Working Paper Shows Causes of Crisis Started Long Before 2005

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The causes of the most recent downturn go back a lot further than mortgages made between 2005 and 2007, according to a recent working paper by veteran securities researcher Mark Adelson.

The working paper lists several interrelated causes, but the one that goes the farthest back is the so-called quant movement, which Adelson finds the beginnings of in the ’40s Manhattan Project.

Adelson said the term “Monte Carlo simulation,” used extensively by those selling mortgage-related securities and others prior to 2008, was coined in the Manhattan Project.

The quant movement, which—roughly and simply put—was a movement toward quantitatively modeling possible outcomes, is known for creating a false sense of security as companies took on risks.

As Adelson noted in his working paper posted on his website, “The heart of the problem associated with quantitative models was 'model risk,’ the risk that a model varies too much from the real world to produce useful results.

“Model risk might not have been a problem if financial professionals had retained skepticism about the reliability of their quantitative models. However, that was not the case. In fact, the (sometimes false) appearance [of] rigor and precision tended to encourage excessive reliance on such models.”

Adelson’s paper suggests such confidence played a role in what he describes as a “30-year trend of deregulation” and “the spread of risk-taking culture throughout the financial industry.”

The conversion long before 2005 of securities firms to corporations investing clients’ money, from partnerships where the partners who ran the business invested their own money, also played a role, according to the paper.

In this light, Adelson added to the observations in his working paper that a “phony macho of risk taking” contributed. “Risky,” complex deals made some Wall Streeters involved in them prior to the downturn feel tough and brave, causing some on the “Street bemoan the lack of them today,” he noted. But relative to the days of Wall Street partnerships, he said, “It’s not brave to use someone else’s money rather than your own.”

Adelson also notes that globalization multiplied risk-taking concerns.

As he acknowledges in citations through the working paper that the specific causes listed are not new. But other accounts “don’t put it into a larger perspective” or don’t go back as far and link the causes together, he said.

Also as noted in a previous article on this publication’s website, a key reason for the release of the research now is that there are now rough estimates of the overall losses from the crisis as a whole, compared to those experienced by 2005-2007 mortgages.

While, “we obviously don’t know what the total bill is,” Adelson said enough numbers are in to show that mortgage losses cannot account for the larger problem, and he documents how he arrived at these extensively.

Some other commentators on the crisis have suggested derivatives that referenced mortgage securities magnified the losses on the underlying loans and led to system-wide concerns. But Adelson cites a view in his paper that at least one instrument, credit default swaps, cannot be blamed for magnifying the risk.

Citing significantly, the dissenting view of three commissioners in a Financial Crisis Inquiry Commission report, Adelson notes that “derivatives, such as credit default swaps, cannot magnify losses because each derivative contract is a zero-sum game; for every dollar of loss by one party to the contract there is a dollar of gain for the other party.”

 

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