Computer Models and the Global Economic Crash

Anti-Globalism passes along a review in Ars of some recent speculation on the role of interconnected computer models in the global economic crash. "If Ritholtz, Taleb, Mandelbrot, and the rest of the computer modeling and financial engineering naysayers are correct about the big picture, then we really are arguably in the midst a bona fide computer crash. Not an individual computer crash, of course, but a computer crash in the sense of Sun Microsystems' erstwhile marketing slogan, 'the network is the computer.' That is, we have all of these machines in different sectors of the economy, and we've networked all of them together either directly (via an actual network) or indirectly (by using the collective 'output' of machines in one sector as input for the machines in another sector), and like any other computer system the whole thing hums along nicely... up until the point when it doesn't."

Comments

Can somebody 'splain this?

[seanadams.com]

I am not an economist but I have owned a couple businesses and consider myself a reasonably practical person.

I have always believed that the vast majority of today's financial instruments have been invented out of thin air for no reason other than to ultimately ensure the employment of bankers and brokers.

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features. The only reason you "need" all that is because the banks created all these funny rules so that they could introduce more and more products and services. This is done so they can charge you more for each of those things, and also to differentiate them from their competitors.

Besides consumer banking, can somebody explain to me why we NEED "commercial paper"? Yes, I've read the wikipedia page and I know how it's used, but I don't understand why it's needed. If you can't make payroll then you're pulling from your credit one way or another - why do we need separate instruments for a 2 week loan versus a longer term loan, or a credit card, or whatever?

And don't even get me started on real estate lending...

It's like freaking starbucks - you can get your banking services just as special as an upside-down triple no foam half calf non fat 160 degree two splenda mocha. But it's one thing for a coffee company to cater to every individual snowflake's desire, and quite another IMHO for something as important as our financial system to become as absurdly complex and fragile as it is.

As for the people who are really benefitting from all this complexity - well, it's only during recession that we all collectively take a good hard look at who's making a contribution to society and who isn't. Unfortunately the powers that be think they can beat a recession by tweaking some rates, stealing from taxpayers, or shuffling money from one hand to the other. That's just going to hurt us more in the long term. We need to clean this shit up now - get rid of unnecessary products and overhead, and let the unproductive companies go bankrupt. Let the UAW strangle themselves to death. Just get it done.

Re:Can somebody 'splain this?

[Anonymous Coward]

We don't need it. But the system made people borrow more than they could.

First it was "minorities" (or rather ACORN's definition of a minority "someone who votes for us") that got suspended rules on borrowing, thanks to the CRA, introduced by one disaster president without teeth, Carter, also known for being the cause of the human rights situation in Iran, and activated by the next disaster president, Clinton.

But the damage that this inevitably caused was seen by many opportunists that were just about everyone. So just about everyone, not just Americans, but Europeans, Arabs, Japanese, Chinese, ... the whole nine yards, was given relaxed loaning standards. Since that money ended up in banks, it could be paid to their investors as intrest.

So why did this system work ? Well mostly the money paid for houses was put in bank deposits. So let's depict the money flow :

bank -> lender -> seller -> bank

This is however not how it looks in the administration. Let's check how the accountants enter this scheme :

bank -> lender
bank : + $loan_amount in future income
              - $loan_amount in money
lender : + $loan_amount in money

lender -> seller
lender : - $loan_amount in money
seller : + $loan_amount in money

seller -> bank
seller : - $loan_amount in money, + (100+x)% * $loan_amount in future income
bank : + $loan_amount in money

So now let's look at the total balance of the banks, in the short term :

+ $loan_amount in future income (slightly more)
- $loan_amount in future liability (slightly less)

Ultimately, however, this is a ponzi scheme, but for society as a whole. Everyone who connects is vulnerable in exactly the same way. Even black gold will provide no release, nor will a "knowledge economy".

As long as the pie constantly grows there is no real problem, as the banks control all money (through association with "government banks", or by simply being those banks). They literally print money, which represents value.

