Complex systems

Common Causes of Catastrophic Failure


“Don’t cross a river if it is four feet deep on average.”-Nassim Taleb

“Complex systems are full of interdependencies—hard to detect—and non-linear responses.  In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.” Nassim Taleb

“The condensation of credit cycles and the increasing incidence of credit dislocations is a consequence of the globalisation of the world economy, technological advancements in the electronic transmission of information, and financial innovations such as derivatives and securitisation that blur the distinctions among markets and asset classes.  The confluence of these developments has perversely made the markets more informed but less informative.  Information and capital rocket around the world at unprecedented velocities and volumes, leaving investors to process market data before reacting.  Today, a pin dropping in Argentina can cause simultaneous ripples (or waves, or in rare cases tsunamis) as far away as Japan.  By the time the pin drops, it may already be too late for investors to protect their capital.  In a financial world dominated by innovation and new products that blur the traditional distinctions between debt and equity, disruptions in the credit markets are certain to affect all hedge fund strategies in all asset classes.  The increasing frequency and severity of extreme credit events points to the heightened risk of contagion among markets and asset classes. ”  Michael Lewitt, 2003

It’s hard to see how an investor could have had a reasonable understanding of the risks sitting on the books of many of the global banks.  Increasing reliance on credit markets posed risks, even for those banks with large deposit bases.  An investor with a generalist mindset and an appreciation of credit markets would be mindful of the potential for capital destruction in the sector.

“The analysis of credit cycles involves an understanding of monetary policy, financial and industry innovation, and regulatory change.  The ability to identify in advance those moments when credit cycles veer into crisis also requires imagination, an appreciation of human folly and a willingness to imagine worst case scenarios.  In order to identify times of maximum risk, understanding human psychology is at least as important as understanding economics.  Credit cycles involve a combination of historical, sociological, political, economic and psychological factors that are both unique to each specific cycle and common to all cycles.  Hard and soft data must be examined.  The unhappy truth is that markets don’t learn their lessons very well.  Financial history tends to repeat itself.  The only questions are when and to what degree.  Hedge fund managers charged with preserving capital and producing positive returns in both good and bad markets must pay particular attention to the etiology of credit cycles and particularly those extreme turning points that lead to financial crisis that can consume years of returns in the blink of an eye”  Michael Lewitt 2003

–Michael Lewitt, The Credit Strategist (October 1, 2012)

“Moreover, markets are motored by technology. Money is moved around the world by massive computer power that reduces every form of capital to the same thing – bytes, or 1s and 0s. This leveling of differences is essential to facilitate the flow of money around the world, but it does not come without a cost. The treatment of everything as the same thing conceals the very real differences that lie behind the numbers. Technology creates the illusion that capital is stable and continuous when it is in fact highly unstable and susceptible to abrupt discontinuities. The failure to understand the dynamic nature of capital heightens the risks involved every time an investor takes cash and exchanges it for a stock or bond or tangible asset.

Its stewardship by human beings is what renders capital unstable. Even the most rational human being is highly irrational and driven by emotion. Human beings suffer from a fascinating dichotomy – they live their physical lives sequentially but are endowed with minds that are not bound by time. We live our lives in order but we can think them out-of-order. The ability of the human mind to remember and to imagine introduces an enormously influential element of unpredictability and emotion into human action. An investor’s greatest challenge is to reconcile this dichotomy, which is an ineluctable part of the human condition. And while an investor can try to rely on models that by their very nature simplify reality, he must acknowledge and include in his calculations the incalculable.

Credit is therefore the ultimate human construct. It relies on the past to predict the future. It enlists both memory and imagination. And it is subject to discontinuities that can lay ruin to the best laid plans. Central bank creation of limitless amounts of credit out of thin air is the ultimate human act. But it must be understood for what it is: not something that reduces risk, but an act that radically heightens systemic risk.”

“Remember that you are a Black Swan.”

“The three most harmful addictions are heroin, carbohydrates, and a monthly salary.”

Nassim Nicholas Taleb

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