But sometimes something unwanted happens: If the model is only approximative and there is money involved a tendency to game the model itself becomes very strong. We are after all humans. Homo Ludens that is.

To understand commerce, and even run commerce and industry we have developed a model, or rather a set of models where the most important one is called double-entry book-keeping, a 514 old model that tries to represent the transactions. Being rather coarse it soon required rules, regulations and referees - after all money is involved so the participants soon found ways to adjust, tweak and even cheat for their own gain.

And with rules duct-taping a two-pages-at-a-time paper based model representing reality what do we get? An increasing tendency to game the system of course. How much of the activity on Wall Street and in the City of London would you think is focused on gaming the system and how much is focused on fulfilling real life tasks like creating new products or repairing bridges? Anybody's guess I would say, but if you ask me, quite a substantial part being gaming the system. Certainly more money in gaming a system than in actually delivering a tangible value. Tangible values have the bad tendency of keeping the margins down, gaming the intangible and invisible has no limits.

Adding more rules will never change that reality. Deregulation or not, no real difference but the time-span before the model functionality is messed up again. Fair-value measurement standards, leverage ratio limits, no skin off my nose - it's all about the referee adding rules. Bailout, new rules, new referees and scared participants will forever be a part of it all. We'll sort this one out now, then we'll sit back and wait for the next one. And mind you, this is no Black Swan, this one is a Plain Goose returning from it's winter habitat. They fly off every now and then, then they return, that should not surprise anybody.

The current crisis is a game crisis, the best way to solve it is to stop the game, simply by moving the activity off the game pitch.

For this you have to look for a new model to represent reality more directly leaving less opportunity to game it. As you cannot create new models based on the old ones one has to start by dumping old models. I would suggest killing off the old Italian model as a good start and replace it with something slightly more modern.

Then of course, accepting the reality that we have the tendency to game any model, keep on refining the models instead of adding new rules.

Apologies extended to my old chums in the investment banking industry, it's not your fault, you've been in it just for the game.

Original Post:  http://thingamy.typepad.com/sigs_blog/2008/10/financial-crisi.html

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