Guest essay by Michael R. Smith, C.C.M.
Forbes, “Absolute Return” column, April 21, 2008, page 246:
Here’s another name you should own, Freddie Mac ($29 per share)…Freddie is cheap at 1.1 times book [value].
Less than five months later, Freddie Mac’s stock was worth 25¢ per share, a loss of 99%. It has since recovered to 70¢ per share, so the loss is “only” 97.6%.
A forecast of a stock of a single company five months into the future seems easy. The company had government backing (federally sponsored corporation). What could go wrong?
Yet, the forecast published by Forbes, short of an outright bankruptcy, could not have been more inaccurate. It is worth examining how a situation that seemed rock solid (government-backed securities!) became catastrophic to see if there are any lessons that might apply to the atmospheric sciences.
The assumptions that Freddie Mac (and other financial stocks) were low risk was primarily a result of computer models. As one expert stated (using pseudonym at http://blogs.zdnet.com/Murphy/?p=1265 ),
The problem is inherently complex – imagine being asked to value a portfolio of 10,000 residential mortgages issued to a total of something like 17,652 individuals. Each mortgage balances some issue amount against some payment stream; each has had zero or more payments recorded against it, each has an initial interest rate; an interest computation method; zero or more early payment opportunities; some mention of late or missed payment penalties and conditions, and an expiry, renegotiation, or call date.
While I do not doubt that is “complex,” the level of complexity is miniscule when compared to the complexity of the earth-atmosphere-ocean system and their interactions. Yet, faith in these model valuations led to a prediction that Freddie Mac stock was “cheap” when a meltdown of the financial system, largely due to the incorrect valuations and risk estimates by computer models, was less than 180 days away.
After the meltdown occurred, a second Forbes article stated, “All existing models for calculating risk, he [Nassim Taleb] says, should be thrown out because they underestimate extreme price swings. ‘The track record of economists in predicting events is monstrously bad,’ he says.” (February 2, 2009, p. 21) Of course, we learn this after our home values and values of our 401K’s are wrecked.
Given the failure of these models to predict the implosion six months hence, would you invest the remainder of your 401K on what the same model predicts for the next six years or, if you are in your 20’s, what it predicts for sixty? I don’t know what your answer might be, but common sense would indicate applying the forecasts from these models to your portfolio with extreme caution.
June 1, 2009, we learned from The New York Times that “Models’ Projections for Flu Miss Mark by Wide Margin.” The model predicted, according to the Times, “by the end of May, there would only be 2,000 to 2,500 cases in the United States… On May 15, the Centers for Disease Control and Prevention estimated there were upwards of 100,000 cases in the country…”
Just six months earlier, the models’ predictive capability were touted because of real time input from Google (www.cidrap.umn.edu/cidrap/content/influenza/panflu/news/nov1308google-jw.html ). Now, the flu has been declared a “Pandemic” by the World Health Organization (/www.pandemicflu.gov/ ) in spite of the modest number of cases projected to be in existence by June, 2009, by the models. Another critical short-term modeling failure.
Question: If the model predicts low risk for the next six months, would you decide to forego a flu shot? Again, your answer might be different, but common sense would dictate getting the shot.
How do these examples relate to climate modeling and policy?
We currently have climate models that have missed the fact that atmospheric temperatures peaked 11 years ago and that oceanic heat content has, at best, failed to increase. See: http://climatesci.org/2009/03/04/large-uncertainty-in-the-simulation-of-the-global-average-surface-temperature-by-the-ipcc-models-a-study-reported-on-the-weblog-the-blackboard/ , http://climatesci.org/2009/02/09/update-on-a-comparison-of-upper-ocean-heat-content-changes-with-the-giss-model-predictions/ , among many others.
Given the inadequate performance of these models over the last 5 to 10 years, why do we believe we can make accurate, highly specific forecasts 50 to 100 years in the future? Is it because we are so close to the problem we are blinded to the dangers like the economists who did not see the meltdown coming?
