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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.
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. ... we did it
because everyone else was doing it.
... didnâ(TM)t seem worried at all:
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
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
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
My work here is dung.
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.
Thanks, New York Times. Does your average reader have the reading comprehension of a 9 year old these days?
Here's what happened in simple English: investment banks invented various ways of packaging mortgages into securities. They then convinced ratings agencies to give these new securities AAA status even though the ratings agencies didn't understand them. This gave mortgage brokers a license to commit fraud because they could give a mortgage to anyone with or without a pulse and there was a sucker just dying to buy that new mortgage from them. With such easy money available, real estate agents were able to pump and dump properties (strong-arming housing appraisers was a favorite tactic) like there was no tomorrow and convince people that housing prices only go up in a straight line. In the final act of the play, the investment bankers, mortgage brokers and real estate agents that caused this retire in the Cayman Islands while taxpayers are left to clean up the mess while we hope our economy doesn't literally implode.
I don't see what's so complicated about any of this. It's pure and simple fraud on the most massive of scales.
I'm a big tall mofo.
1. House prices and property keep on rising. If you buy a house now you can sell it next year for say 15% more. Gear up, buy and then let out your property to make even more money. Look at all the TV proggys on making money from houses to prove this point. Whatever price you pay is not an issue. Borrow at 7 times your earnings and 125% of the said value of the property is no problem. Fill your boots and make a ton of money, guaranteed. No risk.
(Don't listed to those old type bank managers who were so unhelpful and whom banks fired years ago in favour of salesmen selling whatever they could. They knew nothing).
If in the unlikely event someone could not pay their mortgage (very rare event) the property would absolutely be worth more than their mortgage arrears. Even better sell the loans to some other sucker. No risk here.
2. As you all know interest rates are undeniably under control and will never significantly rise as our central banks are such clever chaps (and chapesses) and have everything under control. So we will see a low interest rate environment for many years, so no risk here.
3. Inflation is absolutely under control and will never get out of hand, again thanks to the geniuses managing our economy. So no worries here.
4. Gearing is good and isn't risky, if you are really clever. Gear up as much as you want and to make even more money at little risk. Better still borrow in say Yen at very low rates. The Yen will never rise against the $/£ to any degree, so no risk here.
5. Banks and bankers are very clever people and know what they are doing. Look at their pay and bonus packages to see how astute they are. Shareholders would never allow incompetents to have such large pay packages if they were not undoubtedly geniuses. With the bankers at the helm nothing can go wrong, obviously. No risk here.
Risk Calcs = 1 + 2 + 3 + 4 + 5 = naff all risk so fill your boots.
What could possibly go wrong?
Check out this 47 minute video for a very easy to understand and clear explanation.
http://video.google.com/videoplay?docid=-9050474362583451279
Unless you've been through university on some Economics degree - you were probably unaware of this.
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.
when you use words like "socialist retort", "socialism", you make all your readers think that you are a brainwashed holistic economics zealot that thinks there is only unbounded and uncurtailed wild west capitalism and its counterpart strict socialism in the world, and lose them.
and let me break another news while im at it : there is a third concept : balanced economies. economies in which existentially critical services are controlled by government (like military, police, justice, healthcare) and all the remaining sectors are properly regulated so that no self interest group, criminals, fraudsters, scamsters can do stuff to break the entire system.
what im describing is europe.
judging from the success of europe in the last 20 years (in all respects, including better distribution of wealth), and the extent that u.s. sank ( to the point of sinking ENTIRE world economy with itself), i'd say that that holistic economic rant of yours have no substance anymore.
so please, stop it at least from now on, and conceive something new. reagan, republican eras are dead. and they wont return. neither the stupid 'let businesses be' 'youll kill jobs' 'market can solve' stupidity and accompanying wild west behaviour will.
Read radical news here
First let me say, I don't think your analysis is wrong per se. At the level of the mechanics of where the crisis happened and how it played out in the minds of the people in the middle of it, it is perfectly valid.
However, this whole line of analysis is very much like analyzing a car wreck and concluding that the cause of accident was the driver's excessive application of braking and over correction. The driver was dead drunk. The underlying cause was the fact that his reflexes were so shot he couldn't react properly. It is largely irrelevant what the details are of how he lost control of the car, he was bound to do so under the circumstances.
Likewise the so called 'financial crisis'. Think of our economy/financial system as a bit like a building. Every part of the structure both adds 'load' to the building, and also supports the weight of the other component parts. As long as enough structural integrity exists to support the load at every given moment, the building stands.
Unfortunately what our whole society from top to bottom has been doing is looking at this structure and saying to themselves "you know, it is a waste of money to have that beam be 150% stronger than the load it is carrying" and then someone comes along and removes the beam and replaces it with one that's only 105% strong enough so they can use the extra materials someplace else, make more return on their investment.
Well, that could only go on for so long, and naturally people got a bit nervous and engineers pointed out that the building maybe was a bit shaky, so we invented a way to tie all the beams together more securely "well, if one fails its ok, if we spread out the load enough then no one part of the building will be overloaded".
Until finally one day the wind started to blow... Once one single part, ANY part of this massively over leveraged structure reached its failure point there was no margin left anywhere to take up the extra load anymore! Every part was already stressed to the absolute maximum limits of its capacity. And as long as things had kept going on an even keel it was inevitable that the search for profit would create even more leverage until inevitably the whole structure became so intolerant of even the slightest disturbance that it had to come crashing down.
The really disturbing part of this is that, as any engineer can tell you, when you reach this kind of situation of critical instability any small problem results in a cascade failure of the entire system. Every industry, practically every business, is leveraged out so far that even the smallest dips in cash flow result in immediate insolvency, which then propagates down the supply chain and up the 'wage chain'.
This thing is like an avalanche coming down the side of a mountain at 300 mph. The snow all around it looks all nice and quiet, but that means nothing. This thing has momentum, large momentum, and there isn't any stopping it because there's no redundancy left in the economy to act as a brake. No bailout plan or insurance scheme or nationalizing of banks or any other action anyone can take now is going to stop it until it gets to the bottom of the mountain.
The sad fact is we clearly saw, or should have seen, it coming. The system gave us every sign of being ready to fail. What was the 97 Asian financial crisis except a localized version of the same thing? It just didn't get big enough to build up the momentum to smash the whole system. Only one wing of the building fell off that time. If we had exercised any prudence whatsoever we would have taken the hint. But 'This American Life' certainly has it right in the sense that greed and hubris overrode common sense.
And look at where we are now. Hope you all have a nice supply of canned goods stashed. Best case scenario is they're about to get a lot more expensive.
"Malo periculosam, libertatem quam quietam servitutem." -- Jefferson
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.