Thursday, March 12, 2009

How the Crisis Fooled BofA CFO Joe Price

Responding to a question after a speech at the CFO Rising conference in Orlando, Price, who has been the finance chief of the bank since January 2007, said that financial services industry officials had failed to foresee the economic meltdown because they relied on backward-looking models, CFO Magazine reports.

Econometric models simply don't work in economics where all factors are variables and there are no constants. Indeed, part of the mortgage crisis, as I have written, was a result of the use of faulty econometric equations:

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.

In the case of the mortgage crisis, econometricians assumed a very narrow range of movement for default rates on sub-prime mortgages. What they failed to take into consideration was that in the new world of securitization, many originators of mortgages did not have incentive to carefully analyse the ability of a borrower to pay a mortgage, since the originators sold off the mortgages and simply earned an origination fee, without exposure to default risk. This resulted in originators creating mortgages with the potential for much higher default rates. Thus, the default rates on subprime mortgages started to dance in a dance style not scene since Michael Jackson's moonwalk dance.

Price is clearly admitting that the econometric models were well entrenched at BofA and throughout the banking industry far beyond the mortgage sector. Couple this with bankers' general lack of understanding of the business cycle, and this is what blew them all up.

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