response to Nihilist's Revolt - Bailout Plan

30, 2008 4:13 am

Let's take this pause to examine several alternative "frames" for "this crisis", and what candidate solutions each one would suggest. In every case except psychological, we need to distinguish perceptions from reality.

One view is that something has "broken" in the global system to extend credit to responsible borrowers, and it needs to be "fixed." Perhaps what has broken might break more, and we need more attention and adrenaline.

A different lens would say that the credit business is a symptom, not a "root cause." What is broken is psychological, a global sort of unjustified panic, and what we need is to calm the panic and then everything will be fine again. Actually, less attention and way less adrenaline would be good in this scenario. "Nothing to see here folks, false alarm." A calm voice, a firm hand on the helm, a sense of authority would be good, we can all go back to watching television.

A third view is that this is a crisis of "social capital." In that view, what has bottomed out is "trust" and delayed gratification. What has replaced those is distrust and a "me first, right now" mood.

Psychological issues and passing unjustified anxieties can be calmed by the media - although the voice from the box seems to be crying "panic now!" Financial systems might be improved with more "regulation", or possibly by letting American ones fail and relying more on global ones with less credulity that are still strong.

But the issue of a sudden realization that we have no social capital left remains. To the extent this is the root cause, we have a much different problem here, calling for different solutions.

This seems to me to be the case, as each year's Federal Budget takes longer and longer to get passed, with bickering and paralysis replacing negotiation and reasoned discussion and even horse trading.

Negotiation and deals require trusting the other party to keep their promises, and that seems to be gone.

If that is the problem it is a huge one, and the wrong parties are at the table. All those social scientists and all those subjects we've been throwing out of the curriculum because they were not "math" or "science" are more relevant than high finance. We need cultural anthropologists. We need to understand the role of religion and morality in building trust in the future, and, for that matter, a thought for the future in present decisions.

The bailout bill will not address this latter problem. It's the wrong frame.

Before solving the problem in one frame, let's be sure it's the right frame, and that we're solving root causes, not symptoms, because there's not much ammo left in the box. There's only so many more trillion dollar rescue plans before we are, sadly, broke.

Political Grace

this from the Wall Street Journal: (Peggy Noonan):
=======================

Veer

Where is America?

America is on line at the airport. America has its shoes off, is carrying a rubberized bin, is going through a magnetometer. America is worried there is fungus on the floor after a million stockinged feet have walked on it. But America knows not to ask. America is guilty until proven innocent, and no one wants to draw undue attention.

America left its ticket and passport in the jacket in the bin in the X-ray machine, and is admonished. America is embarrassed to have put one one-ounce moisturizer too many in the see-through bag. America is irritated that the TSA agent removed its mascara, opened it, put it to her nose, and smelled it. Why don't you put it up your nose and see if it explodes? America thinks, but does not say.

And, as always America thinks: Why do we do this when you know I am not a terrorist, and you know I know you know I am not a terrorist? Why this costly and embarrassing kabuki when we both know the facts, and would even admit privately that all this harassment is only the government's way of showing that it is "fair," of demonstrating that it will equally humiliate anyone in order to show its high-mindedness and sense of justice? Our politicians congratulate themselves on this as we stand in line.

All the frisking, beeping, and patting down is demoralizing to our society. It breeds resentment, encourages a sense that the normal are not in control, that politics has lessened everything, including human dignity. Another thing: It reduces the status of that ancestral arbiter and leader of society, the middle-aged woman. In the new fairness, she is treated like everyone else, without respect, like the loud ruffian and the vulgar girl on the cellphone. The middle-aged woman is the one spread-eagled over there in the delicate silk blouse beneath the removed jacket, praying that nothing on her body goes beep and makes people look.

Getty Images

Hail to the Candidates

The 2008 presidential campaign has generated a range of original songs.

• Read more about the tributes and listen to clips from some of the numbers.