Almost no one familiar with meteorology or climate models would disagree that they are more complex than the mortgage valuation or influenza prediction models. The basic processes of the earth-ocean-atmosphere are incompletely understood and we barely understand many of their interactions.
We also know that forecasting the weather beyond five days is dicey at best. Then why are we making 29,000-day weather forecasts? Don’t think we are doing that? Consider the following:
“By the period 2080-2099, devastating heat waves of the kind that killed more than 700 people in Chicago in 1995 will occur three times per year.” (USCCP, p. 119, citation below)
That is a weather forecast – a forecast of specific meteorological conditions at a specific time and place. The document is filled with similar predictions, along with recommendations based on those predictions.
We are sometimes told that climate forecasts can be made because the “weather” errors will be cancelled out because they are “random.” Here is what was said about the mortgage computer models,
Now, because you can predict roughly the probable range for most of these assumptions but not the actual values the variables involved will have for each of the time periods you have to consider, what you do is write a monte carlo simulation in which you try tens of thousands of value combinations and plot the results to see what, on average expectations, the portfolio might be worth.
Notice, that at this point even something as large as 0.0005% error in the outcome would be completely insignificant – so randomization error should have no effect, right? (op. sit.)
It was believed by most the mortgage instruments were safe because the errors (i.e., a higher default rate of subprime lenders) would cancel out (because the risks were spread) and because, if desired, default insurance could be purchased from institutions like AIG. Of course, AIG used similar models to determine its risk. We just learned how well that worked.
In spite of these spectacular failures of less complex computer modeling in economics and public health, the atmospheric sciences seem to be making similar miscalculations. If your common sense would lead you to disregard these models’ forecasts when planning your portfolio and whether you get a flu shot, I would suggest we adopt a much more modest approach to the use of climate models. While they are useful research tools, the numerous uncertainties (cloud feedback, particulates, volcanic ash, the current quiet sun, etc.) are so great we cannot claim to have forecast skill decades into the future.
Otherwise, when I read, during a period of falling temperatures and ocean heat content,“Global warming is unequivocal,”* I hear, “Freddie Mac is cheap.”
- U.S. Climate Change Program, Key Finding #1, January, 2009, http://downloads.climatescience.gov/sap/usp/prd2/usp-prd-executive-summary.pdf
Michael R. Smith is CEO of WeatherData Services, Inc., An AccuWeather Company, and a Fellow of the American Meteorological Society. This weblog represents his personal opinion. AccuWeather’s Global Warming Blog can be accessed at: http://global-warming.accuweather.com/ .
Speaking of positive or negative feedback within a model – I still say that the same group that wants to bring down capitalism is pushing the AGW ideology. The simple problem with this is if capitalism isn’t around and healthy enough to underwrite the billions (maybe trillions) necessary to enact the drastic measures called for to save us from AGW, the movement will expire.
Simply said – the world is not economically healthy enough to play this (AGW) game. Whether natural or by coincidence the model is providing negative feedback to AGW alarmism.
With regard to the subprime/economic meltdown; another major regulatory failure was the repeal of the 2nd Glass-Steagal act that seperated retail and investment banking. Introduced in the early 1930s to prevent the reoccurence of speculative losses by large financial institutions, they were repealed, after much lobbying by the banking sector, in 1999 by Clinton. Both Finance and Government share the blame for this one.
Tim (22:10:58) :
I just noticed the following Google Ad showing up under this article:
SALE – The Great Warming
with Keanu Reeves and Alanis Morissette – only $9.95
http://www.thegreatwarming.com
On following this link I found an interesting excerpt by the author of the underlying book, journalist Lydia Dotto. Dotto, like so many other warmists, insists that the issue is the precautionary principle:
“The real question, therefore, has little to do with proof. It has to do with the precautionary principle-in its simplest terms, “better safe than sorry”-or, more precisely, our willingness and ability to embrace it.”
http://www.thegreatwarming.com/stormwarning.html
This now is the heart of the AGW position. Even IF all the predictions and alarms have no firm proof, should we not buy the insurance?
