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What can you trust?

by Dennis Howlett on September 29, 2008

While I have been fairly strident about the problems attached to the US financial markets and in particular the role of the audit crews, it turns out that one of the main problems was much simpler. According to the New York Times:

The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

The methods they used hinged on assuming long term risk factors rather than taking into account relatively short term risk events. As Saul Hansell, the reporter says:

It was like a weather forecaster in Houston last weekend talking about the onset of Hurricane Ike by giving the average wind speed for the previous month.

As anyone who has developed a cashflow forecast will tell you, short term factors carry as much if not more weight when trying to assess a forward position because the longer the timeframe under review as the basis for assumptions, the more uncertain the model becomes. That’s why we’ve developed systems of rolling forecasts.

This is not rocket science but forecasting 101. So if that’s the case, then why didn’t anyone ask the obvious question as to the underlying assumptions governing the creation of risk adjusted models? I suspect the answer is equally prosaic. As professionals, we are accustomed to running tests around the transactional controls rather than the underlying assumptions which govern those controls beyond the audit trail and authorization processes. Or maybe the audit folk took one look at the models and were blinded by their complexity or simply relied on the outcomes as reported to them by actuaries?

What is becoming clear to me at least is that US bankers didn’t have the experience to realize that housing markets don’t have an ever upwards trajectory. Or maybe they were too terrified to face the truth.

Either way it is a classic case of garbage in, garbage out.

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Tagged as: New York Times, Risk management

  • Hi Dennis

    I think the causes are far more fundamental than the technology, but rather human weaknesses instead, let me explain.

    Just over half a decade ago I and another colleague (from the business money markets) created a startup that focused on building credit risk analysis software. Although it was aimed at more specialised business finance rather than residential mortgage markets, the lesson I learned from the experience is probably relevant here.

    Our software enabled the banks to get levels of transparency into the business being financed at a much greater depth and accuracy than the 'fag packet' math previously relied upon. In this case a great deal of complexity related to the insurance of the risk, compliance with credit re-issuing and aggregated ledger risks could be easily assessed.

    Often when we cranked the lever on the business and it's ledgers the risk turned out to be much greater than the intuition of the current banks risk assessment employees.This in turn could lead to more business rejections. It also highlighted some of the bad past decisions made by existing sales.

    But here is the catch, what the software was doing was spoiling the cosy 'finger in the air' sales process, and as such the decision came down to sales dept vs risk dept. Often greed would win with comments like 'We are doing fine right now and making money so why upset the apple cart'.

    Thus I would not be at all surprised if the same human weakness of greed allowed the banks to over extend themselves in the mortgage markets, attempts by innovative technologies would unfortunately fall on deaf ears.

    regards
    Al
  • That's the invisible 800lb gorilla - or at least it's invisible to those who choose not to see.
  • "...in looking for people to hire, you look for three qualities:
    integrity, intelligence and energy.
    And if they don't have the first, the other two will kill you."
    Warren Buffett
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