But the system needs an ever increasing input of value, or it falls down. As any ponzi scheme does.

Right now the input of 1 subsystem fell *slightly*. Very, very slightly. Eventually the value input will stop altogether (esp. if "peak oil" theories are right, but if they're wrong that will simply provide a delay).

The system is, as they say, doomed.

*AND* we should destroy anyone who was involved in shortselling any commodity related to loans, they should be prosecuted for making (and winning) the bet that tens of thousands of people would lose their livelihoods, their houses. These people's gains should be impounded, their bets imposed for the total disasters that they were. And all other short-selling should be suspended as too risky to the economy.

Or at the very, very least, banks should be prohibited from loaning money to allow shortselling, and they should be forbidden from using money invested in shortselling practices as collateral for loans.

But we won't do that. If we did, the financial sector would shrink to 10% of it's former size, which would put much less money in Obama's hands to work with. Much, much less. And it will mean telling hundreds of thousands the truth, that they cannot be trusted with enough money to buy a house. Many of them will be "traditional americans", but obviously both the poor and "minorities" will be overrepresented, and won't be able to buy a house. (who are the original spark that started the fire, I do not want to claim it's "their fault", but they are part of the problem)

Re:Can somebody 'splain this?

[PingPongBoy]

How red is the herring?

The masterminds are devious? The ignorance is enforced in the entire system?

Maybe, but could it just be the sheer sustained growth of knowledge and the lack of ability to handle the knowledge? I see people grasping at straws and stepping on each other to acquire not knowledge but wealth. The successes of the few trigger the enthusiasm of the masses. That is exactly what happened until the slippery slope became the avalanche. The funny thing is, what is in this simple analysis that could not find its way into a computer model?

For years, I have heard the occasional debate in the media about how unsustainable the increase in housing has to be. I wasn't even listening to financial gurus. The words of wisdom were coming from typical journalists who were sort of in tune with the common man.

Clearly the missing factor in the computer models, the X factor, is the belief that world progress itself was going to sustain the affordability of the high cost of living. Higher housing costs and education costs were to some people an unavoidable way of life, and a benchmark of progress, and somehow everyone else is able to get into the game no matter how high the stakes are. The message was simple: if you bother yourself in the age of fun-on-the-internet and really-cool-lifestyles to drill down into this mindset, you will see that the whole economy is sound and proper because the wealth is easily sustainable via production on the backs of the third world. Then immigrants will come, cluster, and afford the million dollar 2-bedroom bungalows with no garage, a bizarre effect that will exist in only a few years if housing prices were to maintain their collision course. This mathematics somehow did not appear in a computer model because our ability to control computers has not advanced to the level of simple linear projection.

So what is the data telling us now? The stock market is down because businesses have just focused on raking in as much money as they can from the economic situation of Christmas past. Now it is Christmas present, and there is no real plan for Christmas future. As a result, people are scared shitless to invest anything. The fear can only be allayed with real results. Trust has to be won. These are sweeping concepts that are not that easy perhaps to quantify and observe, not that easy to run on a computer model...

Re:Can somebody 'splain this?

[hey!]

For example, lots of people have a checking account, savings account, credit card, poersonal line of credit, HELOC, brokerage account, and more. I see absolutely no reason why a single account could not offer all those features.

Neither did advocates of banking deregulation in the 1990s.

One of the reasons for this "redundancy" is (or used to be) that different rules apply to each kind of account. You used to have have commercial banks, investment banks, and insurance companies, and each did something different under different rules. Then the rules that had been in place since the Great Depression were repealed by Gramm-Leach-Bliley, and suddenly the legal boundaries between these kinds of financial services was gone.

Subsequently, we are facing the greatest economic crisis since the Great Depression. Coincidence? I'm not entirely sure, but surely some of the problem is that practices and attitudes that were normal in investment banking suddenly started to crop up in other businesses.

