Arnold Kling  

Another Tale of Suits and Geeks

Yeah, right . . . The Time Inc... Ya Gotta Believe...

Felix Salmon writes,

because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.

Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up.

The suits vs. geeks divide makes its appearance:

the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.

Thanks to Tyler Cowen for the pointer.

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COMMENTS (4 to date)
Bill Woolsey writes:

When I read the article, I had the impression that the risk of CDOs was determined from credit default swaps.

To me, this assumes that the those writings the credit default swaps must be able to dig into the CDOs and determine their "true" risk, and then price the credit default swaps properly.

Then, those seeking to determine the risk of the CDO's can free ride on the work done by those sellng the credit default swaps.

But it didn't work that way, did it? Tell me that I am wrong. That credit default swaps were not sold based upon risk assessments on securities that were determined by the prices of credit default swaps?

Please explain.

Vasco writes:

I think this Suits v. Geeks narrative goes too soft on the "geeks" as you call them. Sure, the managers wen't along with all that, either because they understood it or not, but it's the geeks who created models that in many cases bore no relation to reality, as was shown by their failure to take into account the possibility that house prices might one day fall.

This just goes to show the danger of Economics and Finance graduate programs churning out people with great math skills, but zero economic intuition or understanding of the underlying theory. Don't get me wrong, I'm not an Austrian who thinks math has no place in economics, but the current situation goes too far in the other direction, especially at mid-rank schools who have trouble attracting good economists but can get mathematicians well enough.

Vasco writes:

As an addendum to my last comment, it's worth pointing out that not only were many economics and finance graduates working as quants more or less ignorant of the underlying theory, a lot of these quants weren't even economics or finance graduates, but were from Physics or pure Mathematics. Is there and wonder at how this happened? This would be like putting an economist in charge of the CERN.

Norman Pfyster writes:

Astonishing how you can read an article on how the quants fucked up as supporting your narrative about how it's all the managers' fault.

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