Wednesday, November 26, 2008

Scientific American Gets It Half Right

SA, 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 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. 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 airplane, financial models can never be allowed to fly solo.

SA is correct in placing part of the blame with quants, i.e. econometricians, who were using faulty equations. But SA is way off base (and makes the same error as the quants) if it thinks the equations can be spiffed up with behavioral economics.

The problem was, is and will always remain that when dealing with human interaction there are no constants. Without at least one constant, you can't have an equation that will always work correctly.



  1. It seems that a lot of them tried to put in a constant in their formulas, that is that real estate prices would always go up. Not only was that false in the long run but during the limited time it was true the other variables were pointing in the wrong direction if someone actually looked. That was that as RE prices went up, the number of people buying who could actually afford it went down. These numbers were padded by a skyrocketing number of “buyers” who bought but could not actually afford the RE.

    With the constant inserted in the formulas that RE would always go up, then profits were almost guaranteed, without that constant we have what we have today, massive losses and massive bailouts to try to keep the incompetent at best and criminal at worse bankers in business.


  2. DJ

    Another constant that was assumed was the default rates on subpirmes.

    They took the default rates before securitization and plugged those numbers into their equations when in fact, the default rates have been much higher because the originators no longer had incentive to be concerned about default risks if they were going to just sell of the mortgages.