America makes it through security, gets to the gate, waits. The TV monitor is on. It is Wolf Blitzer. He is telling us with a voice of urgency about the latest polls. But no one looks up. We are a nation of Willy Lomans, dragging our wheelies through acres of airport, walking through life with a suitcase and a slack jaw, trying to get home after a long day of meetings, of moving product.

No one in crowded Gate 14 looks up to see what happened with the poll. No one. Wolf talks to the air.

Gate 14 is small-town America, a mix, a group of people of all classes and races and ages, brought together and living in close proximity until the plane is called. Our town appears, the plane is boarded, the town disappears. An hour passes, a new town begins. This is the way of modern life. We live in magic and are curiously unillusioned.

Gate 14 doesn't think any of the candidates is going to make their lives better. But Gate 14 will vote anyway, because they know they are the grown-ups of America and must play the role and do the job.

But here's something they notice, we notice. Our leaders are now removed from all this, removed from life as we live it each day.

There is as I write broad resentment toward President Bush, and here is one reason: a fine and bitter sense that he has never had to stand in his stockinged feet at the airport holding the bin, being harassed. He has never had to live in the world he helped make, the one where Grandma's hip replacement is setting off the beeper over here and the child is crying over there. And of course as a former president, with the entourage and the private jets, he never will.

Nor will Bill Clinton, nor the senators and leaders who fly by private jet.

I bet a lot of Americans, most Americans, don't like it. I'm certain Gate 14 doesn't.

Giacomo Marchesi

All this is part of the mood of the moment. It is marked in part by a sense that our great institutions are faltering, that they've forgotten the mission; that the old America in which we were raised is receding, and something new and quite unknown is taking its place; that our leaders have gone astray. There is even a feeling, a faint sense sometimes that we have been relegated to the role of walk-on in someone else's drama, that as citizens we are crucial and yet somehow...extraneous.

But we are Americans, and mean to make it better. We long to put the past few years behind us, move on, and write something good on the page we sense turning.

In all this I am not saying, as Rodney King did, Why can't we all just get along? We can't because we're human: something's wrong with us. But we can do better.

I don't mean "we must outlaw politics," or "splitting the difference is always best." Politics is a great fight and must be a fight; that is its purpose. We are a great democratic republic, and we struggle with great questions. But we can approach things in a new way, see in a new way, speak in a new way. We can fight honorably and in good faith, while -- and this is the hard one -- both summoning and assuming good faith on the other side.

To me it is not quite a matter of "rising above partisanship," though that can be a very good thing. It's more a matter of remembering our responsibilities and reaffirming what it is to be an American.

If nothing else, this means we must now have our fights over big issues, issues of real consequence that are pertinent to the moment we're in. We shouldn't be fighting and hitting each other over the head over little things, stupid things, needlessly chafing ones. When I would think of this the past few years I'd always return to one thing, a prime example of the old way of doing politics. This was the movement, now quiescent, to alter the Constitution of the United States to outlaw...flag burning. Imagine changing that great document for such a stupid thing. As if it meant anything if an idiot burned a flag; as if a lot of idiots were even burning flags -- which they weren't, and aren't. I called it a movement, but of course it wasn't: it was a political game played by one team in order to embarrass the other. "He doesn't love our flag -- he won't even protect it!" Boo! goes the crowd.

And yet the oddest thing is...the crowd knows it's being played. They know their buttons are being pushed. And this doesn't leave them feeling more inspired by, more trusting in, the system. So much of our silliness is, in the end, destructive.

And so I came to think this: What we need most right now, at this moment, is a kind of patriotic grace -- a grace that takes the long view, apprehends the moment we're in, comes up with ways of dealing with it, and eschews the politically cheap and manipulative. That admits affection and respect. That encourages them. That acknowledges that the small things that divide us are not worthy of the moment; that agrees that the things that can be done to ease the stresses we feel as a nation should be encouraged, while those that encourage our cohesion as a nation should be supported.

