Thursday, April 8, 2010

Whole Economy On Fire

At my previous firm, I advised the CIO on risk management.  I enjoyed this part of my job because it allowed me to think about problems that others didn't think about.   Lynn Eden's book Whole World On Fire was the last great book on investment and finance risk management I bought working there. (When Eden taught at Carnegie Mellon, I took all her courses, by the way.)  I'm reminded of this because I just saw the film Thirteen Days

This book makes for unpleasant reading.  Imagine detailed discussions about the disastrous consequences of nuclear weapons use, after the obvious stuff like buildings vaporize and people melt.   Let me summarize.  Smart military thinkers knew a lot about what nuclear weapons would do in terms of first order damage.  You need to destroy a hard target?  Hit it with a bomb or missile.  They could model the hell out of that stuff.  They couldn't model well other stuff, so they sort of ignored it.  Like, the fact that virtually everything on earth would catch on fire.  And burn up everything.  This led to massive waste of resources, detailed, irrelevant modeling, and organizational momentum like you wouldn't believe.

[Interestingly, the insurance industry understands somewhat better situations like this.  In the California quake reinsurance markets, for example, insurance companies may buy separate reinsurance that specifically covers the massive fires expected after a major earthquake.]

That's about everything you need to know about financial market risk management.  Risk managers and investors focused too much on what they understood how to model, and the models they used were as "inside the box" as anything you can imagine.  Organizational behavior tells us what we need to know.  Overcoming organizational behavior problems will allow us to manage risky situations better than any Consumer Finance Protection Agency or whatever other regulatory body someone wants to design. 

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