JT Note: As we review second quarter earnings, expect no mention of inadequate models or "Level 3" black hole asset prices. The following adapted article is as true today as it was in May of 2005.

"Model Monkeys" Lose Track of Reality (Blast from the Past)
Financial Times - May 20, 2005
by Gillian Tett and Peter Thai Larsen

As the dust settles from the recent credit market turbulence, some hedge funds and banks are reportedly nursing trading losses.

One reason is that the industry has pinned considerable faith - and business strategy - on a set of models that now seem less than fail-safe.

" People thought the models were almost infallible - the last few days have been a real shock," says one senior banker. "Many people are still scrambling to work out what has gone wrong."

First, many hedge funds and banks have started trading arbitrages between debt and equity products, using complex mathematical models.

Second, many of these same participants have also leapt into credit derivatives - also relying heavily on new, partly untested models.

" Bank books have [in this area] become like invisible hedge funds," said Janet Tavakoli.

However, although the banks' pricing models have become central to this business, they have never been entirely based on science. For while banks have generally used the same basic statistical technique in their modelling systems, they have employed different assumptions about corporate default, recovery or correlation rates.

Just how much financial damage this has inflicted on banks or funds is not yet clear.

However, senior investment bankers said most banks had found ways to hedge their positions, though it will not be clear how effective this has been until they start reporting second-quarter earnings figures in the next few months.

Meanwhile, some banks are already thought to be urgently examining their maths.


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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)

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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