An article in nytimes "In Modeling Risk, the Human Factor Was Left Out" draw my attention because it attempted to peer into the current financial turmoil from risk modeling perspective. Maybe this kind of microeconomics thinking would refresh my mindset about the crisis.
"But the larger failure, they say, was human — in how the risk models were applied, understood and managed. Some respected quantitative finance analysts, or quants, as financial engineers are known, had begun pointing to warning signs years ago. But while markets were booming, the incentives on Wall Street were to keep chasing profits by trading more and more sophisticated securities, piling on more debt and making larger and larger bets."
Even most people are blind to the risk, some insider can still have sensible insight to point out the risk. But if only few people have different view, they are dissents. They are just ignored by others.
"That out-of-control innovation is reflected in the growth of securities intended to spread risk widely through the use of financial instruments called derivatives. Credit-default swaps, for example, were originally created to insure blue-chip bond investors against the risk of default. In recent years, these swap contracts have been used to insure all manner of instruments, including pools of subprime mortgage securities.
Credit-default swaps, though intended to spread risk, have magnified the financial crisis because the market is unregulated, obscure and brimming with counterparty risk (that is, the risk that one embattled bank or firm will not be able to meet its payment obligations, and that trading with it will seize up)."
Credit default swap has been ever well known to financial professional, but it is so to everybody by exposing devastating catastrophe to the public. This kind of risk management instrument fails to meet their goal. I think the increased complexity brought about by weaving so many institutions together was less investigated that people are less informed upon the accordingly increased risk. So it is no wonder CDS was notoriously blamed as the main cause of this crisis. But is it simple like this?
"Math, statistics and computer modeling, it seems, also fell short in calibrating the lending risk on individual mortgage loans. In recent years, the securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.
If the incentives and the systems change, the hard data can mean less than it did or something else than it did,” said Raghuram G. Rajan, a professor at the University of Chicago. “The danger is that the modeling becomes too mechanical.”
Risk management model are mainly based on math and statistics. In the world of this model each party is treated as a robot. That means their behavior are certain or statistically certain. However, it is obvious that this model is not compatible with the real world. It seems that we just can't precisely model the real world because we are all insiders so that we can't thoroughly understand it. We are part of this world but we try to understand the whole. It is mission impossible. The so-called reflectivity theory from a famous insider George Soros also well extrapolate this point. So, attempting to manage the risk by statistic modeling is doomed. So, what can we do to prevent such risk or at lest mitigate the magnitude of the risk?
"The Fed economists concluded that the risk models used by Wall Street analysts correctly predicted that a drop in real estate prices of 10 or 20 percent would imperil the market for subprime mortgage-backed securities. But the analysts themselves assigned a very low probability to that happening."
It seems that the models are less disappointing that it roughly predicted the probable collapse of subprime mortgage securities. However, in the booming times the probability of this kind of dismal event are deliberately minimized.
“The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs,” he observed. “It’s these hierarchies of beliefs — these behavioral factors — that are so hard to model.”"
"To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”
This point also coincides with the modeling paradox.
"Among economists and academics, he said, the research was well received. “On the industry side, it was dismissed,” he recalled."
Well, the academia is not to blame because at least some of them have uttered warning according to their work. However, the sound of academia is so small that it is totally overwhelmed by the uproar of the Wall Street.
"Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.
“We’ve learned the hard way that the consequences can be catastrophic, even if statistically improbable,” he said."
Fire safety rules is a good metaphor to such statistically improbable events as financial turmoil. So, modeling is a daydream, and financial instruments such as CDS are also just mess. What left is rigorous regulation long resisted by the Fed. According to the testimony by the former Fed chairman Greenspan, the belief that the market will self-correct itself to remain healthy is also a daydream. So, it seems that regulation is necessary. But is regulation sufficient? The old question about regulation is "who would be responsible for regulating the regulators?" From the perspective of politics, check and balance strategy is well formed to mitigate the possibility of wrong-doing by government. So is it possible that this strategy is introduced into financial market? If so, how? If you can figure out this problem, please let me know, thanks:-)
