Tuesday, October 07, 2008

Blaming 'Physicists' for the Crisis on Wall Street

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Ah, a cop out if there ever was one, in my opinion. The clip above (thanks to Buzz Skyline for sending me the link) is from last Sunday's episode of 60 minutes, "A Look at Wall Street's Shadow Market". Steve Kroft makes the point that obscure and extremely complicated stuff (ya know, algorithms, models, the "fine print") may be to blame for this swamp of pecuniary mud we're currently wading in.

-60 Minutes requested interviews with top executives at Bear Stearns, Lehman Brothers, Merrill Lynch , Morgan Stanley, Goldman Sachs, and AIG. They all declined.

A snippet of transcript:

With its clients clamoring for safe investments with above average return, the big Wall Street investment houses bought up millions of the least dependable mortgages, chopped them up into tiny bits and pieces, and repackaged them as exotic investment securities that hardly anyone could understand.

These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.

"Obviously they turned out to be wrong," Partnoy says.

Asked why, he says, "Because you can't model human behavior with math."

"How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy...and sell?" Kroft asks Jim Grant.

"The instruments themselves are at the heart of this mess, Grant says. They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."

"People don't know what they're made up of, how they're gonna behave, Kroft remarks.

(End of Transcript)

There are a combination of factors that contributed to the crisis, but it all comes down to your standard 'causation equals correlation' argument. The models and algorithms themselves did not cause this chaos nor did the physicists who created them- neither is "at the heart of this mess".

The fancy mathematical tools used to break up and restructure mortgage-backed securities were supposed to minimize risk. Executives and managers (whom employ fancy tool wielding physicists) made judgment calls based on information they did not understand. This is a problem when you are responsible for decision-making and oversight.

The rationale? "Hey! We messed up because we couldn't understand anything! If those physicists and mathematicians hadn't created those arcane instruments, we wouldn't have been able to screw everything up, so clearly, it's their fault!"

...not very convincing.

Here's an interesting Physicsworld article from January of 1999, "Mutual Attractions: Physics and Finance" that explains why physicists are drawn to Wall Street in the first place.

1 comment:

  1. incredible analysis, & do we say that it is not the law of physics or mathematical algorithms which made the market insane, but it's money which corrupted the mind & game of financial gambling resulting in not huge monetary losses, but instead murder of FAITH. Ganesh Tiwari , Union Bank of India, e-mail... ganeshparamtiwari@gmail.com