So where are we now? I yank this into the present to look at the landscape on which a rise to the challenge is possible, but not, I'm afraid, very likely.

Veer

It is autumn, and America is picking a president. It has been exciting. The whole year was confounding, putting the professional political class in its place, leaving the experts scratching their heads, and giving us all the feeling -- so precious, so rare -- that the people are in charge. They make the decisions, not pollsters. And you never knew what they'd do next. John McCain was over and done a year ago, out of money and out of luck. And then: he wins the nomination. Barack Obama was unknown and outmatched a year ago, sure to be a victim of someone else's inevitability. Well. Nothing is inevitable. And he wins the nomination.

A year of marvels. And now two men, McCain and Obama, each worthy in his way of admiration, battle it out. Neither seems by nature inclined toward brute, gut-player politics. One, McCain, had been hurt by it in the past, his presidential prospects in part done in by it in the Republican primaries of 2000. He has a temper, and at some point he'll have shown it, but the ugly road, I think, embarrasses his pride. The other, Obama, seems temperamentally not inclined to be a killer, to encourage the dark side of politics. It's not his history: he took down a machine without raising his voice.

However.

Something tells me that the election will show itself to be rough indeed, if not because of the candidates themselves then very much because of their surrogates or would-be surrogates -- a million freelancers and operatives, YouTube Fellinis, and political action committees.

Two huge teams are in a massive public brawl in an era in which the Internet has liberated everyone in the country from the old restrictions, the old establishment, the old, encrusted media monopoly.

YouTube has yielded, this year, the most moving and wittiest advertisements about each of the candidates. Professional political consultants with their piece of the buy didn't produce them, artists did. For Obama, it was the video by will.i.am, with the Obama speech and the snatches of song made from his words. More than anything else this year, it captured the feeling behind his movement. The McCain video, alas, was anti-McCain, and keyed off the will.i.am video. It featured young people and artists taking snatches of McCain speeches, turning them into song, and then starting to...freak out as they listened to the words. It made you laugh out loud. Anyway, one of the untold stories of the year is the failure of the political professionals to compete with the art and brightness of the nonprofessionals.

All of this will be part of the background music of the 2008 campaign. So: it's probably gotten mean out there.

And of course it is not only the result of technology, and partisanship, and human mischief. Some of it has been the result of the past seven years, that trying time with which we have not fully come to grips. Some of the personalities and circumstances that shaped the era are about to ease off the stage. In some way we're about to turn the page. Maybe John McCain or Barack Obama can help us write something good on it.

Yet the economic crisis brings a new question, only recently being articulated, and I know because when I mention it, people go off like rockets. It is: Do you worry that neither candidate is up to it? Up to the job in general? Is either McCain or Obama actually up to getting us through this and other challenges? I haven't heard a single person say, "Yes, my guy is the answer." A lot of shrugging is going on out there. The big shrug is a read not only on the men but on the moment.

The overarching political question: In a time of heightened anxiety, will people inevitably lean toward the older congressional vet, the guy who's been around forever? Why take a chance on the new, young man at a time of crisis? Wouldn't that be akin to injecting an unstable element into an unstable environment? There's a lot at stake.

Or will people have the opposite reaction? I've had it, the system has been allowed to corrode and collapse under seven years of Republican stewardship. Throw the bums out. We need change. Obama may not be experienced, but that may help him cut through. He's not compromised.

The election, still close, still unknowable, may well hinge on whether people conclude A or B.

—Adapted from "Patriotic Grace: What It Is and Why We Need It Now," by Peggy Noonan. Copyright 2008 by Peggy Noonan. Published by Collins, an imprint of HarperCollins Publishers.Peggy Noonan is the author of seven books. This is adapted from her next book, "Patriotic Grace," which will be pu

Clueless, says NY Times Op Ed

My Comment on NYTimes op-ed piece.
==========================================
Desired comment:
==========================================
Curious logic, both of you. Let's separate economics from politics and problem from solution and fall back on basic principles.

