In retrospect, the financial planning by our most sophisticated financial institution looks incredibly stupid. Merrill Lynch never included in its plans the risk that its counterparties could demand more collateral. Citigroup proceeded to dive headlong into the mortgage market on the assumption that a national housing decline was impossible. Everyone, it seems, failed to guard against the risk that they might be forced to sell assets to raise capital during a downturn. So it’s worth asking: how did so many rich guys get so dumb?
If we’re really cynical about it we’d say: they weren’t dumb. They took huge risks, got paid immense amounts and the worst that happened is they lost their job. A few guys with hundreds of millions now have dozens of millions instead. Give them a few years, or even a few months, and many of them will be back in the drivers seat again, at a new bank or a hedge fund. Even the public scorn attached to bank failures is vague and undirected. Except for a few CEOs, almost no one is living with a scarlet letter attached to their name.
But a good many of these guys and gals probably thought they were making the right decisions. One of the reasons they thought that was because the super-smart maths dudes and physicists they hired told them that they had calculated the risks involved in various positions and proved that everything would be OK.
Scientific American, in an editorial, blasts the “quants” and other scientists who helped contribute to this horrendous financial destruction.
The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame. After the crash, the quants and traders they serve need to accept the necessity for a total makeover. The government bailout has already left the U.S. Treasury and Federal Reserve with extraordinary powers. The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.
For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioural economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers. These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering: risk management models should serve only as aids not substitutes for the critical human factor. Like an aeroplane, financial models can never be allowed to fly solo.
Melissa Lafsky, who writes the Reality Based blog for Discover magazine, seconds this condemnation and call for reform. “In other words, maybe we should start calculating risk using models that take into account actual human behaviour, as opposed to some nebulous dreamland where markets don’t freeze solid and eras don’t go down in a haze of napalm,” she writes.
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