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.