Well, we might ask if a person living in Arizona should buy hurricane insurance? Or earthquake insurance? We buy insurance when there is a body of demonstrable evidence indicating the phenomena we’re insuring against – actually exists and has caused damage.
What is truly alarming is how the alarmists seem incapable of snatching success from the phantom burning building. They cling to demonizing CO2 – even as it it shown daily to be the most “greening” trace gas in our atmosphere. Yet, if they simply dropped demon CO2 and went with the Energy Independence campaign – they could build windmills, brew biofuels, manufacture hybrids and sell EVs to their heart’s content. But will they own up to their AGW blunders? No. Too much pride apparently. And pride for the religiously circumspect, is one of the seven deadly sins!
Time for new management alarmists?
http://www.spaceweather.com/ Is usually very up to date with sunspot numbers ect..
The flu upgrade is because they think once real flu season hits H1N1 will turn to a deadlier strain much like the one around the 1900’s did. The fact that it is persisting into non-flu season is what has them worried. But it is a great excuse to halt stuff like tea parties like the ones scheduled to happen on the 4th of July.
Model or not.. who didnt honestly see that housing was in an unnatural bubble? I lived in Las Vegas during its height… we wondered then why people were willing to buy homes at outrageous prices with variable contracts in an area whose only real industry is gambling. LOL It went on till no one was willing to buy the properties any more then the banks cried foul? Where did all the money made on these properties go? Was that subtracted when the bubble burst? I doubt it. See it was fine when it was making everyone money, but a tragedy and an emergency when it wasnt. To compound that.. our congressional oversite IS apparently bought and paid for.
As for the whole AGW agenda: It does not reduce pollution in air, water or land. It does not even reduce Co2 with its Cap and Trade agenda. It does not promote learning or scientific advancement, it stagnates it. It will not protect our resources, land or any creature that would dare stand in its way. Protect the polar bears but its ok to kill the raptors:0 Save the rainforests, but level the mountain ridges and desert floors. I have stopped trying to convince people who believe in AGW models not believe it. Instead I ask them to look at what the current plans for its cure are actually really doing. It is an eyeopener for most, who like myself consider themselves a friend of the Earth. Enron was just a test run. We decide if we are going to let them do it on a global scale.
OT but: As a retired lawyer with securities law experience, the lead part of this post about Freddie Mac and Fannie Mae caught my attention. Independent forecasters like Forbes have no legal liability for being wrong. However, both Freddie and Fannie are federally sponsored enterprises subject to special oversight by a specific federal agency and both the House and Senate banking committees. There is irrefutable evidence that Barnie Frank and Chris Dodd, Chairs of the Congressional banking committees, along with current and former Freddie and Fannie executives deliberately mislead the public and shareholders about their financial condition . I am amazed that no one has considered suing Freddie and Fannie executives under SEC Rule 10(b)5 for damages resulting from misrepresntations and and false reporting to the SEC.
Sadly, I suspect that members of Congress are immune from liability when acting officially.
For sure, it would be fun to depose Frank, Dodd and current and former CEOs of Freddie and Fannie under oath about all of the misrepresentations, non-disclosures and large political contributions made to keymembers of Congress. They are all personally responsible for the enormous losses suffered by shareholders.
Wasn’t it demonstrated during the previous Administration that the weather can be controlled? Here’s proof!
Well, predicting is hard work. One has to be consistent and persistent. Here is a great example of just that kind of dedication:
The ads here sometimes are masterpieces of irony: This time I was offered a “Psychic forecast for 2009” 🙂
REPLY: Well when you see such absurd irony, be sure to click on it to find out what it is about. – Anthony
Mariss Freimanis: We live in the era of “the short attention span”; be thankful for it. Ideas that took decades or centuries of thought to digest in the past now pass through the body public in a few months to a few years. AWG is well on its way past the peak of the curve and is starting its downward slide on the backside.
