Grokking Finance
Last week, apenwarr linked to Havoc Pennington's elementary exposition of a useful tool of financial analysis, Return on Equity, part of Havoc's promising looking series on how understanding business concepts can be useful for folks trying to organise things together.

At type other end of the scale, to try to understand the limitations of business and finance techniques for non-specialists, maybe it is worth trying to understand why these fields seem to behave strangely. I can't claim to really understand the pathologies of MBA-driven thought, but I did read an excellent opinion piece on why finance seems to be attracted to reckless gambles, Frank Portnoy's FT opinion piece from Monday, A crisis of similar ingredients.

Portnoy's analysis suggests three common factors behind financial crises that he observed in the last two major crises, from 1994 and over the past year, and that he suggests these are necessary features of financial markets:

1. Informational asymmetry: which arises from the knowledge gaps in how financiers make sense of data and in modelling risks. For example, he notes that in 1994 when Askin Capital Management applied mark-to-market accounting to its assets, it suddenly reported that it was insolvent, "the financial markets were stunned". and goes on to note that "not very many people can price complex financial risks accurately, especially those related to mortgages".
2. Moral hazard: he emphasises moral hazards arising from unforseen consequences of guarantees made by government sponsored enterprises, but he might also have mentioned the moral hazards arising from accountancy standards, or the idea that some firms are too big to fail.
3. Regulatory arbitrage, "the manipulation of legal rules for financial advantage". He observes that the special legal status of AAA-rated instruments have resulted in credit rating agencies being at the centre of both the 1994 and the current crisis. He notes that "highly rated structured finance instruments are incomprehensible to most investors", and of course, the risk implications of highly complex structured instruments are not well understood by the ratings agencies.

Portnoy ends, noting that "Information asymmetry, moral hazard and regulatory arbitrage are the basic ingredients of high-margin finance. Soon the markets will be booming again, and the people who exploit these three themes will do the best, as they always have".