Most contend that the recent mortgage meltdown was caused by corruption, greed, and incompetence. The headlines and sound bites support this idea but lack the deep reporting to prove their case. To demonstrate, in regards to the alleged corruption, I haven’t noticed a spike in the number of mortgage-related “perp walks” in the papers or on the evening news. How did I miss all of these examples of corruption?
Second, pure greed by itself actually would have drawn many hedge fund managers and their counterparts to short-sell mortgage-related investments during the bubble. Just think of the profits and bonuses for the few who did. Therefore, one can’t rightfully blame greed when the greedy people actually missed a big opportunity to make money and deflate the growing bubble. (And to be sure, the bubble never would have reached its size had there been more greedy short-sellers to offset all the buyers.)
And finally, it seems to me that a widespread miscalculation of risk among sophisticated buyers is a more accurate description of what occurred than just the simple incompetence of a few. After all, the players who contributed to the buying frenzy were not only the Wall Street risk managers, but also academics (including Nobel Laureates), financial journalists, foreign governments, highly-regulated foreign banks, Freddie and Fannie, and so on. This long list of participants, with very few dissenters, tells me that the many sophisticated parties who do their due diligence were just wrong.
But how did this widespread, devastating mistake happen? How did these various groups consistently miscalculate the level of risk and fail to anticipate this financial tsunami?
To find the root cause, it’s important to identify some common threads throughout these groups. The most obvious was the computer risk models which generated thousands, if not millions, of simulations but provided very little transparency. I believe risk management and finance professionals now understand that computer simulation models can easily create a false sense of security in an “uncertain” environment. And without transparency, the investors couldn’t challenge the model’s underlying assets and assumptions nor could they question its results.
Monty Hothersall
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