This strikes me as being perfectly true. But why?
Well, in the past not too many people had the idle time to think about stuff like this, and so new ideas were slow to process. There just weren’t that many people thinking about it all. But economic growth gave a lot more people the idle time in which to chew over new ideas, and that has resulted in ideas being picked apart far faster than ever before.
This website is in itself a testimony to that. The volume of comments far outstrips the post that first prompted them. There are a lot of people thinking about these things.
My guess is the AWG fad has passed its zenith.
That’s probably true too. Once they started claiming that “the debate is over”, everyone who was watching knew that it wasn’t over at all. Once an attempt is made to close down a debate, it means that something is badly wrong somewhere.
Watch out for the politicians though, they will be the last to give it up once they have gotten the scent of money.
And that’s probably true also. The political classes will be the last people to let go of this wonderful tax opportunity. But it won’t be the first time in human history that the people will have confronted their supposed political representatives. And this time the people will be far more powerful than they ever were before.
On the downside, we can expect future contention to happen even faster, and issues that once took centuries to resolve will be dealt with in days or hours. They’ll happen so fast that many people simply won’t know they ever happened.
Jack Hughes (20:24:09) :
Why not start off with a much simpler project like world peace ?
That’s the point of the exercise, World governance = World peace!
Don’t see it happening that way though!
DaveE.
The official definition of a WHO-Pandemic has little to do with the number of cases and a lot to do with the number of countries and their geographic distribution. Thousands of people die each year from “flu” but not this one it seems. This is more like another UN scam.
http://www.who.int/csr/disease/avian_influenza/phase/en/index.html
“The ads here sometimes are masterpieces of irony: This time I was offered a “Psychic forecast for 2009″ :-)”
Perhaps we should submit “Mother Earth” and get a complete forecast for 2009. I bet it would be just as accurate as the climate models.
Many of the above comments refere directly or indirectly to human bevavior, which can be group-irrational and impossible to model.
There is a beautiful example from Scandinavia, reported by World Nuclear News –
“Denmark trades power in the same Nord Pool, which has announced that from October the spot floor price for surplus power will drop from zero to minus EUR 20 cents/kWh. In other words, wind generators producing power in periods of low demand will have to pay the network to take it. Nord Pool said that “A negative price floor has been in demand for some time – especially from participants trading Elspot in the Danish bidding areas. … Curtailment of sales may give an imbalance cost for the affected seller and thus creates a willingness to pay in order to deliver power in the market.” This is likely to have a negative effect on the economics of wind power in the region, since a significant amount of Denmark’s wind power production is affected. ” WNN 1/4/09, Nord Pool 4/2/09.
This is a lovely example of the type of human behaviour that modellers consistently fail to include in their models – because they cannot.
My take is that power suppliers who had to subsidise windmills have been getting their own back, which is a natural reaction. Cost that into your wind and solar projections and see what comes out the end.
Stoic (01:30:13) :
If you’re talking Marlow BUCKS, just off J4 on the M40, I know it well.
Cross motorway traffic from the M4 to the M40 can extend back to the A404 Marlow junction regularly. It’s truly horrendous!
DaveE.
crosspatch (21:11:17) :
Best and most logical explanation yet of the financial mess we are in. Thank you.
Got this from comments in Jennifer Marohasy’s blog:
The Scientific method – here are the 8 steps according to Wikipedia:
1. Why does the climate change?
2. Collect climate data and mathematical formulae that can be adapted. Thermodynamics is one very productive area.
3. Search for something that correlates with climate change over a human lifetime. Hypothesize that this is the cause. Note that it must seem to be controllable and be produced more by affluent humans. CO2 is ideal for this purpose.
