The Rise of the (Financial) Machines

BartlebyScrivener writes "A New York Times Op-Ed quoting Freeman and George Dyson wonders if Wall Street geeks and 'quants' outsmarted themselves with computer algorithms to create the current financial debacle: 'Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth. It's not much of a stretch to imagine that all of that imaginary wealth is locked up somewhere inside the computers, and that we humans, led by the silverback males of the financial world, Ben Bernanke and Henry Paulson, are frantically beseeching the monolith for answers.'" The quoted essay from George Dyson is available at Edge.

Comments

This American Life

[eldavojohn]

First, I think we briefly discussed the quants two years ago (and had a book review on it).

Second, I don't think the current financial problem world wide is the quants' fault. I think this credit crisis and market failure (although it might have a little to do with the quants) can be directly attributed to the world market investing heavily in the subprime mortgage bubble. Now, there's still software to blame, but it's not the quantitative analysis guys, it's the software in the hands of people who were in charge of buying bad loans and shipping them off to Wall Street to be sold to investors with a monthly mortgage check paying a huge return.

There was a This American Life episode on this sometime back that dealt with explaining the global subprime mortgage financial crisis (now known as a worldwide credit crisis). About 26 minutes into the first episode, you hear them talk about exactly this (you can stream the shows from these links or look at transcripts). Alex Blumberg & Adam Davidson are two producers of the show interviewing those involved. Enjoy this dialog from the show on the no doc loans these idiots were handing out like candy to anyone:

Alex Blumberg: But Glen didn't worry about whether the loans were good. That's someone else's problem. And this way of thinking thrived at every step of this mortgage security chain. A guy like Mike Francis, from Morgan Stanley, he told me he bought loans, lots of loans, from Glen's company, and he knew in his gut they were bad loans. Like these NINA loans.
Mike Francis: No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? Weâ(TM)re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.
Alex Blumberg: It's easy to ignore your gut fear when you are making a fortune in commissions. But Mike had other help in rationalizing what he was doing. Technological help. Mike sat at a desk with six computer screens, connected to millions of dollars worth of fancy analytic software designed by brilliant Ivy league math geniuses hired by his firm, which analyzed all the loans in all the pools that he bought and then sold. And the software, the data ... didnâ(TM)t seem worried at all:
Mike Francis: All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. Thatâ(TM)s not so bad. If Iâ(TM)m an investor buying that, if I get a little bit of return, Iâ(TM)m fine.
Adam Davidson: Wait Alex. I want to step in for a moment because this is a very important piece of tape. A big part of this story, of this whole crisis, is that a lot of really smart people, people who knew better, fooled themselves with this data. It was the triumph of data over common sense. Can you play that tape again?
Mike Francis: All the data that we had to review to look at, on loans in production, that were years old, was positive.
Adam Davidson: As we now know, they were using the wrong data. They looked at the recent history of mortgages and saw that foreclosure rate is generally below 2 percent. So they figured, absolute worst-case scenario, the foreclosure rate may go to 8 or 10 or 12 percent. But the problem with is the

Re:This American Life

[ScytheLegion]

I have a good friend who is in Upper Management at one of the major banks affected by the sub-prime/securities collapse. He told me a year and a half ago what was going on and used a great analogy to illustrate the point. This isn't necessarily breaking news, just an easy way of understanding a complex situation which the media tends to spin way out of context. Obviously, there's much more to it than this and I'm certainly not an economic expert...

All the major banks (6 at the time) were purchasing enormous blocks of "bad paper" (high risk "AAA" mortgage loans) from each other. They would in turn, back the bad loans with their own securities investments or even securities from other financial institutions willing to assume a percentage of the risk.

Billions of dollars of this bad paper, which everyone knew was bad since it was over extended by weak securities, was being passed around like a hot potato in a game of musical chairs. They all knew the music was going to stop and someone would be caught with their pants down. At times, particular banks in ownership of the paper would only hold on to it for hours or days - just long enough to make a fractional profit from the bulk interest. Although incredibly risky, this method would collectively work for everybody involved except one - like playing a single round of Russian roulette. My friend said the day to day business for the past 1.5 years was to simply find a buyer if you were holding the paper, or try to be next in line to purchase as quickly as possible, then sell again as quickly as possible.

