Wednesday, November 26, 2008

How Scientists Helped Cause Our Financial Crisis

Garbage in, Garbage out. Models are not reality. Models only help explain reality and therefore help our understanding of a reality that is generally too complex to fully grasp.

These ideas are taught in every stats, econometrics, and finance class worth its weight. On every test students use (indeed sometimes overuse) "data limitations", "it uses historical data", and "surprises (or black swans) can occur that would make our model incorrect" as problems with such and such model. And yet somehow, quantitative geniuses (or at least the traders and managers who relied on the models) seeming forgot (uh, looked the other way?) and ignored the problems.

So how did so many smart people seemingly forget? In part they were paid to forget (bonuses, promotions for big successes with little accounting for risks taken--for more of this see Taleb's "Fooled by Randomness".

Scientific America and ClusterStock look at this issue in How Scientists Helped Cause Our Financial Crisis
"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?"
Scientific America quoted in the same piece:
"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....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 behavioral 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....risk management models should serve only as aids not substitutes for the critical human factor. Like an airplane, financial models can never be allowed to fly solo."
Remember, models are representations of reality. Economic models, no matter how super, are no more reality than are super models are representations of the average Joe (or Jill or Jim or Jerry or Jane).

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