I appeared on a Canadian business show with structured finance expert Janet Tavakoli on March 31. Janet and I don’t completely agree about the role of the quants in the meltdown — she fingers fraudulent behavior in the structuring of the billions of structured products (all those complex deals packed with subprime mortgages). I completely agree that there probably was a great deal of fraud — or something very close to it — although I also believe that the bad actors used the complexity of these products to mask their actions.
I also believe that the credit crisis was much bigger than toxic CDO (collateralized debt obligations). Banks were overlevered using overnight “repo” markets. Hedge funds were overlevered using faulty risk models. There was a popular delusion that the global economy was in a period of low volatility, which Ben Bernanke, in 2004, called the Great Moderation. Wall Street was collectively congratulating itself that, due to the great innovations of the quants, the entire system was more efficient.
As we all know, that was dead wrong.
Scott,
You seem to be mischaracterizing my position. As I wrote in my books, including DEAR MR. BUFFETT, which came out in January 2009, I stated that the bad actors used the complexity of these products to mask their actions, and described ways in which it was done. It wasn’t limited to CDOs, but to a plethora of structured financial products and underlying risks, which I also point out.
You state: “I also believe that the credit crisis was much bigger than toxic CDO (collateralized debt obligations).” Yes, as do I, and I wrote about this extensively, including flaws with a variety of correlation models, credit derivatives models, and total return swap models, and more.
You also state: “Banks were overlevered using overnight “repo” markets.” Yes, I explained how that was Bear’s undoing, the effect that the implosion of the Peloton funds had on repo, and the implosion of CCC, and more.
You also state: “Hedge funds were overlevered using faulty risk models.” Yes. As I mentioned in the interview, I wrote about this problem with total return swaps (and LTCM) in 1998.
Not sure what point you are trying to make here.
Hi Janet – Thanks for the comment. I was primarily referring to the comments on the broadcast, not your other writings. And I really don’t think we have conflicting views, we’re simply talking about two somewhat different, albeit related, issues. I totally agree that there was a great deal of unethical and probably fraudulent behavior in structure toxic CDOs, which is your primary point, at least as you expressed it in the article. And there’s little doubt that toxic CDOs played a central role in the credit crisis. What I’m trying to get at in my book is the creation of a financial system based on math, rational expectations, efficient markets, etc., and all the quantitative investing strategies riding on this system, that played a part in not just the meltdown of 2008 but the quant fund crisis of August 2007, Long-Term Capital Management, and Black Monday in 1987. If the subtitle of the book could be longer it would be “How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It — Over and Over Again.