Simply put, he said this just isn't the way the banking industry is supposed to operate. The level of irresponsibility wasn't really about the high risk sub-prime mortgages that were issued to questionable applicants. The true irresponsibility lays in the C-Level/Executive Management teams of all the major banks, who encouraged and practically mandated the daily buying and selling of high risk bulk paper at a volume that would collapse even the strongest of banks. The key here is the volume of risk - literally enough to crush any bank.

The first bank who got caught was Bear Sterns in January 2008. For some illogical and unbeknownst reason, the industry assumed a major financial institution like Bear Sterns would never be the one caught without a chair when the music stopped. The psychological ripple effect of this sobering event just made the stakes higher and increased the speed at which the game was played, rather than putting the brakes on.

He said that initially it was almost a relief when Bear Sterns collapsed, because he and many other people in the industry thought the game was over and they had made it through unscathed. But, to his astonishment everyone continued to play this dangerous game with a gambler's mentality. Each time Fannie Mae/Freddie Mac cut the rates, the banks took it as a sign to play another short term round of the game. Eventually when the larger, more conservative banks realized this was well on it's way to failure (the tip-off was the Fed stopped cutting rates) they ceased backing the paper with their securities and the game ended for everyone leaving the smaller banks, securities firms, and finnancial institutions with the highest debt/risk scrambling to recover from losses. Lehman Brothers was the odd man out this time around.

just my 2 cents... oops 1.5 cents now...

Evils of subprime

[alexhmit01]

Guess what, subprime defaults are still under 10%, and even if they rise to 25%, that still means that 75% of the people with subprime mortgages were able to buy houses that they weren't otherwise. So "blaming" subprime is silly... the problem is that the holders of the banks mistook the risks, but nobody cared because as long as prices went up, they WERE risk free.

The problem in the boom was people took 2/28 and 3/27 loans... these were priced at 30 year loans (for amortization), but after 2 or 3 years, they reset from the low "teaser" (often 1% - 2.5% higher than the prime mortgages) to a high rate that would be 10% - 11%... The people getting them often didn't know that if interest rates STAYED the same, their rate would go from 7% - 11%, and they were qualified at the 7%... they assumed that sure the loan rate would "reset," but if interest rates could go up, they could also go down...

Brokers, new in the field, said things like "prime rate is stable, long term rates shift," because you had a 2 year stretch without the Fed moving it's rates. If someone had a low credit score now, they weren't going to be better in 2 years, because new home owners underestimate the costs of owning a home... but on paper, if you had some blemishes on your report, in Fannie Mae conforming only REALLY looked back two years (looked at 4, but mostly at 2)...

If you had a business or health failure, and took a LOT of hits on your credit score from not paying bills but nothing before/after, maybe you were better in two years. Most subprime people have a bunch of problems that are permanent. But, even if your score didn't improve, you could always refinance with another 2/28 in two years, giving the brokers your new equity in the house to try again...

So nobody worried, because with the market going up, if you couldn't make the payments, you could refinance out of trouble.

wrong-o, blame Moody's

[Anonymous Coward]

The people who made this a catastrophic mess (as opposed to just a nasty mess) are the credit rating agencies (Moody's et.al.) who pretended there was any way to make a security (mortgage-backed or otherwise) exactly as low-risk as a U.S. Government obligation. Far fewer folks would have been legally allowed to purchase these products if the ratings had reflected the actual risk inherent in them and thus the potential impact to the economy of a failure in MBSes and CDS insurers would have been far, FAR less.

Moody's played exactly the same role in this debacle as Arthur-Anderson played in Enron's and I personally think they *ought* to suffer the same fate AA did so that future ratings agencies understand that failure to perform due diligence jeopardizes their company's existence. Wall Street understands Moody's role in this and the broad market continues to tank in spite of Bernanke's and Paulson's actions because we don't trust the ratings given by Moody's to other financial products or even companies so nobody knows how much risk they are really sitting on.

Let me say this clearly -- the heightened leveraging of the investment banks caused some problems but it isn't the leveraging that made this a catastrophic problem. The problem is catastrophic only because (a) folks who shouldn't have been allowed at all to be exposed to these risks were allowed to buy in and (b) folks who should have been allowed to take these risks weren't prepared through proper compensation for the risks they took on. All because the credit rating agencies did garbage-class work.

Until the credit rating agencies get as scared of the consequences of their negligent actions as accounting firms were post-AA this will continue to be repeated every time some finance person imagines up a new way to pretend to eliminate risk from investments which are fundamentally risky.