From http://www.nplusonemag.com/?q=node/418
Well, a paradigm shift in finance is maybe what we've gone through in
the sub-prime market and the spillover that's had in a lot of other
markets where there were really basic assumptions that people made
that, you know what?, they were wrong. The thing is that nobody has enough brain power to question every assumption, to think about every single facet of an investment. There are certain things you need to take for granted. And people would take for granted the idea that, "OK, something that Moody's rates triple-A must be money-good, so I'm going to worry about the other things I'm investing in...
The problem is that the DNA of a lot of these models is very, very similar, it's like an ecosystem with no biodiversity because most of the people who do stat-arb can trace their lineage, their intellectual lineage, back to four or five guys who really started the whole black box trading discipline in the '70s and '80s. And what happened is, in August, a few of these funds that have big black box trading books
suffered losses in other businesses and they decided to reduce risk, so they basically dialed down the black box system. So the black box system started unwinding its positions, and every black box is so
similar that everybody was kind of long the same stocks and short the same stocks. So when one fund starts selling off its longs and buying back its shorts, that causes losses for the next black box and the people who run that black box say, "Oh gosh! I'm losing a lot more money than I thought I could. My risk model is no longer relevant; let me turn down my black box." And basically what you had was an avalanche where everybody's black box is being shut off, causing incredibly bizarre behavior in the market.
What tends to happen in financial markets, is bad things happen
when you really divorce the people who take the risk from the people
who understand the risk. What happened is that that distance in the
sub-prime market just increased and increased and increased.