Although Hank Paulson is actually, in my opinion, one of the more decent individuals as a person in the administration, he's very much the wrong man at the wrong time. One of the things he did as head of Goldman Sachs was to convince the SEC to get rid of the "net capital rule". That was the rule that required banks to maintain a certain level of cash on hand to cover cash demands in unusual situations. This is obviously extremely expensive for companies who had to keep huge volumes of cash on hand, losing mind boggling amounts of value even against modest inflation.

Had the rule been kept in place, we might not have had to pony up seven hundred billion dollars to bail out Wall Street.

Re:Can somebody 'splain this?

[Anonymous Coward]

What, so you should have a ton of money in the bank sitting around doing nothing?

It's doing something. It's insuring me against a rainy day.

That's not to say I couldn't invest some of it, but the emphasis is on some. If I'm riding month to month on rolling lines of credit, like the referenced businesses are, then I did it wrong.

Re:Can somebody 'splain this?

[agslashdot]

Take a hollow toothbrush. Fill it with toothpaste. Then take a hollow shaving razor. Fill it with shaving foam. Now glue the toothbrush to the razor. For kicks, lets also glue a fork, a knife and a spoon to this appartus.

Now I claim you can brush your teeth, shave, eat your breakfast, butter your bread, drink your soup - all with this one appartus.

So then why do we have a separate toothbrush, razor, spooon, fork etc ? Is it because we want to ensure the employment of spoonmakers worldwide ?

Without CP, MBS, CDOs honestly there is no way you can run a modern industrial economy. You can glue them up into one savings account, but it would be as unwieldy as your toothbrush-cum-razor-cum-fork.

I built most of this financial gobbledegook in a previous life...

Re:Can somebody 'splain this?

[Chris Burke]

Credit is needed in a system where you are able to make purchases in certain items. The problem is when people over leverage themselves.

Well, that's how the problem starts.

The problem gets compounded when you treat debt like it's a magical source of new money. As in, if I loan you $10, then you have $10, but then I also have a "debt asset" worth $10, which makes a total of $20. That's exactly how people were explaining it to me as recently as 2007 when suggesting that debt is good and actually "creates wealth". But that's bullshit. Ultimately there's not $20, there's the $10 I used to have but instead gave to you, and at the end of the day I can at best expect to end up with that $10 back plus interest. But people kept treating the debt itself like it was additional money, selling the debt, and making additional loans with debt as collateral -- debt-backed debt! So there were trillions of non-existent dollars spinning around in a big financial machine and everyone loved it. It reminds me of Worldcom who made billions of dollars selling unused bandwidth to a subsidiary and then buying it back, tons of money spinning in circles but none of it actually real.

Now this was all fine and dandy for a while, but eventually the system only works if that debt is paid off, which is when the problem became apparent. It turns out that a lot of that debt was never going to be paid back, which means the big debt-amplification-machine was not just running based on a false premise, is was running on nothing. When the debt failed to be paid, that failure was amplified up the system and soon our entire financial system is at risk because of an unusual number of home mortgage defaults. The bubble was burst, the curtain was lifted, and now we're all paying for it.

Credit is essential to our economy. That's for sure. But we can't keep treating debt like it's wealth when really it's a negative asset that you hope to recoup with some payoff. Too much of it is bad, building a whole economic system on it is, well, what we're seeing the consequences of now.

Re:Can somebody 'splain this?

[kgskgs]

Commercial paper or financial complexity is not the real problem. The real problem is reality. Let me explain.

There were three fishermen in a village. They were not able to do fishing because they lost their nets. One day one of them heard of a fishing net weaver in the neighboring village. So he went and rented a net from the weaver. To pay rent, he borrowed the money from the same weaver. He could go fishing now. The second one found out and he did the same thing. The third one went to rent a net as well. The weaver had only two nets. But he smartly figured out that the three fishermen never go fishing at the same time, so there will always be one net idle. He smartly figured out scheduling algorithm. So also started renting the two nets to three fishermen.

