THofler

How Models Caused the Credit Crisis

A several years ago a famous Berkeley physics prof complained to me that few of the PhD students he encountered were interested in slaving in his lab for a few years because most of them were not interested in a career in physics. They were in a hurry to get to Wall St.

And before that crew hit the street, there was the crew of physics wash-outs (& wised-ups) that went there.

Having built a few computer models & seen a great many presentations of others, I'd cynically suggest that the modeler's confidence of the model's applicability to the problem at hand is proportional to the the number of man months or years invested in the model. Even in the area of physical science these models frequently miss major portions of the realities at hand.

I'd suggest to Max that the assumption of a "normal" market when applying a financial model is invariably a mistake. Maybe someday we will have models that include factors to compensate for a variety of possible market & economic shocks, but so far collapses of the LTCM type seem to be the norm.

Over reliance on models badly applied, is not the whole problem, but a big contributor. My guess is that the substantial contributors are: a very preferential tax structure for real estate; Greenspan easy money; Greenspan lax regulation of mortgage brokering; bad models applied badly by lenders; grotesquely irresponsible and ignorant ratings agencies; and financial illiteracy about debt in the general population.