Risk Models Missed the Human Factor

While many of us are marvelling this morning on the results of this historic U.S. presidential election, there's another story that deserves your attention and one that Senator Barack Obama ought to read before he appoints his cabinet of regulatory czars to fix the financial mess.While many have blamed financial engineers whose models failed to detect the global financial meltdown, today's New York Times has an excellent story, "Wall Street's Extreme Sport," which explains how the quants who designed risk models didn't account for human behavior. With the illustration of an executive Bungee jumping off a building, the article explores the reasons why quantitative models were not able to keep up with the explosive growth of complex derivatives or pick up the warning signs such as falling home prices in certain regions or declining credit quality of individual mortgage holders.

While many articles have explored this turf before - complex derivatives, leverage and lack of liquidity - I think this story sums up all the ingredients of the Molotov cocktail including the ABCs of credit default swaps and how they are fraught with counterparty risk. Because the securitization process of selling off mortgages and packaging them into large pools was like a runaway train, it prompted the lenders to automate their processes and rely upon computerized credit scoring models instead of human judgment.

But the real culprit was the human factor in that technology got ahead of the human's ability to manage it. Andrew Lo, an economist and finance professor at the M.I.T. Sloan School of Management, said in the article, "The technology got ahead of our ability to use it in responsible ways." In fact, Lo, who his director of M.I.T. Laboratory for Financial Engineering, wrote a paper which he presented in 2004 that warned of the rising systemic risk in financial markets, in which he focused on liquidity, leverage and counterparty risk from hedge funds.

The paper was evidently well received by regulators but it was dismissed by the industry, which continued to go along its merry way of chasing profits in good times. Well, that's no longer the case. To curb all this enthusiasm for mixing financial engineering models with leverage, Lo told the NY Times that not only do we need better risk models, but more regulation. He suggests high capital requirements on banks, and the use of exchanges and clearinghouses for trading exotic securities. And hedge funds with $1 billion in assets should be urged to file their holdings with regulators, he added.

In fact, after reading this article I'm convinced that President Elect Obama should appoint a Secretary of Financial Engineering to serve as a liaison between the regulators and the major banks and brokers to balance out all these forces as they come together. Why? Congress is going to pass many laws that restructure financial services regulation and it would be a shame if they kill innovation. In short, this article points out that everyone is blaming the models, but the problem is that humans mistook the models for reality.There's another story that deserves your attention and one that Senator Barack Obama ought to read before he appoints his cabinet of regulatory czars to fix the financial mess. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio