Can risk be modeled?

If you are talking about Life Insurance and the risk of death, more than one hundred years of experience has proven that, short of a war or pandemic, mortality is predictable. Law of large number will reduce the variability and you can model to a degree of confidence. If you are talking about probability of default on debt, then you are talking about modeling people's behavior that will be driven by incentives and the performance of the entire economy, which as many under currents. Everyone probably still have the credit crisis and financial panic of 2008 in mind. One of the source of the panic is that financial engineers assume mortgage default rate will behave about the same as the past 10 years, and priced the CDO/ CDS accordingly. When law of large number does not stabilize the default rate and it becomes clear that trillions of derivative assets are priced on wrong assumptions, the run starts. The disaster was a magnificent view. You put your trust on the model you don't fully understand at your own peril. And some short sellers are wise enough to profit handsomely on it. The lesson I learned is that I should examine the assumptions modelers use carefully, before embracing "financial weapon of mass destruction" (Buffett) as a panacea to reduce funding cost.

The religious right and the small government don't come together

I come to the US at the age of 27 and have worked and lived here for 15 years. I still found the US a country hard to understand. The conservatives want three things: small government, strong defense, and Christian value. But I consider these goals are mutually exclusive of each other. A small government and strong defense mean very little social support. Health Care debate in America is the best example for little social support. The bottom 15% of the US citizen don't have health insurance. This is the highest in all of the OECD countries. These same people also have a 31% unemployment, compare with a 3% unemployment for people on the top 10% of income scale over the years. The US has the highest infant mortality rate among OECD countries. At a rate of 0.006 it is double that rate of Italy at 0.003. But if you look at GDP per capita alone, US is 50% higher than Italy, at more than $46,000 versus Italy's about $30,000. All these economic indicators point to a policy of social Darwinism, in the sense that freedom is valued above equality, and under free competition the weak and the poor is often on their own, struggling to survive. This is understandable to me since America is proud of its capitalist traditions. What is hard to understand for me is that this same group of people who advocate small government and personal liberty and free market capitalism also call themselves Christian and hold religion dear to their heart. A good example is when Sarah Palin hailed her supporters for holding on to their gun and religion, and the crowd cheered. To me this is puzzling - is Christianity somehow consistent with Darwinism? What is the content of this religious right? A moral value that believe in free competition and winner take all? To me edging out the poor and the weak has nothing to do with Christianity, which it is about compassion and love. So why would these people call themselves religious? And religious on what kind of faith? A mysterious, interventionist God? A God that punishes the evil and has no compassion toward the weak and poor? A religion that serves the ideological ground to use gun to fend off anything they don't like? It puzzles me.

I am still seeking to understand, but I wonder if I ever will.

Make a difference

Q: Do you matter?
A: Depends on if you can make a difference.

Q: How do you make a difference?
A: By setting a good goal and work dilligently to achieve the goal.

Q: How do you set a good goal?
A: You consider the interest of your family, your company, your society, as well as your own. The goal has to be specific, measurable, achieveable, realistic, and time-based.

Q: How do you achieve your goal?
A: by being methodical and persistent.

God and Science don't mix

http://online.wsj.com/article/SB124597314928257169.html

By Mr. Krauss of Arizona State U.

Very good reasoning and thought proviking.

Is religion solving or contributing to the world's trouble?

Free Market as a Religion

Overall I support the claim that free market system is better than any other systems. But a lot of free market ideology that is being promoted, such as the version Stephen Moore of WSJ is promoting (see http://online.wsj.com/article/SB124355131075164361.html), is far beyond economics as a science and approaching a political ideology that akin to religion.

When I was in school my economics profession told us that market can fail when there is information asymmetry. That usually means when buyers don’t know what they are buying. In those situation regulations are necessary.

What does it mean buyers don’t know what they are buying? Let me give some example:
Pharmacy – we have no idea if a new drug will kill us, so we want FDA to be our gate keeper.
Insurance – we have no idea what all the fine print has done to exclude our coverage, so certain unfair provisions can be prohibited by insurance commissioners.
Credit Card – fine prints are challenging to understand, so the new law requires companies to make it easy for us to understand how much interest and fees we pay.
Banking – do you know which bank is unsafe to deposit if there is no FDIC?

You get the idea. I found it disturbing that some people push deregulation and smaller government as a religion. The motive behind it is obviously for profit, but they claim it is for the good of society. I am not a fan of big government, but I think the existence of FDA is certainly necessary. Why would you want a private “drug rating agency” to replace FDA? What happens if they make a mistake like the credit rating agencies have before the crisis? What if these drug rating agencies become captives of the pharmaceutical companies?

When you push a generally correct idea to the extreme and make a religion out of it, you lose the benefit of common sense. Small government is good, but anarchy is not.