To paraphrase Bertand Russell, when experts disagree, you cannot be sure any
position presented is correct. We don't even have recognized and trusted experts. The activity proposed is unorthodox, if not unprecedented in this country, so even experts admit we are in uncharted territory.

What are we sure of? Enough, it turns out, to reach a conclusion.

Is there a crisis? Yes.

Does anyone comprehend all of the national and international aspects of the crisis, its full scope and scale and character, and all the players involved? No.

What are the odds that complex, interconnected systems with huge stakes are capable of behaving unexpectedly, even paradoxically, as well as generating unintended and unanticipated "side-effects"? 100 percent.

So, how many people in the world, after extensive study and modeling, could reliably predict all the significan teffects of any of the proposed interventions? None.

Then, how many people in the world, after incomplete study, little discussion with experts, and no simulation or modeling, could reliably predict all the significant effects of the proposed solutions? None.

So is it possible ANY proposed solution would actually make things worse, not better? Yes.
Is our intuition a good guide to behavior of complex adaptive systems with feedback? Demonstrably no. John Sterman at MIT and others have demonstrated that even simple feedback baffles most people and their predictions, while confident, are well off the mark.

If we cannot reliably predict the outcome, then how good a track record do we have in quickly realizing and admitting that a course set out upon is not looking good, or in fact, should be rejected after all? Sadly, history suggests continuation of even blatantly failed policies is human nature.

If it turns out to be the right direction, are we sure we are going far enough? No.
Is it possible the true final cost might be well larger than initial predictions? Yes.,

if this turns out to be the wrong direction, is it relatively easy to undo? No.
Is it possible to undo at any cost? Not clear.

Would an attempt to undo it result in yet another case where we are spending most of our effort trying to undo the impact of prior, ill-conceived "solutions"? Yes.

Are well all very good at recognizing when our help is only making things worse? No.

If someone else was doing this in a parallel economy, say on Mars, that we had no stake in, what would we think the odds are that their first intuitive guess as to an obvious solution is, in fact the solution? I think, very low.

Does having a strong vested interest, and a sense of panic, improve human judgment and decision making? Not generally, no.

All of this comes together to say that the a priori odds that any solution proposed will solve the crisis are very low, close to zero. It may be the same odds that you could fix a broken television by reaching inside and cutting the obvious wire, and we're arguing over which wire is the obvious one.

If we take this action, and it doesn't work out, how many more such tries do we have? Not many, at that price tag. A failed attempt not only fails to solve the problem, it uses up limited ammunition andt time.

Now, this is hard but try. Aside from political considerations, and group psychology, are we more likely to improve things or to cause yet more damage by any such large-scale action? I have to conclude from the above that carefully-considered inaction is more defensible, safer, and stabler than (re)action, politics aside.


======================= actual comment ======================

• 
  
• 72.
  September 26th,
  2008
  8:23 pm

  A drama in one act:

  * Pilot?! The wing is on fire!
  Yep, seems to be.
  * Should we dump fuel?
  Well, it might be the exact wrong time to do that.
  * Don’t we need to do something?
  Yes.
  * So we dump fuel?
  No, that would just catch fire from the wing and cause the airplane to explode.
  * But it’s the only suggestion we’ve come up with and we need to DO something NOW!
  OK, then I’ll put the airplane into a dive and go so fast that the wind blows out the fire, as it says in the manual.
  * NO, we want to stay UP!

  The crowd of passengers forcibly removes the pilot and pushes the fuel-dump button.

  The end.

  — Posted by Wade

=========================================================

OK, now bring politics back into this picture. Do the American people tend to support carefully-considered inaction? No. Do we care what the American people think? Both journalists say "No." That's a story in itself, but for another day.


Wade

Yes, yes! A Bailout Plan at Last!

All this talk and no one has addressed how they intend to value junk, if we don't use a market.

