Doug wrote: > One of the many problems with CDOs > and the like is that they're built > by mathematicians who assume that > the markets will always behave > "normally."
Since long, people in finance *know* in their minds that the distribution of returns is nonstationary, that it has "memory." On the analytical side, the fundamental intractability of nonstationarity forces them to frame the problem in terms of heavy-tail distributions. But that's like an arms' race: the quants keep fattening the tails of their respective distributions only to realize that even the fattest tails are unable to deal with the next extreme event. Clearly, the root of this silly practice is not lack of mathematical sophistication, behavioral quirks (in spite of Taleb), or sheer stupidity. It is moral hazard! Simply put, there's a strong incentive to disregard unlikely (extreme) events. Most of the time, disregarding extreme events works to your advantage. You'll do fine most of the time. And, when an extreme event hits you (if you haven't retired yet), many others along with you will be hurt. Nobody will fault you personally. You (like all others) can credibly claim that the event was truly unpredictable and demand that the Fed bail you out, as it's done before. You and all others are too big to fail. You and all others can bring the whole economy down. Etc. Ultimately, this will continue until those below pull the plug.
