This Seems Kind of Obvious in Hindsight

Saul Hansell at the NY Times has an interesting article about why risk assessment programs in investment banks were not sounding the alarm coming into the recent turmoil.  The article contains this gem:

Ms. Rahl said that it was now clear that the computers needed to
assume extra risk in owning a newfangled security that had never been
seen before.

"New products, by definition, carry more risk," she said. The models
should penalize investments that are complex, hard to understand and
infrequently traded, she said. They didn't.

I continue to see parallels between recent problems and the meltdown at Enron.  In fact, in many ways events in the natural gas trading market were a dry run for events in the mortgage market.   One filmmaker coined the phrase "Smartest Guys in the Room" to describe the hubris of the guys who ran Enron.  To some extent the phrase was absolutely true - I knew Jeff Skilling at McKinsey and he was indeed the smartest guy in the room.  But everyone can be wrong, and sometimes the smartest guys can be spectacularly wrong as they overestimate their ability to predict and control complex events.  I think this is a fair description of what went on in Wall Street over the past several years.


  1. ErikTheRed:

    I think your explanation is far too generous.

    I've never been anywhere near Wall Street (physically or otherwise), but I've read articles about it over the years that give an extremely simple "Occam would love it' answer: they let greed overcome common sense. An example that comes immediately to mind is the Rise of the Quants - the mathematicians who come up with these fancy models for derivative instruments and whatnot. While extremely bright, they were also extremely inexperienced. This in and of itself is not a problem - everyone starts out inexperienced and has to learn from various mistakes and whatnot to grow in any aspect of life. Some of them took extreme pride in their naivete - bragging that they worked in a world of pure mathematics with complete disdain for the underlying fundamentals. They didn't know and they didn't want to know. The problem is that the "Masters of the Universe" handed over the keys to these kids and then rather than supervising them or keeping things under control, went off to go cash checks and spend the enormous short-term profits they were creating. There was effectively no "adult supervision," nobody around to keep things in historical perspective. This reason alone is sufficient for me to believe we need to let the system burn itself out. There are layers upon layers of frigtarded idiots filling dysfunctional management structures in these companies that need to lose their jobs in order to keep our economy safe. It's not any one thing - it's the entire structure that needs to go.

    Having the smartest guys in the room is a great and wonderful thing if they're properly supervised by the most experienced guys in the room.

  2. m:

    Two comments:

    1. My understanding is the risk managers WERE sounding alarms, but were summarily ignored by management. One firm that didn't ignore their risk managers, JP Morgan Chase, has discounted their financials for risk for years. This means brokers weren't incented to sell risky loans because their commission was discounted by the risk of the loan.

    2. One big problem, as you mention, was their risk models. After they lowered their lending standards, they failed to update the models to account for that fact. So, the models predicted risk based on people with decent credit. Oops.

    Full disclosure, I'm a risk manager, but not of a bank.

  3. Climateer:

    Where else are computer models used in systems that are "... complex, hard to understand..."?