The financial modelers who set up the credit-default swap system that led to the credit crisis may have had innovation and research on their sides, but by underestimating the infinite variability of human behavior they may have set us up for a stumble, according to a story in the Times. Indeed, historians will note not the pioneering spirit of those analysts that figured out how to make profit from home foreclosures, but rather our heedless pursuance of these vehicles that led to a global blunder that turned out all-too-human.
The major mistake made in the credit crisis was a failure to accurately assess the risk of the model—the belief that sound mathematics could trump the possibility of an unexpected occurrence, namely a sharp decline in home prices. “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,” says Federal Reserve economist Paul S. Willen. “It’s these hierarchies of beliefs—these behavioral factors—that are so hard to model.”
For all their complex equations and diverse research structures, financial models are relative child’s play compared to the endless variations possible in how the global community behaves. “To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules,” according to one quant.
But even more dangerous than the variability of human nature is the refusal to acknowledge this unpredictability—the attitude taken by financial managers across Wall Street who naively bought into the invulnerability of the credit-swap market. Taking the think tanks’ word that disaster was only minutely possible, fund managers embraced the lure of easy money, to the ultimate detriment of the global economic state.
As the blame for the credit crisis is sorted out, it seems rational to spread it evenly amongst the participants in an ill-planned and ill-executed financial system, but to do so is to avoid learning from the mistake. Between the quants responsible for the bubble’s design, and the managers responsible for its inflation, history will most likely place its stigma on the latter.