Forecast

An Actuary’s job is to predict mortality. Death is certain in life but the timing is uncertain. Using the rule of large numbers (statistical jargon on converging expected value), an actuary can make some reasonable forecast.

Forecast in general is applied in many aspect of life: GDP, employment, sales revenue, weather, and so on. Guessing what is going to happen next is never easy. But experience and logic usually make some forecasting possible. There is some margin of error but within range. These forecasts are what you depend on for decision making.

When making a decision, you also weigh the benefit of upside and the risk of downside on you options. In other words you consider both the severity and the probability. If one of the outcomes can be catastrophic, you want to insure against it even if the probability of happening is low. You should not be paranoid about risk, though, as risk taking usually has a benefit, too. By assessing both upside and downside, the severity and probability, we can make decisions methodically, systematically, and rigorously.

Relationship Management

A successful business man needs to be able to build amicable relationship with customer, colleague, supplier, and the general public. So it is important to be able to speak to a group of people and build relationship. This ability has to do with public speaking, salesmanship, and understanding the value of customers and society in general. Successful relationship management is more than half of the success, so is very important.

Too big to fail is a problem

What makes capitalism work is market discipline. When you have institutions that are “too big to fail” the market discipline breaks down. Efficiency argument for free market no longer stands.

After the Fed pumped trillions of dollars into the financial system, is there any regulatory change that makes the financial system safer?

US Health Insurance

Americans on a per capita basis pay about twice the price Japanese pay on health care, and yet life expectancy in Japan is longer than in the US. Arguably Americans are the least efficient health producer in the world if health performance is measured by life expectancy. There are a lot of reasons that contribute to this phenomenon but the central piece is an America idea about liberty.

In Europe and Japan mandatory health insurance or health tax is a norm. Mandatory health insurance avoids the classic insurance problem: adverse selection. Adverse selection is an insurance industry jargon referring to a market phenomenon that young, healthy people avoid buying insurance while the sickest all sign up. In order to be profitable private insurance companies either drop coverage for the sickest by way of pre-existing condition, or raise the premium significantly for everyone. The result is a combination of high health insurance cost and lack of coverage in the US.

Mandatory insurance is the solution to adverse selection, but it runs counter to American’s idea about liberty. “I, as a consumer, should have the right to decide what I am going to buy. If I decide food, clothes, and housing come in priority to health care, it is my decision and no one else’s.” That might be true, but sooner or later, people will get sick and eventually everyone will die. People who don’t buy health insurance usually end up in emergency room, costing expensive resources without paying. There is no solution to this problem, except for mandatory insurance or the inhumane way of throwing out very sick and injured people out of hospital.

It is hard to convince people that health care is something you have to buy, though. I have heard people say: “Some say everyone is required to have insurance to operate a car, and the same should apply to health insurance. That is not right. I can do without a car but I can’t do without myself. Mandatory health insurance is an unfair tax that helps the sick” Another fear that Americans have for a health tax is that people will lose their choice of health care provider. “When you don’t pay out of your pocket, you don’t have a say who is your doctor or nurse. But health care is so personal that I demand a choice.”

With this conflict between American idea about liberty and the need to avoid adverse selection, no answer is easy. Maybe there won’t be a solution in the US for health care. Coverage will continue to be insufficient and cost will continue to be high.

How did we get into this mess?

1. Housing price steadily went up since 2001.
2. Buyers of all sorts sensed opportunity and started buying.
3. Lenders loosened lending standard because they saw low risk in the short term, due to rising price of housing; long term they had planed to sell the loan to Wall Street for repackaging and resell
4. Wall Street used financial models to create complex securities based on mortgages and then sold them to investors, especially from China and Oil countries
5. China and Oil countries accumulated savings and need to invest. Treasury was yielding low so they invested in these mortgage backed security thinking they have good collateral behind it.
6. Credit rating agencies didn’t understand the new instruments, such as CDO square, and went to Wall Street for help. They use the same financial models to assess the risk of these new financial instruments, and gave AAA rating to a lot of the product that turned out to be CCC.
7. China and Oil exporting countries see the AAA rating and bought those securities in bulk. This creates a credit boom as liquidity is everywhere.
8. But when housing market reversed its upward trend and started to go down, everything turned.
9. Buyers stop buying, foreclosures are rising, lenders stop lending, Wall Street can’t sell the securities they repackaged, foreigners stop buying those security, and rating agencies quickly down graded previous AAA to CCC, consumers are reeling, corporations cut back and layoff, and quickly we are in a financial crisis plus recession.
10. Deleveraging process needs to run its course. We will see down turn extend beyond 2010. When everything is purged, the economy will grow again.