So where were the quants?

That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities.

Before I started covering the Internet in 1997, I spent 13 years covering trading and finance. I covered my share of trading disasters from junk bonds, mortgage securities and the financial blank canvas known as derivatives. And I got to know bunch of quantitative analysts (”quants”): mathematicians, computer scientists and economists who were working on Wall Street to develop the art and science of risk management.

They were developing systems that would comb through all of a firm’s positions, analyze everything that might go wrong and estimate how much it might lose on a really bad day.

We’ve had some bad days lately, and it turns out Bear Stearns, Lehman Brothers and maybe some others bet far too much. Their quants didn’t save them.

I called some old timers in the risk-management world to see what went wrong.

I fully expected them to tell me that the problem was that the alarms were blaring and red lights were flashing on the risk machines and greedy Wall Street bosses ignored the warnings to keep the profits flowing.

Ultimately, the people who ran the firms must take responsibility, but it wasn’t quite that simple.

In fact, most Wall Street computer models radically underestimated the risk of the complex mortgage securities, they said. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” in the words of Leslie Rahl, the president of Capital Market Risk Advisors, a consulting firm.

But she and others say there is more to it: The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”

So where were the quants? How Wall Street Lied to Its Computers...

PERSONAL HISTORY about the writer’s years as an aspiring composer in San Francisco. In 1972, several months after he graduated from Harvard and completed one of his first musical compositions (“Heavy Metal”), the writer and his new wife, Hawley, moved to the San Francisco Bay area. The writer’s plan was to live as a proletarian worker by day and an avant-garde composer at night.

This was a great read, too bad the New Yorker can't be bothered to put it's content online.

Personal History: Sonic Youth: Reporting & Essays: The New Yorker

The Securities and Exchange Commission issued a temporary ban on short sales of 799 financial stocks on Friday, a move against traders who have sought to profit from the financial crisis by betting against bank shares.

S.E.C. Temporarily Blocks Short Sales of Financial Stocks - NYTimes.com

not enough, the federal government started to put in place on Friday a sweeping plan to restore confidence in the financial markets.

The actions began to get under way on Thursday with discussions between the Treasury, Federal Reserve and Congressional leaders on what could become the biggest bailout in United States history, a plan likely to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions.

Stocks Surge as U.S. Acts to Shore Up Money Funds and Limits Short Selling - NYTimes.com

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.

You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley. 

As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."

I was sure that there was something like this lurking back a few years and sure enough, here it is.

The Big Picture | How SEC Regulatory Exemptions Helped Lead to Collapse

SALT LAKE CITY, Sept 17, 2008 /PRNewswire-FirstCall via COMTEX/ -- Overstock.com, Inc. chairman and CEO Patrick M. Byrne comments on the SEC's September 17, 2008 press release (see http://www.sec.gov/news/press/2008/2008-204.htm) that purports to protect investors against naked short selling.
Dr. Byrne commented, "At the core of the SEC announcement is a decision that if a hedge fund naked shorts a stock, its broker isn't supposed to let them naked short again. But guess what: they were not supposed to naked short in the first place. Instead of giving the buyer who receives the fail the right to put it back to the naked short selling participant, the SEC once again opts for no penalties for financial rapists.
"If the SEC were anything but a hedge fund bootlick," continued Byrne, "it would not have taken the half-measure of a pre-borrow requirement applied only as a penalty for those failing to deliver within T+3, but would have instituted a market-wide pre-borrow requirement (as it did in its July 15, 2008 Emergency Order protecting Upper Caste financial firms), and mandatory buy-ins at T+3. null

Overstock CEO Comments on SEC's New Rules Against Naked Short Selling - MarketWatch

The market is now consolidating this industry, with the strong eating the weak, which will impose its own fiscal discipline. Good. Maybe then more of our next generation of math geniuses will think about going into engineering the next great global industry — energy technology — rather than engineering derivatives.

Op-Ed Columnist - Keep It in Vegas - Op-Ed - NYTimes.com

A more likely alternative is that enterprises will finally begin making the most out of the little silicon chips housed on the motherboards of the PCs they’ve already bought. A few years ago, major OEMs began shipping PCs with Trusted Platform Modules (TPM), security chips used to store credentials and user certificates. While the technology is only on enterprise-class PCs today, it is widely expected to be on all PCs shipped within the next year or so and could be here tomorrow. null

I think his assessment is highly optimistic but he has the right idea -- security isn't going to get any better until we move away from the fantasy land that user passwords can ever be made secure.

Call off the dogs--authentication solution already in enterprise-class PCs | Tech News on ZDNet

The real-estate industry logically prefers a protected market to a free one. It argues that capital would drain out of housing. "This is antihousing," says Jerry Howard, chief executive of the National Association of Home Builders. "You will do some serious damage to states with strong vacation economies." You can see why home builders are upset: their margins are fattest on luxury homes; a policy that pushes prices toward the middle, as egalitarian as it might sound, would end their party.

But tax policy was never intended to function as a price support. Even less should it support a putative housing bubble. Even the president's directive mentioned sustaining housing ownership — not sustaining housing prices. High prices may even be a disincentive to ownership. And the housing market, the panel concluded, is overcapitalized anyway. Thanks to the interest deduction and other breaks, the effective tax rate on owner-occupied real estate in the U.S. is estimated to be only a fraction of the tax on business. Some of the capital being plowed into McMansions with Olympic-size lap pools would earn a higher return (tax considerations aside) in medical research or pollution control.

From 2006 and probably even more to the point today.

Tax Break - Who Needs the Mortgage-Interest Deduction? - NYTimes.com

Space Exploration Technologies Corp. (SpaceX) has been granted an Operational License by the US Air Force for the use of Space Launch Complex 40 (SLC-40) at Cape Canaveral Air Force Station on the Florida coast. Receipt of the license, in conjunction with the approved Site Plan, paves the way for SpaceX to initiate Falcon 9 launch operations later this year.

SpaceX Receives USAF Operational License for Cape Canaveral Launch Site | SpaceRef - Your Space Reference