All four were happy. The fishermen always assumed that they will have net whenever required. The weaver was happy to be able to rent two nets to three people.

One fine day the assumptions made in weavers scheduling algorithm broke down and all three fishermen needed the net. They came to realize that there are not really enough nets and sometime they might end up not getting the net. So each fisherman started renting the net for more time than required to avoid the risk. This increased the net renting price (Inflation), also the nets started staying idle for long times (Dropped output). The fishermen could not pay their rent loan installment in time. The weaver started losing money and he could not maintain the nets. Ultimately everyone was poor again.

Nothing changed from start to beginning but everybody's risk perception. Originally, with the false perception of zero risk and abundance of resources was created by the weavers assumptions. This perception broke down and everybody started paying high insurance to avoid the risk and this left little money for investment.

In today's case, the net weaver is the bank and fishermen are consumers.

Do you know what is the biggest difference between developed countries and developing countries /third world? In developed countries people keep less for the rainy day and invest more. In third world, people stack up more for rainy day and invest less.

K

Re:Can somebody 'splain this?

[kgskgs]

I forgot to add last couple of lines.

The problem with reality is that it does not issue one way ticket. Life always runs in circle. You cannot theorize something without assumptions. And rest assured there will be one day when your assumptions will not be true anymore.

That's why reality is the problem.

Re:Can somebody 'splain this?

[againjj]

It sounds like those people were talking about the ideas of M0-3 and trying to extend it to debts. There is a reason M3 is no longer measured: as you go up the scale, the values become more and more meaningless/useless.

Re:Can somebody 'splain this?

[Gription]

The part I want 'splained is: Why does anyone think that the stock market is a serious indicator of the state of the economy?

These types of exchanges (stocks, commodities, etc...) are Gambling dressed up for high society. That doesn't mean that they aren't reasonable investments over the long haul. Any reasonable person looking at them over the short haul will see that they are driven by everyone trying to guess which way everyone else is going to jump. This is simply gambling.

Everyone knows the market is going to be way up in a few years because it is currently highly undervalued but because the vast majority of investing groups are buying and selling with short term gain in mind the market is bouncing around like a superball. Maybe if someone was required to hold a stock for a minimum period of time it would make stocks an indicator of something.

Off to the side of this:
I really think that the government could free up a huge quantity of the credit blockade by lending directly to the enduser to force the various credit companies to wake up and try to compete for their markets.

Example: Home loans. 30 year fixed rates have usually floated at around 2+% over prime. Now because the mortgage companies wrote unserviceable loans so they could sell them instead of service them, they are all licking their wounds and are currently loaning at 5+% over prime. This works out to a subsidy to the mortgage companies so they can make up for their idiot losses. At the same time no one can sell their house because no one can get credit and if the houses don't move the price drops screwing home owners. At the same time banks are dumping foreclosed homes further driving down the home price comps. (Oh and the banks DO make loans for the houses they are dumping!!!)

If they would just refinance the so called "Toxic debt" mortgages at 3% over prime it would drop the payments down to a point where most of the "toxic" loans would be workable for the debtors and then they wouldn't be toxic. At 3% over prime it would be plenty profitable too. If they would force the mortgage companies to carry the paper on a portion of the loans (selected at random) it would guarantee that they wouldn't write fraudulent loans either...

(now get off soapbox...)

Re:Can somebody 'splain this?

[Lumpy]

Which is why I will never EVER become Incorporated. I prefer honesty and doing things right.

What you say makes ZERO sense. I'm not having "tough times" right now. In fact I have CASH and am sucking up lots of gear being auctioned by my competitors at $0.10 on the dollar. I recently got a $4800.00 Beta cartoni tripod for $500.00 at a Grand Rapids business auction.

Sounds like I'm doing it the right way and all my competitors are not.

Re:Can somebody 'splain this?

[Spasemunki]

Why? The point is there, the delivery isn't well formed though. Lending money to folks regardless of race, creed, or gender, who don't have the means to pay it back is going to lose every time.

