how did a housing crisis become a financial crisis, ending up as an economic crisis?
how come highly trained professionals didn't see it coming?
a nice simple summary visualizing all the subprime mortgage, CDO, CDS, leverage, tranching, rating, AAA, default, frozen credit market stuff:
at the barebones level, wired magazine gives insight into the core mechanism in their article Recipe for Disaster: The Formula That Killed Wall Street.
the culprit:
the gaussian copula function
basically a quantity measuring the correlation (preciser: the dependence structure) of two random variables.
"the corporate CDO world relied almost exclusively on this copula-based correlation model."
"everyone was pinning their hopes on house prices continuing to rise."
the idea, published in 2000, quickly became a metric quants ubiquitously used to evaluate risk and a cornerstone of financial engineering allowing simple modeling of vastly complex risks. particularly default risks of CDO tranches. until august 2007...
the ideas:
- tame the nasty nature of real-world dynamical, complex and latent variables by substituting them with a clean and simple number summing up everything
- convey an image of what is happening: correlation is more like a constant than a fluctuating variable and all you need to know and compute
- let the method be adopted by investors, banks, rating agencies and regulators
- ignore any warning signs (for instance d. sornette in 2006: "this recurrent use [of gaussian copulas] has been ratified by the recommendations of the BIS concerning credit risk modelling. however, there are many indicators suggesting that this [...] approach may be grossly inadequate to account for large credit risks [...]." pg. 138)
- let everyone make a lot of money
- let quants forget about the concrete reality behind the math and crank up the models
- let managers, lacking formal math skills, execute transactions worth trillions of dollars based on the models
- forget about the underlying magic that makes it all work: a decade of soaring housing prices
- lend money to people without jobs and income
- be surprised when everything blows up in your face
cartoon from cagle.com
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update 28th of june 2010:
12 comments:
an interesting study:
Our paper started with the question why managers of banks and their boards had failed to see the problems of irrational behavior within the last years and ignored the systematic risks of group think. Most managers and boards constantly increased the financial leverage of their banks, which not only increased the vulnerability of their bank to the mortgage backed securities losses but also of the whole financial system. We answered the question by the increasing homogeneity of these committees, especially within the financial sector: In the last few years people with non-management backgrounds and women were highly underrepresented in most positions. In our theoretical section we demonstrated how homogeneity fosters group think and systematic risks. We hypothesized that in radically changing environments underrepresented groups, i.e. non-experts and women, make far better market forecasts. These expectations were strongly supported by our data. As a consequence, it might be the case that the financial crisis could have been lessened if the leaders and boards in banks had been more diverse.
You Pay a Fee for Strong Beliefs: Homogeneity as a Driver of Corporate Governance Failure
http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=2&em=&pagewanted=all
"[...] the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
"They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.
"In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
"how come highly trained professionals didn't see it coming?"
...because there's a huge "blind spot" in economics and finance, which "highly trained professionals" in the system are highly trained not to see?
...ever considered the properties of money itself and the structure and dynamics of the money/ monetary system?
... since money is created as interest-bearing debt - ever considered the scale invariance of interest and the consecutive auto-accumulation of money ("wealth condensation") as a core problem?
...are growing sovereign debt, human and natural exploitation, derivatives and co just emerging phenomena of money's inherent constraint to grow?
..so that the scale invariance of interest determines an exponential process of auto-amplification...?
analogue to your thoughts on the laws of nature in this blog, would it be interesting to see your thoughts on the "laws of money"
a good one:
http://www.uni-muenster.de/PeaCon/wemgehoertdieeu/
have a nice one... :-)
http://www.guardian.co.uk/commentisfree/2009/oct/28/economics-alternative-theories-stiglitz-regulators
The right tools could have identified the unsustainable build-up of leverage in pockets of several economies in the years leading up to the crisis. Policy makers should work to develop a more robust system for tracking leverage at a granular level across countries and over time. One needs to look at specific metrics such as the growth of leverage, and the borrowers' ability to service debt if there is a disruption to income or rise in interest rates.
http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp
http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html
I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.
What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.
How Did Economists Get It So Wrong?, p. krugman, nytimes.com, sept. 2 2009
This Time is Different: A Panoramic View of Eight Centuries of Financial Crises
oh, really?
the economist: banks and risk
if more businesses operated like goldman sachs
The question we should ask, however, is why the economics profession has been so resistant to the obvious.
[...]
Our problem, in short, isn’t lack of nifty new ideas; it’s the refusal of too many economists to face up to the fact that some of their preferred theories don’t work, a fact that has been obvious for decades.
P. Krugman: Bourbon Economics
In the end, those of us who expected the crisis to provide a teachable moment were right, but not in the way we expected. Never mind relearning the case for bank regulation; what we learned, instead, is what happens when an ideology backed by vast wealth and immense power confronts inconvenient facts. And the answer is, the facts lose.
Wall Street Whitewash; P. Krugman; Op-Ed Column NY Times
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