Sunday, October 5, 2008

MUST SEE: 60 Minutes On The Mortgage Crisis and Credit Default Swaps

60 Minutes has a must see report on the Mortgage Crisis and Credit Default Swaps. As a long term critic of econometrics and its role in the sub-prime crisis, I certainly consider the remark made by Frank Partnoy, a former derivatives broker and corporate securities attorney, who now teaches law at the University of San Diego, and carried in the 60 Minutes report, as one of the most important remarks I have heard from MSM on the current crisis (our emphasis)

These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.

"Obviously they turned out to be wrong," Partnoy says.

Asked why, he says, "Because you can't model human behavior with math."

"How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy…and sell?" Kroft asks Jim Grant [Of Jim Grant's Interest Rate Observer].

"The instruments themselves are at the heart of this mess," Grant says. "They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, on who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."

"People don't know what they're made up of, how they're gonna behave," Kroft remarks.

"Right," Grant replies.

This was exactly my point when I wrote just yesterday:

This is a point we have been emphasizing for years. The problem consists in the fact that econometricians can't design equations without at least one constant. Since there are no constants in the world of human action, econometricians take a variable that has held fairly constant over some period of time and assume it is a constant. This works fine, and can for long periods of time, until Wenzel's Observation #1 comes into play: Any variable has the potential to eventually start to dance. A dancing variable is one that no longer acts like a constant and moves considerably outside its previous assumed range of movement.
Congratulations to Steve Kroft and Producer L. Franklin Devine for an excellent overall report, and for finding and reporting on the role of econometricians in the sub-prime disaster.

The video and transcript of the report are here.

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