Because nothing about the regulations that the GP poster was talking about ever required banks to lend to people who were unable to pay. Because banks who were subject to those regulations were not responsible for the majority of the sub-prime loans that trashed the market. You're correct that lending to people with bad credit, who can't possible repay their loan, is a bad idea. The idea that banks were compelled to do that by legislation that put an end to certain discriminatory lending practices (like "redlining", the practice of identifying minority neighborhoods and declaring that no resident of that neighborhood, and no home within it, was a reasonable credit risk) is complete nonsense. Banks started extending sub-prime mortgages to unsafe lenders because they thought there were profits to be made in doing so, not because they were compelled to lend by anti-discrimination laws.

It's pretty simple. In the old days, two people walk into a bank. They both have modest, working-class jobs and good credit history from auto loans and store credit cards. They are both asking for loans in about the same amount. One guy is buying a house in a working-class white neighborhood. The other is buying a house in a working class black neighborhood. What happened before the CRA was that the first guy got a loan, and the second guy either got denied or had his fees and rates jacked up. The CRA simply said that if you were challenged on it, you had to be able to show that you were consistently following through with your risk calculations without regards to race or the ethnic makeup of certain neighborhoods. A good borrower asking to buy a house fairly appraised at $200,000 in a historically black neighborhood couldn't be charged twice the rate as the same borrower buying in a white neighborhood.

Now if the person asking to borrow is an obvious credit risk- bad history, no income, loan principle vastly in excess of their income or earning capability- you can still deny them under the CRA. You just can't deny people who's mailing address is in one zip code, and lend to people from another zip code. Nothing compels you to lend to bad risk borrowers.

Some right-wing pundits are claiming that this was somehow responsible for the sub-prime meltdown. They claim that in order to avoid the appearance of discrimination, banks were making bad loans to minorities in order to pad their numbers for loans to minority borrowers and neighborhoods. But this simply isn't true; in fact, most of the lenders making sub-prime loans were never subject to the CRA. Even if the CRA was compelling banks to make loans they otherwise wouldn't (which there is no evidence for), the private lenders who wrote most of the sub-prime loans had no need to give the appearance of compliance, and could make decisions purely based on the risk/reward profile of their customers. They decided that people with low incomes and poor payment histories were a good bet, because they could re-package the debt as mortgage-backed securities and resell the risk. They didn't make loans to poor people who couldn't pay because the law compelled them, or out of the goodness of their hearts; they did it because they believed there was a profit to be made. Meanwhile, the CRA regulated banks, which conservatives claim were being forced to lend to bad borrowers, were making far fewer sub-prime loans, and weren't attempting to commoditize their debt aggressively the way the private lenders were.

The real truth is that the growing housing market, low interest rates in the wake of the dot com bust, and the unregulated market in debt-backed securities created a toxic environment. Private lenders saw great potential profits in lending to the sub-prime market, and believed that debt-backed securities gave them a way to avo

Re:pointing fingers

[AJWM]

Two words: "emergent behaviour".

No one group of programmers programmed all these computers, there was no single set of specs for the whole network. All the components may well be "functioning exactly as they should be" (although in reality I'm sure there are a few bugs in the systems, but that's irrelevant here), but the system overall may behave in an unexpected way.

(That said, I don't think that's the whole problem either -- too many people playing a bit fast and loose and less than honestly with other people's money is also part of the problem.)

Re:pointing fingers

[BigTom]

What is tightly regulated? Half the Quant algo trading models get thought up in the evening, coded overnight and activated in the market the next morning.

If you try and slow them down they just run to the head of the desk bleating that the "nasty IT man stopped me making $1000,000,000 for the bank with his silly QA nonsense" and whoosh, its in production. It is prop trading so its their risk.

Can't model in human traits

[HW_Hack]

How can you model in greed - corruption - and the ever popular human trait of freaking out ?

