Friday, September 19, 2008

How Wall Street Lied to Its Computers

The New York Times published yesterday an article in its section of Technology, called How Wall Street Lied to Its Computers, written by Saul Hansell, where he wrote about the crisis in Wall Street.

He begins the article puzzled about what happened: "That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities."

He talks about the quantitative analysts (”quants”): mathematicians, computer scientists and economists who were working on Wall Street to develop the art and science of risk management. They were developing systems that would comb through all of a firm’s positions, analyze everything that might go wrong and estimate how much it might lose on a really bad day. We’ve had some bad days lately, and it turns out Bear Stearns, Lehman Brothers and maybe some others bet far too much. Their quants didn’t save them.

In the article has some comments and statements, I highlight:
Some analysts said that most Wall Street computer models radically underestimated the risk of the complex mortgage securities. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” in the words of Leslie Rahl, the president of Capital Market Risk Advisors, a consulting firm. But she and others say there is more to it: The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable." He also said: "They continued to trade very complex securities concocted by their most creative bankers even though their risk management systems weren’t able to understand the details of what they owned."

"So some trading desks took the most arcane security, made of slices of mortgages, and entered it into the computer if it were a simple bond with a set interest rate and duration. This seemed only like a tiny bit of corner-cutting because the credit-rating agencies declared that some of these securities were triple-A. (20/20 hindsight: not!) But once the mortgage market started to deteriorate, the computers were not able to identify all the parts of the portfolio that might be hurt.

Lying to your risk-management computer is like lying to your doctor. You just aren’t going to get the help you really need."

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