4. Create a computer program with the formulae and run. Tweak parameters to make sure it correlates to the data you have collected. You can do anything here since you can block anyone else seeing what you did, see 7.
5. Does it correlate with data? If not, change parameters step 4.
6. Extend hypothesis into distant future. If no end of the world disasters change the parameters step 4 otherwise conclude that humans are causing it since we have chosen something humans produce. Demand more funding for research into this imminent danger.
7. Keep method and data secret, we don’t need criticism we are perfect.
8. Get others to create same computer program and see if they copied your program well enough. Here the opinions of politicians and economists will add to the correctness of your theory.
http://jennifermarohasy.com/blog/2009/06/agw-is-just-a-theory/?cp=2#comments
DaveE (20:22:49) :
“If you’re talking Marlow BUCKS, just off J4 on the M40, I know it well.
Cross motorway traffic from the M4 to the M40 can extend back to the A404 Marlow junction regularly. It’s truly horrendous!”
That’s the one!
MikeN (10:05:45) :
Joe Romm’s Climate Progress has a guest blogger talking about by 2050 he will be retiring underwater or on fire. When I called on this, all the other commenters agreed.
But there were dissenters taking this unusually harsh approach:
“Is should also be obvious that the worst environmental crime anyone can commit in the industrialized world is to have children, for those kids will almost certainly consume disproportionate amounts of available resources, and do disproportionate damage to the environment.”
There’s a wonderful Ramirez cartoon. How can I insert it in a comment to show it to you all?
REPLY: You can’t, but just port the complete URL and it will automatically generate a link. – Anthony
Thanks Anthony. Does this work? http://www.ibdeditorials.com/series17.aspx#cartoon254432864315188
To view the cartoon I spoke of, you have to click on the red-robed poo-bahs. Btw, Michael Ramirez recently won a Pulitzer Prize for his work.
Weather prediction is getting more accurate over the years, thanks to supercomputing being used to go predicting. This is because there are numerous variables that are required to be considered for prediction. The weather predictions that we are getting from weather department now are pretty accurate.
However, economic predictions have more to do with human interests which changes with factors, both within and outside the subject.
Tony Smith
http://www.aafter.com
Financial Modeling almost invariably tucks in an assumption that “6 sigma events” happen very rarely. And that’s true. The thing is, in chaotic systems, particularly markets where “positive feedbacks” are the norm, you don’t really have a normal distribution of adverse events. In fact, markets are such that adverse events often INCREASE the likelihood of more and worse adverse events. This is due to a number of man-made factors such as leverage, fear, greed, and occasionally fraud.
Any old-timer from the stock side of the business knows that those “rare, six sigma events” are almost an inevitability sooner or later. They just plan on it. That’s why you’ve not had a stock market related failure of a brokerage house in 70 years (give or take). Old timers in the bond and mortgage business were replaced by pointy headed MBA’s and modelers with little understanding of how markets really work.
Now, with climate modeling, we know that we have a chaotic system. We also know that there is order in chaos, but that like markets they tend to be self correcting. Actually, more so, since climate isn’t effected by emotion nor leverage. The problem lies in that in addition to being chaotic, climate is vastly more complex and still poorly understood, at least in places.
That the modelers are so arrogant as to assert confidence in prediction isn’t surprising. That smart people believe that they can reliably predict climate, however, is.
After the meltdown occurred, a second Forbes article stated, “All existing models for calculating risk, he [Nassim Taleb] says, should be thrown out because they underestimate extreme price swings. ‘The track record of economists in predicting events is monstrously bad,’ he says.”
It wasn’t economists who made that prediction. Finance is the field that deals with individual securities and MBAs in Business are the ones who do the product creation and packaging. Economists are peripherally involved (mostly in broad market theory and long term economic forecasts along with interpretation of what any given government report means to the economy at large).
