Thursday, February 18, 2010

Passion Party #164 - Computers Run Amok, Part 2

Computers Run Amok, Part 2

Once the mortgage industry decided that anyone with a high credit score that was breathing deserved to buy a house, we should have known we were in trouble.

All bets were off, and we were in for a wild ride.

This fundamentally flawed concept was then multiplied by banks looking to rush in to this growing market to move more product (remember, in the upside-down world of bankers a loan is an asset and benefits the balance sheet.)

And then came the Quants:

A new breed of computer scientists and mathematicians, they were financial engineers that used super-powered computers and crazy-complex math formulas to pluck money from small discrepancies in the market and hand it to their investors. They worked for companies like “Process Driven Trading” and “Applied Quantitative Research”. They used “random walks” and “calibrated correlations”. They created CDO’s (Collateralized Debt Obligations) and CDS’s (Credit Default Swaps) and other “derivatives”, like side bets in a poker game, that were built to mitigate risk.

In reality, they just broke the risk up and made it so invisible that it began to permeate the system.

Once again the computer models, built by fallible humans, had some fatal flaws.

They were built on the “fact” that a sudden national collapse in American home prices would never happen.
They were built on the “fact” that the movement of the US housing market could not possibly trigger losses in stock portfolios that had nothing to do with housing; stock portfolios, say, of British stocks or banks based, say, in Iceland.


For more information, I recommend two new books:
“Quants” by Scott Patterson (a writer for the Wall Street Journal) and
“I.O.U.: Why Everyone Owes Everyone and No One Can Pay” by John Lanchester (a British novelist who gives a bit of world view to this whole mess)

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