Obama's Financial Adviser is Wrong: Malfeasance - Not Models - Killed Wall Street
TSF - February 24, 2009 (reprinted by my friends at WOWOWOW with TSF permission Feb 25, 2009)
by Janet Tavakoli


Paul Volcker, former U.S. Federal Reserve Board chairman and member of President Obama’s economic advisory team, gave a speech in Toronto on February 11 at the Grano Salon Speakers Series on the U.S. economic crisis. He made the mistake of blaming mathematical models instead of malfeasance as the key source of the financial meltdown:

“They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events happen once every hundred years. But we have ‘once every hundred years’ events happening every year or two, which tells me something is the matter with the analysis.”

Volcker was only partly right; there is something the matter with his analysis. The models would have failed to capture unexpected “hundred year events,” the outliers Mr. Volcker referred to in his speech, but that was not the cause of the U.S. financial meltdown. There were no outliers; there were outright liars. The models crunched misleading data fed to them by Wall Street’s financiers. The events that keep happening every year or two are the effects of massive unchecked malfeasance.

The global meltdown was not caused by an unfortunate mistake; it was caused by malicious mischief. Every problem related to the current financial meltdown was discoverable in the course of competent work. Our financial malaise was caused by bad behavior deliberately hidden behind the opaque veil of models and hard to pronounce financial products like collateralized debt obligations and credit derivatives. There is no innocent explanation, and the problem was massive.

Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, misleading loan documents, failed business models, overleveraged hedge fund clients, shoddy ratings on Wall Street deals, and more. Any finance professional worth their salt knew the data being fed the models in no way represented the risk.

We have a different problem than bad models. This is a classic case of garbage in/ garbage out, and Wall Street pros selling the garbage out knew what they were doing. As hundreds of mortgage lenders failed, Wall Street sped up—instead of halted—its sales of overrated deals. It rushed garbage out the door and into investment funds all over the globe. That would be bad enough, but investment banks lent money against this garbage, and—just as Archimedes told us it would—leverage (borrowed money) moved the world. But not in a good way.

WIRED compounded Volcker’s error in its most recent article: "Recipe for Disaster: The Formula That Killed Wall Street" (Feb 23, 2009). WIRED blames a model called the Gaussian copula saying it could not capture extreme “black swan” events or “grey swan” events that happen more frequently than the model predicted. It is true that Wall Street’s models are flawed, but even if the models had been changed, we would still have had our financial meltdown. All models are flawed, and the suggested replacement models would not have captured the problem, either. I have been a decades-long critic of the limitations of Wall Street’s models, but to blame models for our current debacle dodges the real issue: malfeasance.

[JT Note I am quoted in the WIRED article: "’Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus,’ wrote derivatives guru Janet Tavakoli in 2006.” I am a trenchant critic of correlation models, as I wrote to the SEC when I suggested the rating agencies' NRSRO designation should be revoked in February 2007, but I disagree with the article’s premise that models were responsible for Wall Street’s demise.]

Perhaps Volcker and WIRED offered an explanation that is strictly for the birds, because they cannot interpret what they are seeing. At a loss for a reasonable explanation, they claim this was an unexpected “black swan.” Richard Feynman, the Nobel Prize winning physicist who worked on the Manhattan Project, would not have been a fan of Volker or WIRED, because he believed in understanding his birds:

“You can know the name of a bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird…So let’s look at the bird and see what it’s doing—that’s what counts. I learned very early the difference between knowing the name of something and knowing something.”

If you looked at what people were doing, it was easy to see there were no black swans or swans of any color involved. Wall Street’s bankers behaved like Black Bart, the 19th-century California gentleman stage coach robber who galloped off with Wells Fargo’s loot without ever firing a shot. Washington-based financial regulators and Congressional overseers behaved like ostriches. It seems they only raised their heads when it was time to reverse legislation that protected the mortgage lending market, approve an Ambassadorship to the former CEO of a predatory mortgage lender , have dinner with financiers , or collect generous campaign contributions.

The massive creation of phoney securitizations from risky (and sometimes predatory) loans combined with leverage to form a toxic brew in Wall Street’s financial meth labs. Debt such as this is initially sold at full price. It has no upside, but it has a lot of downside. If you lend (or borrow) money against an asset that will plummet in price, you are in trouble from the start. As the prices of these toxic products inevitably fell, hedge funds and other overleveraged borrowers were forced to sell in what is called “the great unwind.” Borrowed money and toxic products caused a vicious cycle of selling that is feeding on itself.

Wall Street has created such a tangled web of risk for itself that financiers often do not trust each others’ prices and often do not trust their own prices. Wall Street would be delighted, however, if U.S. taxpayers would suspend their disbelief long enough to allow the U.S. Treasury to take this mess off of their hands. We were told we would make money. How is that working out so far? We have lost hundreds of billions of dollars in market value and the oversight panels have lost track of our money.

At the most recent Davos conference, Jamie Dimon, JPMorgan chief executive, remarked: “Some really stupid things were done by American banks and American investment banks. To policymakers, I say: Where were they?"

No one in the US has been brought to justice for the enormous financial crime whose consequences are being foisted on the U.S. taxpayers. It is alarming that policy makers like Paul Volker perpetrate the myth of mistaken models instead of identifying the misteps of imprudent and pernicious financial practices.

The overwhelming problem in the market is lack of trust and evasive explanations like those offered by Paul Volker and WIRED are misguided. There shouldn’t be an ill-suited model at the end of this whodunnit, rather there should be a long list of Wall Street bankers and perhaps a few Congressmen and regulators. To the policy makers, I say: “Where are you?”

[Besides, Wall Street is not really dead, is it?]

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008), and
Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (John Wiley & Sons January 2009)


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