It took a fair bit of work for me to shake off my economics mindset and learn to think like a finance guy. They teach very little (nearly none) about securities markets and stock behaviour to economists, and that is largely restricted to the history of the various market crashes and a great deal about what the central banks and Treasury dept. do with bonds and interest rates. (I really wanted a “finance” degree, but my school only offered Economics or Ag. Econ. While the Ag. Econ. degree was closer to a business / finance major, I didn’t want to be explaining the “Ag.” part for the rest of my life…)
The bottom line was that I had to find creative ways (often outside of the classes I was taking) to learn the “Finance” part and stocks in particular.
In retrospect that was likely “a feature” in that “The Efficient Market Hypothesis” was all the rage then (and still is now, I think). I would have believed it and then been convinced that you can’t beat the market. (And I’d have not made my house payment this month… since it’s impossible for me to have done so 😉 I’d have had all the creativity and insight “educated out of me”…
In defense of the quote, however, I must add that “Econometric Modeling” was just taking hold then. It is possible that some finance guys took a class in Econometric Modeling or maybe even an Economic Modeling guy went over to the Finance side and brought his toys with him. But everyone on the Economist side of things that I’ve ever met has known from a deep visceral center that the models were just that: toy models to inform our ignorance. (Guess where I got the attitude about the models… Yup, in my Economics schooling… from the Profes. who were trying to get something, anything, useful out of them… and working out the giant Kinks and yawning gaps in them.)
So my guess is that someone here is trying to sidestep the blame by shoving it at an ill defined “economists”…
There had to be particular people who made the claim that a basket of mediocre mortgages were somehow transformed into AAA by putting them all in a basket together. THEY are the root cause, not econometric modeling. IIRC it was at Drexel (that later got pulled into Bear Stearns) that the original “leap” was made and it was not from an Economist. (I read the history of this about a year ago and could have Drexel wrong… I’ll research it some more a bit after dinner…) That then got put in computer models and cranked out endless error…
BarryW (21:05:31) : Don’t forget we have all ready run out of natural resources (Club of Rome).
Yeah, one of the first “Computers Gone Wild” fantasies from the Club of Rome (via “Limits To Growth” by Meadows et.al.) My response to it (after kicking around in my head for a mere 30 years 😉
http://chiefio.wordpress.com/2009/05/08/there-is-no-shortage-of-stuff/
http://chiefio.wordpress.com/2009/03/20/there-is-no-energy-shortage/
I have seen an assertion that The Club Of Rome is behind both AGW and the Limits To Growth computer fantasies. The style is the same. The method is the same. The outcome (centralized control and reduction of wealth in the hands of common folks) looks to be the same. (i.e. you get less “stuff” and less “energy” while AlGore and friends fly the private jets in peace…)
I have no idea of the veracity of the claim, but it looks plausible on the surface. Worth exploring sometime.
“Limits” is one of the other pillars of my “suspect all computer models” mantra… It was heavily promoted in the ’70s based on the notion that their computer predictions had to be right, they were computerized! It was also the start of the “It isn’t a prediction, it’s a “projection”… When, a few years later, all their “end of life as we know it” doom and gloom running out of everything computer predictions didn’t happen, they published “Limits the Sequel” or “Limits To Growth, the Rewrite” or whatever they titled it and have been squawking every since that they didn’t actually make any real predictions so they couldn’t be wrong. They were only “projections” of what would happen if nothing changed, and, well, something changed…
(Having read Limits too many times – Required in my Econ 136(?) class; I can tell you that when they said “we run out of natural gas in 10 years!” it was certainly presented as a prediction, complete with the dire consequences that would inevitably follow. Since we now have a glut of natural gas and likely will for 50 years to come, I think their computer prediction was broken… whatever you call it.)
At the end of the day, my take on it all is simple: If The Club Of Rome is involved in something, it is highly suspect and most likely both very wrong and very likely to move your wealth into the hands of the power elite. No, o proof. Just a “projection” 😉