Margin Call

Epsilon Theory PDF Download (paid subscription required): Margin Call

There are two cartoons which lead both investors and nations to ruin.

The first kind treats a false measure as a true one.

The second kind treats a model of reality as if it were reality.

Both cartoons are perilous in the face of uncertainty. The first, the measurement cartoon, empowers actions based on a false confidence about the current state of a thing. The second, the model cartoon, empowers actions based on a false confidence about the future behavior of a thing.

Yet while both are perilous, their perils are not equal.

When we pretend our measurement cartoons tell us true things to guide our response to uncertain events, unless we are protected by a shield of time, law, arcane GAAP rules or an iron-clad, authoritarian grip on information, truth will typically out. It is difficult to hide bodies forever. Even if the true underlying reality being measured remains elusive, common knowledge about the cartoon in the face of sufficient contrary information may not. Eventually everybody knows that everybody knows that the cartoon is a fraud.

When we pretend that our model cartoons tell us true things about uncertain events, we may never realize that the predictions from our complicated models of reality weren’t necessarily so.

Often until it is too late.

The perils of measurement cartoons have been the chief focus of our essays thus far. These are stories about how various institutions acted to suppress the discovery, measurement and reporting of the true extent of infected individuals. They are also stories about how policies of governments, corporations and other institutions were designed around those constructed realities.

Stories about the CCP.

Stories about the WHO.

Stories about the US federal and state governments.

Fortunately, as (almost) the entire world has slowly come around to the realization of the reality underlying the measurement cartoon, policies have changed rapidly. Damage was done, but now further damage is being limited. It can be our finest hour, and we believe it will be.

True to form, however, it is the institutions who have relied on model cartoons who have not yet acted to limit damage.

In markets, that obstinacy is still coming to head today, especially for a swath of global macro, relative value and multi-strategy hedge funds. These institutions aren’t full of idiots. They no doubt saw the uncertainty associated with Covid-19 and its policy response. But they believed in their estimates of correlations among financial assets. Even so, it isn’t just that they believed in them. There is no shame in being process-oriented. It is that they continued to bet on those models of correlation with (often) significantly leveraged positions, despite everything in the world screaming at them that their models had become representations of something that looked nothing like the world that was unfolding.

Do you think only one horror story will come out of this? Do you think Sunday’s emergency Fed action had our credit availability in mind? That it was designed to make sure we could still apply for a Capital One card or refinance our mortgages and access short-term capital to keep paying our small business’s employees for a few weeks? Don’t get me wrong about this – a lot of good hedge fund managers will lose money in March. This isn’t about whether you got the trade right. It’s about whether your process empowered you – whether systematically or intuitively – to recognize when the world of risk and cross-asset relationships your models represented wasn’t the world at all, but a cartoon.

That’s why what I worry about more than anything today is the United Kingdom, which is continuing to pursue a strategy which combines vague, conflicting recommendations with targeted social distancing. It’s a strategy effectively built on a foundation of four models: (1) behavioral response models for quarantined humans, (2) seasonality models, (3) mutation properties and (4) ‘herd immunity’ models. I worry not because I have any special knowledge about whether they are correct. I worry because by knowingly permitting the spread of a pandemic of many unknown qualities on the basis of models with hugely uncertain parameters, they are effectively levering up 66 million lives to the accuracy of those models.

Only the call you get when these trades blow up isn’t a margin call.

Here, too, I have hope. The Brits are pragmatic to a fault. They don’t need the government to tell them to keep granddad at home. Many of them have been doing it for weeks. There’s a practicality to their academics, too, an army of which quickly emerged to voice their opposition to the plan unveiled by Boris Johnson’s government. There is some evidence that closures and additional recommendations are forthcoming. The claims of herd immunity aims have been softened. I believe that the UK government will get it right. Eventually. For God’s sake, I named my firstborn son after Churchill, so I’ve got to be pretty sure they’re going to get their shit together at some point.

But for our readers and friends there, please don’t wait for that to happen. As Taleb and Norman wrote correctly yesterday, our civic obligation to the whole in the situation is individual overreaction. The best time was two weeks ago, but the second best time is now.

Epsilon Theory PDF Download (paid subscription required): Margin Call


Good news on this front. The UK government is taking this seriously and has moved in the right direction – knew y’all had it in you! Pressure from, er, non-behavioral science nudging experts across the pond has to be given a lot of credit for this.

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  1. Gentlemen, to whatever extent you feel comfortable, I’d humbly request you make as much as you can .pdf-able as it relates to this crisis over the next several weeks… I have a pack I forward a lot of material to from various platforms. Happy to pay more with my membership as well if need be, but I know that’s not why you do this… Your pieces are truly essential reading. I’m pushing my people hard with data and asking them to push it out even further to those they interact with. Our behavioral changes and solutions to this need to be just as viral as the problem… I know you know this. Just putting it out there for your consideration.

    Thank you!

  2. Ed, yes! We’ve been trying to make sure all of the content right now is PDFable for just the reason you describe. We also want to get the notes posted as quickly as we write them so there will sometimes be a lag! Thanks for thinking of this.

  3. Social distancing but intellectual proximity, both pushed as far as we can to live…

  4. Thank you! And thank you for everything you all do!

  5. Ha !
    I got a first hand example of that.
    2 weeks ago, on Monday 2 March I read a short note from a normally quite on the ball firm about how the virus trajectory in the US would play out the way it did in HK. Luckily they also mentioned that the market was too sanguine about the coronavirus and it was not yet time to buy.
    Yesterday they sent another note, apologizing for the miscalculation , suggesting that the US & EU Governments now bail us all out with helicopter money. True to their intellectual form, they suggested that any future inflation could easily be measured and brought under control…….

  6. Is Boris so foolish?

    We’re caging and bankrupting the small business owner and self employed, the worker who can’t work from home all in the same fell swoop.

    My Friend: the middle class, the shopkeepers make revolutions. I mean an actual revolution, not the 60s.

    See France, Russia, Iran and of course the United States.

    All those people are now caged, going bankrupt and are helpless. In America.
    Watching the Fat Cats cash in their next free Trillion$.

    We’ll see if Boris is so foolish. The UK is betting on beating the second wave of COVID now.
    They’re actually being British for a change. Not panicking in the face of a true test.
    Where we are here now is a one time, one shot deal.
    We’ll not quarantine the USA a second time. This is our one shot at self quarantine.
    There will not be another, we’ve just shot our one bullet.

    And even if it’s the magic bullet the angry and bankrupt will emerge from their cages angry, hungry.
    And if they don’t walk out in the street and see bodies convinced they were played for fools by fat cats and their media minons.

    Boris may not be so foolish, and if the plague does not take the English what will people here say?

  7. And I may add the Fat Cats have their first Trillion…and not the first or last…

    That we have been played for money even if we avoid mass casualties or if we suffer them we already know the answer is yes. We’ve been played. REPO and QE do not cure COVID.

    The bailout will cost us dear if not one more dies. I do not mean money.

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