Risk Mismanagement

May 4, 2009

The necessary post-mortem analyses for the financial system's collapse have begun in earnest. While some have taken to talking about Wall Street's 'stupidity,' this is an unsatisfying and ultimately counterproductive approach. Clearly, the financial crisis had numerous major and contributing causes (the true 'perfect storm'), but failures of models and analytics were key factors. Rather than think of 'models' as a singular entity, it's useful to separate them into 'consumer behavior' and 'position management' models. The first would include credit performance models, which predicted losses that were low by several orders of magnitude. The failure to correctly project credit-related losses led directly to a cascading series of problems, including the creation of entire classes of securities (such as CDOs backed by subprime subordinate bonds) that were fundamentally flawed.

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