Mind Over Model

November 30, 2009
Tom Steinert-Threlkeld

You can't blame the model.

No matter what happens with the rest of this Greatest Recession Since the Depression, let's stop blaming it on runaway quantum finance.

Math is not the problem. It gives answers. It provides precision (sometimes illusory). And, translated into computer coding, it runs endlessly and tirelessly.

But somebody had to make it up in the first place. And maintain it. And manage it.

That is where all the math wizardry on Wall Street can fall apart.

Too often, says Dan Borge, the man who quite literally wrote "The Book of Risk," an assumption gets built into a model because an assumption is needed for a model to work.

A low-level technician puts it into the model. The model gets handed off to some higher up. No one pays attention. Everyone's just trying to complete the model.

The model never gets challenged. Take the example of home prices. In 2005, 2006 and 2007, a lot of asset-backed securities were created on the assumption that ... home prices would go up. If home prices were to go down, the model might even show that something really unpleasant happens.

But decision-makers, not the model, said that was not going to happen. The assumption didn't get challenged. The result? An explosion in derivatives. Then an implosion in credit ... when home prices fall, nationwide, two quarters in a row. For the first time in half a century.

"I don't think people read between the lines when it comes to technology,'' says Michael Panzner, a member of the faculty at the New York Institute of Finance.

In effect, the algorithms that run Wall Street are not put through the same kind of rigorous examination as in other industries, where, say, lives are at risk. At Boeing, calculations get checked by four or five people. "That doesn't happen here,'' said Borge, principal designer of the first enterprise risk management system: the measure known as risk-adjusted return on capital, for Bankers Trust.

What this says is that a lot of risk management today is wasted on risk managers who get caught up in creating ever-more elegant models with ever-greater capacity to model the last three years, rather than the next three.

The search, at this point, is for the Black Swan, that "highly improbable event"-like a downturn in housing prices-that changes predictions, models and reality, radically.

The problem with Black Swans is they, almost by definition, can't be predicted. They are unanticipated events.

The problem is two-fold, says Bill Sharon, chief executive of Strategic Operational Risk Management Solutions in New York. There are also blue, green and yellow swans coming along. And you can spend so much time building lists of all possible events that could possibly go wrong, you don't spend enough time focusing on what can go right. Which will get you through the calamities.

Models should help decide what businesses you should be in, what tacks to take, what prices or fees to charge and what to invest in.

But if you get preoccupied with the apparatus of risk management, you won't see what's really going on.