Tech bubble - Real Estate bubble ... next time I even see/hear the word bubble in the markets I'm cashing out for a while

Re:Can't model in human traits

[Timberwolf0122]

Bubbles would not be an issues if when they happen (it's not like they are hard to spot) everyone just held back and let it deflate, however this will never happen as everyone will want to get in while they can. It's like watching lemmings being herded off a cliff.

Does the argument support the conclusion?

[MoellerPlesset2]

Seems to me the author is repeating the mistake himself: By drawing a conclusion not supported by the data, in this case being the evaluation of the role played by computer models here.

And I agree with that datas: The problem isn't the computer/mathematical models. It's how they were used. In particular, people were using models designed to evaluate one kind of mortgage asset, and plugging in an entirely different kind of mortgage, etc.

The author grants that conclusion, but then makes the claim that although the problem wasn't caused by the computers themselves, that it was somehow exasperated by them. - I don't see how that's the case.

Computers and computer modelling makes it easier to create advanced derivatives and such. But it doesn't make us do it. Just look at the engineering world; We don't choose technically advanced solution just because we can. In fact, the tendency is to go for the simplest possible solution. ("KISS rule")

There's only one reason why you would create advanced, incomprehensible derivative structures: To con people, essentially. To obfuscate the risks. To create money out of nothing. (the most profitable way to make it)

That's not a new problem. There's a reason we created financial regulations, why we have book-keeping, demand financial transparency, auditing, etc. This happened because it was allowed to happen. Because nobody stepped in and stopped this obfuscation from happening. I don't blame the computer models. If someone cons you into signing a bogus, misleading contract - the problem isn't with the paper it was written on or the language that was used. The problem is with the law allowing such contracts to have legal force (which is a regulatory problem from another century).

To extend that analogy, this is a bit like standing in that situation and asking whether or not written contracts are a bad thing, and whether we shouldn't go back to simpler, oral contracts. The bottom line is: As long as it's profitable, there will always be people trying to obfuscate and hide information for economic gain, and there will always be a need for regulation and oversight to stop people from doing that. But blaming the methods by which it's done is pointless.

Gaming the system

[Anonymous Coward]

I was actually pretty involved in automated trading systems until a few months ago. The over-arching problems with the systems is they can either be tactical or strategic. Tactical systems make trades in milli-seconds and make decisions based on a dozen or so parameters. There is no human intervention. The money is made getting your trades in faster than the other guy. The problem is there are a lot of reactionary traders out there who see this movement and then react... without really determining what caused the movement. They just see a large percentage of stock moving and follow the lead.

Strategic trading is data-mining and looking at hundreds of factors and incorporating expert opinion into and making decisions based on long term movements and not singular announcements.

A very good example is Enron. Tactical trading systems would have always bought it because it meet or exceed it's numbers. A through analysis such as the one done by Daniel Scotto would have seen through the fraud.

Unfortunately ... tactical trading is fast and sexy and attracts the Gordon Gecko/Boiler Room types. Very few college grads aspire to be Warren Buffet.

Re:The source of the problem

[megamerican]

Don't worry, I'm sure Congress will audit the Federal Reserve and we'll get to the bottom of this mess!

The Federal Reserve recently refused to disclose $2 trillion in loans requested by a FOIA request citing "trade secret" clauses.
http://www.bloomberg.com/apps/news?pid=20601109&sid=aGvwttDayiiM

In response to Bloomberg's request, the Fed said the U.S. is facing "an unprecedented crisis" in which "loss in confidence in and between financial institutions can occur with lightning speed and devastating effects."

In other words, we'll tell you when we're ready to finally destroy the economy!

No wonder Congressman David Scott said we've "been bamboozled!"

