Wednesday, November 26, 2008

Two links on the financial crisis

First, an editorial from the Scientific American: After the Crash: How Software Models Doomed the Markets:

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 other link is to this great Portfolio article by Michael Lewis, the man who "chronicled [Wall Street] excess" of the eighties in Liar’s Poker:

I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”

I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, “I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers.” I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.


  1. Pratik Ray said...

    The financial crash, in some ways is similar to the Challenger shuttle disaster in 1986.

    There too, the people who actually put together the rockets thought the chances of failure varied from 1 in 100 to 1 in 200. The management higher up, the guys responsible for getting research funding, fuzzed up the probabilities, until it came to 1 in a 10000 or something like that.

    In case of the financial crisis too, the software models badly underestimated the risks.