So I will offer a plan. Then we can look for any better plans.

Here's my plan = "The Plan version 1.0" :

How about they start by offering to buy at 1 cent on the dollar any existing mortgage backed debt anyone, individual or corpation wants to sell?

When no one offers to sell any more, raise that to 2 cents on the dollar.

Keep going, adding 1 cent per dollar a day to the offer, till the $700 Billion is invested.

Advantages:

* Comprehensible plan of action.
* No questionable computations.
* No charges of favoritism.
* Easy to audit
* And, I think, most subtly but most importantly, is that this would have an immediate calming effect on the market, and one that improved gradually over time.

After the first day, you may not know how much that junk in the vault is "worth" but you and everyone else knows that you think it is at least 1 cent per dollar. Each day its effective worth gets both larger and stabler, in a gradual fashion.

The advantage, to anyone who grasps complex adaptive systems, is that no abrupt "step-function" change is put into the market, which would reveal and trigger all manner of new instabilities and demons. The firm hand gets slowly firmer, the ones most in panic get resolved the soonest, and things simply get better over time.

* Oh, and it probably is defensibly prudent - the investing public gets the most face amount of junk assets it possibly can for each dollar invested.

* In fact, there could be a market in this pool of dubious assets being collected, which could bring in more cash and make the entire plan become self-funding after some point.

* Probably, just issue each American Citizen 2,500 shares of stock in this junk-asset holding agency, in exchange for the non-optional investment of $2,500 of their money being taken on as US debt. If people want to hold the shares they can, or they can sell them to anyone else who wants to buy them up. If this thing makes money, all US citizens make money. If it loses, hey, that was in the cards regardless, then.

===
OK. Next? Who has a better plan than that?

No No, a Thousand Times No!

To address the problem we need to grasp the nature of the problem, a task that seems to have been largely overlooked.

Let's look at the whole question known as "stability" and "health" of the financial sector, and reason from solid underlying basic principles that govern all complex adaptive systems, caring as little as does gravity about politics and winners and losers.

As I have stated numerous times in the past, there is expertise in the world regarding what is involved in stabilizing a system, any system. There are universally applicable principles. This field is called "Control System Engineering". The principles are the same whether the system is a jet aircraft in flight or an economy in motion.

Probably the first thing that needs to be said is that "intuition" as to what to do is uniformly wrong. Our intuition is based on very simple systems, almost uniformly lacking feedback, or having consequences we have carefully built a narrative allowing us to ignore.

This sin is equivalent to designing a car so complex no human can drive it, and then blaming the drivers for the subsequent crashes, instead of blaming our own design.

So, doing the "obvious thing" is almost always the wrong answer. This does not depend on how stridently one asserts that it is "obvious" or what caliber gun one can point at the head of those who disagree with one's "obvious" brilliant insight into a system no one else can fathom. It is, after all, "obvious" only if you ignore all the parts that don't work, and focus on the few parts that
do.

There is an entire science of "stability" and a whole field of designing "controllers", electronics that can provide such stability to a given engine or system. Even to those with PhD's and a lifetime experience, the solutions that the computers reveal are seldom "obvious".

We need now to make an extremely important distinction and disentangle two concepts that are generally incorrectly mushed together.

One is the concept of "being under control" and the other is the concept of "controlling".

It is desirable that systems we rely on, drive in, fly in, or put our offices within are "stable" and "under control." The alternative is bridges, planes, or economies crashing down with significant loss of life and treasure.

That said, how the "controlling" occurs, and what the agent is of such controlling, turns out to be a more complicated issue that we are used to.

Let's consider some alternatives. There is the "great man" or "king" or "Czar" approach, in which a single human, possibly with or without advice, uses his great wisdom to decree each step in turn in order to bring about stability. If there is no stability, the solution is either "more wisdom" (seldom mentioned) or "more authority" (a far more popular request.)

