Friday, January 8, 2010

Connecting The Dots

This week was marked by a chorus of cries associated with our inability to “Connect the Dots” in two high profile intelligence failures. With both Umar Farouk Abdulmutallab (a.k.a. The Underpants Bomber) and Major Nidal Malik Hasan (a.k.a. Ft. Hood Shooter), pundits are claiming that obvious patterns were missed that could have prevented both such attacks. Both cases point out the invariably ambiguous nature of intelligence gathering and analysis - - where we may be short on detail while burdened with cumbersome centralized decision making (in the case of the “Underpants Bomber”, decentralized decision making by the adjacent passenger ultimately prevented a potential tragedy). After 9/11, no one wants ambiguity, and system improvements were demanded. But by making our warning systems more sensitive obviously reduces the risk of surprise, but increases the number of false alarms, which in turn reduces sensitivity.

The running commentary on our inability to “Connect the Dots” points out author Malcolm Gladwell’s, wonderful thoughts on “Creeping Determinism.” Were there obvious patterns, signs, connection before both attacks? While in retrospect what happened at Ft. Hood may seem obvious, the problem is that it was not necessarily the case as it happened for those involved. Where “Creeping Determinism” is the sense that grows on us, in retrospect, that what has happened was actually inevitable – and the chief effect of creeping determinism, is that it turns unexpected events into expected events. The occurrence of an event, such as the attempted Christmas Eve bombing, increases its reconstructed probability and makes it less surprising than it would have been had the original probability been remembered. The press and political aristocracy are the masters of applying filters to the past to produce a series of events that seems obvious in hindsight, tossing out everything else that kept those events from being obvious as they happened. It’s connecting the dots on an otherwise blank piece of paper, having erased the previous scatter of dots from which no discernable pattern could emerge. Hindsight has provided us with stark reminders that some of those decisions associated with our two most recent terrorist attacks were wrong. However, it does not mean that those errors were as obvious then as they are now.

On a side note, the “Connecting the Dots” award belongs to Paolo Pellegrini, an Italian financial analyst working for hedge fund manager John Paulson. Beginning in 2006, Pellegrini become convinced that the United States had a serious housing bubble. With limited effort and research, Pellegrini demonstrated that housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation was taken into consideration. But they had soared over 7% annually in the following five years, until 2005. In Pellegrini’s mind, U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Pellegrini’s figures showed that each time housing had dropped in the past; it fell through the trend line, suggesting that an eventual drop would be brutal.

A simple chart, as outlined in Gregory Zuckerman’s excellent retelling of the story in his book The Greatest Trade Ever: The Behind-The-Scenes Story of How John Paulson Defied Wall Street and Made Financial History (2009), was the “Connecting the Dots” moment. The book makes the following point –

The chart was Paulson’s Rosetta stone, the key to making sense of the entire housing market. Years later, he would keep it atop a pile of papers on his desk, showing it off to his clients and updating it each month with new data, like a car collector gently waxing and caressing a prized antique auto. Pelligrini’s masterpiece was a guiding light that told Paulson exactly how overpriced the housing market had become. He no longer needed to guess.

No ambiguity. No shadows. No gray. The chart was about sunlight and darkness and black and white. With the chart, Paulson developed an investment strategy based on the huge bubble. In 2007 alone, Paulson earned more than $15 billion for his firm. His personal tally for 2007: nearly $4 billion. It was the largest one-year payout in the history of the financial markets.

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