13 September 2009

Steve Lohr Gets it Wrong

One of the good things about Sunday is the NYT, and the Sunday Business section. Lots of articles/columns/opinions, and not always a clear cut edge amongst them.

Today, I'll pick on Steve Lohr. Not because what he says is especially egregious, only because it is the latest in the continuing stream of words which miss the point. The avowed essence of the article lies in the title "Wall Street's Math Wizards Forgot a Few Variables", by which he means that the quants didn't get it right because they couldn't model the real world correctly, because the data weren't available.

Here is one quote:

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic.

The point is wrong. The point is that the data were available to model the root cause of the meltdown; the housing bubble. That root cause was the ratio of monthly payment to median income, and monthly payment to sale price. I know this data is available, because it was available in 1971. Banks and builders *chose* to make available a housing stock which was not affordable by the resident population's median income, using accepted ratios. They knew what they were doing, and the data were available to prove that they were gaming the system and its rules. Both they, the quants, and the regulators *chose* to ignore the data which would expose their fiddling. It was clear to me by 2003. Alas, I had no blog back then.

In 1971, I was a college senior, and one of my professors ("Buffalo" Bob Smith) made some money on the side as an economic/business consultant. The place was Springfield, Massachusetts; not exactly Manhattan or Boston or LA, just a middling New England town. Dr. Smith had mined (back then it took a bit more work to do, naturally) public data to create what he called "Shift and Share Analysis". This analysis was sold to one of the local banks, for the purpose of locating branches. I know this, because we discussed the analysis. The root of the analysis was plat level income data. In other words, in 1971, there was sufficient public data available to know what household incomes were, and what they spent it on.

The bone I have to pick with Mr. Lohr is that his article, whose conclusions are driven by the persons he chose to interview/quote, focuses not on the cause of the meltdown, but on the reactions of the bad actors who caused it. Nothing useful will come of their efforts, since their efforts are aimed at further gaming, rather than systemic reform. It is worth noting that earlier in the week the Times ran a story about these same folks securitizing life insurance policies, for their profit, of course. Never mind that doing so distorts the markets.

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