http://us1.institutionalriskanalytics.com/pub/IRAMain.asp The problem is not with models themselves. The trouble happens when they are (a) improperly constructed and then (b) deliberately misapplied by individuals working in the financial markets. In the physical sciences, models can be very usefully employed to help analysts understand complex systems such as disease, buildings and aircraft.... [more]
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp
The problem is not with models themselves. The trouble happens when they are (a) improperly constructed and then (b) deliberately misapplied by individuals working in the financial markets.
In the physical sciences, models can be very usefully employed to help analysts understand complex systems such as disease, buildings and aircraft. These models tend to use observable data as inputs, can be scientifically validated and are codified in a manner that is transparent to all involved in the process. Models used in the physical world share one thing in common that financial models do not: they are connected to and are confirmed or refuted by the physical world they describe.
Financial models, on the other hand, are all intellectual abstractions designed to manipulate arbitrarily chosen, human invented concepts. The chief reason for this digression from the objective use of models observed in the physical sciences is the injection of economics into the world of finance. Whereas financial models were once merely arithmetic expressions of expected cash flows, today in the world of financial economics, models have become vehicles for rampant speculation and outright fraud.
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Spurred on to chase the "policy outcome" of affordable housing, an entire range of deliberately opaque and highly leveraged financial instruments were born with the full support of Washington, the GSEs and the Congress. Their purpose now was to use the alchemy of financial modeling to create the appearance of mathematical safety out of dangerous toxic ingredients. Wall Street firms paid the major rating agencies to award "AAA" ratings to derivative assets that were ultimately based on subprime mortgage debt. And the stage was set for a future economic disaster.
In the case of subprime toxic waste, the models became so complex that all transparency was lost. The dealers of unregulated, unregistered complex structured assets used proprietary models to price and sell deals, but since the "underlying" for these derivative securities was invisible, none of the investment or independent ratings community could model the security. There was no validation, no market discipline. Buy Side customers were dependent upon the dealer who sold them the toxic waste for valuation. The dealers that controlled the model often time would not even make a market in the security.
Clearly we have now many examples where a model or the pretense of a model was used as a vehicle for creating risk and hiding it. More important, however, is the role of financial models for creating opportunities for deliberate acts of securities fraud. These acts of fraud have caused hundreds of billions of dollars in losses to depository institutions and investors.
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Response by Riversider
about 17 years ago
Posts: 13573
Member since: Apr 2009
If we accept that the sudden change in market conditions or the "Black Swan" event that Taleb and other theorists have so elegantly described arises from a breakdown in prudential regulation and basic common sense, and not from some unknowable market mechanism, then we no longer need to fear surprises or systemic risk. We need to simply ensure that all of the financial instruments in our marketplace have an objective basis, including a visible, cash basis market that is visible to all market participants. If investors cannot price a security without reference to subjective models, then the security should be banned from the US markets as a matter of law and regulation. To do otherwise is to adopt deception as the public policy goal of the US when it comes to financial markets regulation.
As Graham and Dodd wrote nearly a century ago, the more speculative the inputs the less the analysis matters. Models only have real value to society when their workings are disciplined by the real world. When investors, legislators and regulators all mistook models for markets, and even accepted such speculations as a basis for regulating banks and governing over-the-counter or OTC markets for all types of securities, we as a nation were gambling with our patrimony. If the Committee and the Congress want to bring an end to the financial crisis, we must demand higher standards from our citizens who work in and regulate our financial markets
If we accept that the sudden change in market conditions or the "Black Swan" event that Taleb and other theorists have so elegantly described arises from a breakdown in prudential regulation and basic common sense, and not from some unknowable market mechanism, then we no longer need to fear surprises or systemic risk. We need to simply ensure that all of the financial instruments in our marketplace have an objective basis, including a visible, cash basis market that is visible to all market participants. If investors cannot price a security without reference to subjective models, then the security should be banned from the US markets as a matter of law and regulation. To do otherwise is to adopt deception as the public policy goal of the US when it comes to financial markets regulation.
As Graham and Dodd wrote nearly a century ago, the more speculative the inputs the less the analysis matters. Models only have real value to society when their workings are disciplined by the real world. When investors, legislators and regulators all mistook models for markets, and even accepted such speculations as a basis for regulating banks and governing over-the-counter or OTC markets for all types of securities, we as a nation were gambling with our patrimony. If the Committee and the Congress want to bring an end to the financial crisis, we must demand higher standards from our citizens who work in and regulate our financial markets
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