The real number of the bailout is actually $8.5 trillion (as of two weeks ago and is probably closer to $10 trillion now.

http://www.sfgate.com/cgi-bin/object/article?f=/c/a/2008/11/26/MNVN14C8QR.DTL

The model assumptions were ideological

[grandpa-geek]

There are two equally valid descriptions of markets. One is by Adam Smith, with the "unseen hand" guiding the markets. Smith markets are well behaved, efficient, and amenable to analysis by what amount to small-signal statistics.

The other description is by Charles Mackay in his book "Extraordinary Popular Delusions and the Madness of Crowds." In that book he describes the Dutch tulip craze and other bubbles in history prior to the mid 1800's. This economic crash is more of the same.

The models, probably because of "free market" ideology, assume a market where Adam Smith's "unseen hand" is at work. The modelers don't consider the kinds of markets described by Charles Mackay. Most of the models are based on the Black-Scholes option pricing theory. If you look at the assumptions underlying that theory, they describe good behavior, efficiency, and changes describable by what amount to small-signal statistics.

Mackay markets are boom and bust, with greed and lies and herd behavior all around. That's what we had. The underlying mathematics has been studied, but not for markets. If you have a pre-LCD TV, an electronic circuit that is non-statistical but related to boom-and-bust market behavior creates the sawtooth sweeps that paint the picture onto your screen.

Re:Garbage In - Garbage Out

[lenski]

Everything worked as advertised.

Absolutely not.

The individual quantitative analysts ("quants") built redundancy into their individual company's systems by counting on external "randomness" (approximately), insuring against possible losses emanating from their highly leveraged transactions through insurance contracts (credit default swaps).

However, All the other quantitative models were built on essentially the same set of assumptions: That their insurers had sufficient capitalization to cover the CDS contracts. The triggering event, a loss in home valuations is particular markets, started an avalanche consisting of lots of finance companies invoking the CDS contracts, all at once. That's when they found out that the insurer (AIG, for example) was just as undercapitalized as everyone else. (There's way more to this sordid tale, so this is a necessarily compressed synopsis.)

Unless one counts "we got ours, you're fucked" as implying "working as advertised", then it didn't work by any stretch of the imagination.

Read Nassim Nicholas Taleb's comments on the Black Swan Event for a properly thought and documented analysis.

BTW, The Edge is a great resource for the intelligent and curious reader. I have no financial interest in these guys, but I've found their insights to be highly informative and balanced.

I'm a Quant....

[Anonymous Coward]

...and I don't think this is the first time financial modelling has been blamed for provoking or exacerbating a crash.

In 1987, it was a simple product called 'Synthetic Portfolio Insurance'. Sounds complicated? It isn't.
Basically, I have a portfolio of risky (stocks) and riskless (bonds) assets, and I want my portfolio to benefit from the greater upside performance of the risky asset, but at worst, I want my portfolio to perform no worse than the riskless. Everyday, the seller of the product rebalances the portfolio according to a set of rules.

So, when the stock market is good, most of my portfolio is in the stocks, and when it's bad, most of my portfolio is in the bonds. This is much like how you or I might behave if we were investing our own money.

However, this is assuming that the instruments don't influence the market. If the holding of the instruments is great enough, there is an unfortunate feedback loop. Should the market suddenly crash, the writers of the instruments are obliged to rebalance their portfolios (i.e., sell stock, buy bonds), which then causes further depression in stock prices, causing further rebalancing, and so on.

This brings me to a second point. True, quantitative modelling makes assumptions about how the market behaves. Good risk management should be taking reserves against the 'known unknowns' due to the model assumptions.
We know that crash events are inherently unpredictable, so we're supposed to be constantly checking the books to ensure that we know our worst-case exposures and that our hedges work.

On the other hand, we then calibrate these models against prices we see in the market.

It's my very strong feeling that the models weren't necessarily entirely terrible (although CDO, CDO^2 and CDO^3 does seem to be pushing it a bit), but that the market was also significantly underpricing risk, particularly credit risk (both default and counterparty default risk) and correlation between credit events, because of the benign market conditions we have had for so long.

So, some of the 'garbage-in' were the market observables used to calibrate the models.