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Wall Street's Fatal Lack of Skepticism


It was missing in the past and it still is today.

Last week the New York Times presented a highly satirical and splendidly targeted piece by Calvin Trillin, one of America's greatest writers and the man who brought Arthur Bryant's barbecue restaurant in Kansas City to international attention.

In the article, Mr. Trillin argued that Wall Street used to be the province of well-connected dullards; the likable and seemingly harmless athletes from rich families in the back of the room who took gut courses and earned gentlemen's Cs. Only when the smart kids in the classroom made their way to the money world did things start to go wrong. The old world view -- "as long as we're making money, just keep doing what we're doing, don't ask questions" -- gave way to a view of "let's trade everything according to our computer model."

The problem, Mr. Trillin argues, is that the good old boys (led by the likes of Bank of America's (BAC) Ken Lewis, everyone's favorite whipping boy these days) were still ultimately in control, and they had no comprehension of what the smart kids were doing. All they knew was that it was working -- at least until it stopped working.

Don't miss reading Mr. Trillin's piece. It's entertaining and insightful. But it neglects one crucial similarity between old-school and new-school Wall Street management: That similarity was a fatal lack of skepticism.

The good old boys felt a sense of entitlement and undue satisfaction with the status quo. As long as the bottom line told a good story, it wasn't necessary to inspect the details of the plot.

The quants, meanwhile, were all about the details of the plot. They thought they could model everything. What they never acknowledged was that models were just that -- models. No really good user of any model ever forgets this.

But the quants had sufficient hubris to believe, somehow, that their models were actually smarter than the market. Any significant discrepancy between a model's prediction and an actual market price had to be because of the market's stupidity. The idea that the model might be based on flawed premises, that the model might be missing something critical or might be assuming something inaccurate -- heresy!

Nowhere is this more evident than in my own favorite little world of convertible bonds. Ever since hedge funds (some of which I've managed) took control over convertibles in the mid-1990s, the prevailing wisdom has been that convertible bonds should be traded like options; like "long volatility" instruments in geek parlance.

Riddle me this: If convertibles are long volatility, why did a year that saw by far the highest volatility since we've been measuring it (2008) lead to a frightening collapse in the prices of convertibles? Why, in a year (2009) that's seen volatility itself fall back to traditional levels, has this supposedly long-volatility strategy been among the top performers?

Convertible experts out there will point with partial justification to the other key input in the traditional model: credit spreads. Credit spreads widened to levels not even seen in the Great Depression last year but have now tightened to pre-Lehman levels in many cases.

True enough. But here's the problem: Credit spreads, particularly with convertibles, are notoriously difficult to estimate. In fact, with many issuers of convertible bonds, the convertible itself is the only piece of publicly traded debt. It's the only observable credit instrument. So how do you come up with a good estimate of the company's credit to evaluate the convertible? The best you can do is make an educated guess.

I have nothing against educated guesses. In fact, I kind of like them. But I'd never say that my educated guesses are categorically wiser than the actual trading price of an instrument. Anyone who's read my book or my columns knows that I'm no efficient-market devotee. Far from it. Still, the only thing of which I'm more skeptical than efficient-market theory is the omniscience of statistical models of tradable securities.

Skepticism, Mr. Trillin -- that's what we need, whether the feckless country-club set or the arrogant quants are driving the bus. As long as we're too willing to accept, we're guaranteed to fail.
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No positions in stocks mentioned.

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