On the far side, there is a more complex type of agent, spread more diffusely, hard to see on a small scale, but easy to see on a large scale. One example, and mind you this is only one, is the "Invisible hand of Adam Smith", or the functioning of a "free market."

This is just one example of millions of possible "emergent agents" that brings about stability, often in a way baffling to humans, or incomprehensibly difficult for humans to fathom. One example often cited is the set of decisions involved in feeding New York City on a daily basis.

The conservatives have it right, that some kind of emergent agent can be far more powerful at setting things right and repairing instability than can any single local human with their local perspective. What they have wrong is that there is only one such solution, so they don't put in the time and effort to find one BETTER than Adam Smith, but still not in the hands of any small clique of people, regardless how sincere, who as all humans do, will lose all sense of perspective once they gain power, and who will therefore spend all their assets attempting to acquire more power, which they incorrectly think will finally solve things. It is so "obvious" to them that the solution is close, if only they had complete control.

The problem with this logic is that other people are only part of the obstacle. Another obstacle is that complex systems have a mind of their own and do not behave in a manner comprehensible to a human, or predictable by a human, any human, regardless who they are. the only reason it seems that it is close to such a Nirvana is that all of the things not understood have been diminished and discarded. So, all the points I have kept on this graph form a straight line, see? (of course, I had to discard all those that didn't fit my preconceived notion that there is in fact a line here, not a sine curve or something more complicated.)

Ok, so, say for a moment you had 100% of the world budget, 100% of the world in worshipful obedience, and total authority. Then what?

It's not like the world has a steering wheel and only needs to be brought back onto the road, now that we've decided who's driving. The world is more like a 747, and we are more like 6 year olds, and having total authority to push buttons does not a pilot make.

The only solution remaining for us is to find a type of distributed emergent agent, like Adam Smith's hand only better, that can be created using simple decision rules, such as "be greedy", and that collectively form a stabilizing field.

My perception is that "be greedy" as a generative rule is not a very good solution and "be nice" is a better one. Before concluding such a solution is impossible, we need to study the role of context in making behaviors occur and sustaining them in the face of apparent results.

That is the task that we should be putting 700 billion dollars into, not fighting over WHICH human should make 'the decisions",

Wade

We need an improved "invisible hand", Adam

David Brooks wrote a piece in the NY Times this morning on regulation of the financial industry.

Incidentally, there is essentially no engine today in any product that does not have a "controller" as part of the design, to increase stability, response time, etc. No elevator would stop at the floor without an abrupt "jerk" without a controller. The design of such controllers is in the field called "Control System Engineering."

A sample text book is this one: Feedback Control of Dynamic Systems, by Franklin, Powell, and Emami-Naeini. These are the concepts we need for a "governance" or "regulatory" system that actually works as advertised.

Control system engineering is to complex systems what "civil engineering" is to automobile bridges across rivers -- it is completely general and non-political, it won't tell you where to build or what to build with, but it WILL tell you the required properties of the materials and that some things will simply not work. You can't build the Brooklyn Bridge out of plastic, for example, regardless how cheap it is. You can't design a regulatory system that depends on feedback, for another example, and then blind the sensors that are supposed to determine the feedback.

The advantage of such engineering is that it focuses on issues such as "stability" (a big one right now) and gives power to insight, such as that blinding the eyes of a system will make it drive off the road for sure.\

Search "feedback" or "system thinking" in this weblog for other posts on such matters!
====================================================


One obstacle to a good solution is the incorrect assumption that a process "under control" equates to a small group of people doing "the controlling." Let's keep those separate.
The question of whether we need more "governance" should be distinct from who, or what, should be the active agent. For much of the US History, many have favored Adam Smith's "invisible hand" of the marketplace to do this controlling.
The classic debate over more or less "government" desperately needs this distinction.
The question should be whether there is an improvement on the class of "invisible controllers" that (a) do a better job and (b) are even less corruptable by those who would hijack the process.
There is no question that we have very complex processes running out of control, and that this is not the preferred state. Fine.
The question is how to achieve the "under control" part. The institution called "government" has typically decayed to "a few people" who, regardless of wisdom and intent, have been unable to grasp the com
plexity of the beast or improve on its operation and results.

