Wednesday, November 26, 2008

After the Crash: How Software Models Doomed the Markets

From a March '08 post*:
Short version on modeling errors? As
Alfred Korzybski said
"The map is not the territory"...

From Scientific American:

Overreliance on financial software crafted by physics and math PhDs helped to precipitate the Wall Street collapse

If Hollywood makes a movie about the worst financial crisis since the Great De­­pres­­sion, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Ex­­change Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number-savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

The software models in question estimate the level of financial risk of a portfolio for a set period at a certain confidence level. As Benoit Mandelbrot, the fractal pioneer who is a longtime critic of mainstream financial theory, wrote in Scientific American in 1999, established modeling techniques presume falsely that radically large market shifts are unlikely and that all price changes are statistically independent; today’s fluctuations have nothing to do with tomorrow’s—and one bank’s portfolio is unrelated to the next’s. Here is where reality and rocket science diverge. Try Googling “financial meltdown,” “contagion” and “2008,” a search that reveals just how wrongheaded these assumptions were....MORE

HT: the WSJ's Deal Journal

*This is a topic near and dear to our hearts:

Some of our recent posts on models and modeling, climate and financial:
How Models Caused the Credit Crisis
Quants Lose that Old Black (Box) Magic
Finance: "Blame the models"
Climate Models Overheat Antarctica, New Study Finds
Climate modeling to require new breed of supercomputer
Computer Models: Climate scientists call for their own 'Manhattan Project'
Computer Models: " Misuse of Models" and "No model for policymaking"
Climate prediction: No model for success
Climate Models and Modeling
Based on Our Proprietary "What's on T.V." Timing Model...
How many Nobel Laureates Does it Take to Make Change...And: End of the Universe Puts
The New Math (Quant Funds)
Modeling*: The Map is Not the Territory
Inside Wall Street's Black Hole
That gets you back to the end of February. Here's another type of modeling error:

Friday night, however, I got to thinking. What if I really was God’s gift to modeling? What if I really was meant to be the next top model? What if I didn’t go and I would never know how my life could change? I mean, really, who passes up the opportunity to be famous, well-liked, and have the potential to make enough money to pay off student loans? I finally decided that “you live once” and printed out the application online....