The deep cynicism resulting from such failure seems related to the abandonment of a goal of prosperity for all and replacement with a goal of "prosperity for me and my friends at everyone else's expense" which turns out to be a short-term illusion, given how interconnected everything is.
These are problems in the area of "control system engineering" and "complex adaptive systems" and the necessary insights are probably in those fields.

Why more math and science are NOT what we need

I had a post recently, the link I'll add here soon, in which I protest the emphasis on math and science education in our schools, because, I believe, that is not where things are breaking.

For example, I really don't believe that if every Senator had more math and science, or even, say, twin PhDs in math and science, that they would be any better at reaching consensus than Oxford University professors are at deciding what e-mail system to purchase.

The reason is that all this "math" and "science" takes place in a social context that can magnify or neutralize or reverse essentially anything.

The following piece from today's New York Times makes it clear that having computers and "quants" doesn't really solve much. As I continue to repeat T. S. Eliot, they continue "dreaming of systems so perfect that no one needs to be good." It won't ever happen.

================================================

September 18, 2008, 7:52 am — Updated: 5:00 pm -->

How Wall Street Lied to Its Computers
By Saul Hansell
CORRECTED 5 p.m.: Spelling of Leslie Rahl.

So where were the quants?

That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities.

... I got to know bunch of quantitative analysts (”quants”): mathematicians, computer scientists and economists who were working on Wall Street to develop the art and science of risk management.

They were developing systems that would comb through all of a firm’s positions, analyze everything that might go wrong and estimate how much it might lose on a really bad day.
We’ve had some bad days lately, and it turns out Bear Stearns, Lehman Brothers and maybe some others bet far too much. Their quants didn’t save them.

I called some old timers in the risk-management world to see what went wrong.

I fully expected them to tell me that the problem was that the alarms were blaring and red lights were flashing on the risk machines and greedy Wall Street bosses ignored the warnings to keep the profits flowing.

Ultimately, the people who ran the firms must take responsibility, but it wasn’t quite that simple.

In fact, most Wall Street computer models radically underestimated the risk of the complex mortgage securities, they said. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” ...

But she and others say there is more to it: 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.

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

.... Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman...
...

But since the markets were placid for several years (as mortgage bankers busily lent money to anyone with a pulse), the computers were slow to say that risk had increased as defaults started to rise.

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.

But many on Wall Street did even worse, as Mr. Berman describes it. They continued to trade very complex securities concocted by their most creative bankers even though their risk management systems weren’t able to understand the details of what they owned.
...

So some trading desks took the most arcane security, made of slices of mortgages, and entered it into the computer if it were a simple bond with a set interest rate and duration. This seemed only like a tiny bit of corner-cutting because the credit-rating agencies declared that some of these securities were triple-A. (20/20 hindsight: not!) But once the mortgage market started to deteriorate, the computers were not able to identify all the parts of the portfolio that might be hurt.

Lying to your risk-management computer is like lying to your doctor. You just aren’t going to get the help you really need.

They would have gotten things right if only they were fed the most accurate information. Ms. Rahl said that it was now clear that the computers needed to assume extra risk in owning a newfangled security that had never been seen before.

“New products, by definition, carry more risk,” she said. The models should penalize investments that are complex, hard to understand and infrequently traded, she said. They didn’t.

“One of the things that has caused great pain is complex products,” Ms. Rahl said.

....And, ultimately, the most important risk-management systems are the ones that have gray hair. “It’s not just the Ph.D.’s who must run risk management,” Ms. Rahl said. “It is the people who know the markets and have lifelong perspective.” And at too many firms it is those people who failed to make sure the quants really did their jobs.

(c) 2008 the New York Times Company