Wall Street Meltdown: Blame Software?

James had a curious post about the Wall Street meltdown... and how some of the blame lies with bad programs from IT.

Did you know that a significant portion of all trades executed by Wall Street don't have human intervention and are submitted by computers? Did you know that you can write your own trading algorithms and put computers directly in the NYSE data center to avoid the latency of network hops to make your bad programs execute even faster?

Would we have had a subprime crisis if Wall Street banned algorithmic trading? The notion of Quants has the ability to take a bad situation and make it even worse. More importantly, many used quant strategies as a way to hedge their other bets but never considered that the logic behind the programs might be flawed...

Interesting thesis... but I think James is asking the wrong questions.

The problem was not in the software, or in any of the algorithms that IT implemented... The problem was inherent in the financial models themselves. The IT folks simply implemented those models... and the software programs were simply dumb agents that did exactly as they were told.

Now... if we banned computers from trading, would we have avoided this problem? Absolutely not. If we banned computers, then the financial "wizards" who got us into this mess would simply use different "dumb agents" to do their bidding... in other words, stock brokers.

Back in the 1980s, there was a classic book on how Wall Street was completely crooked... called Liar's Poker. It was an autobiography of a stock insider. The author was right out of college, and was paid huge sums of money to give stock advice to millionaires... despite the fact that he had neither the training nor the desire to do so. Recently, the author came out with an excellent article on the sub-prime mortgage crisis, and the few folks who saw it coming... it was utterly chilling to read how reckless, irresponsible, and deeply stupid some wall street financiers were. They weren't just liars; they were idiots.

For example... one huge reason why this crisis came about was because people were turning risky sub-prime mortgages into bonds. Not a bad idea... but somehow they would take a collection of highly risky BBB loans, smash them all together, chop it up, and claim they were now ultra-safe AAA bonds. The entire point of bond credit ratings are to prevent this kind of crap... Since a BBB bond is high risk, it usually pays a large interest rate. In contrast, since AAA bonds are "safe," they pay a low interest rate... so if you could claim a BBB bond was AAA, your fake AAA bond would pay a much higher interest rate than actual AAA bonds, and thus be in huge demand... you would make a killing, and it would create pressure to make more and more of these sub-prime mortgages, just so you could sell them as fake AAA bonds. Just like Alan Greenspan said, the "demand for paper" drove this crisis, because Wall Street demanded that lenders lower their standards, so they could get more crappy loans.

It was a complete and total con, and the guys from Marketplace have a great video describing how it worked. But what was more shocking was how the ratings agencies went along with the scam. Naturally, you can't just claim your crappy bonds are rated AAA, any more than you can claim a R-rated movie is a G-rated movie. No... you have to get the bond ratings agencies (Standard & Poor, Moodys, etc.) to agree that you bond is AAA... essentially, the bond rating agencies didn't do their job:

[Moses Eisman] couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to [mortgage] default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative [growth] number. “They were just assuming home prices would keep going up,” Eisman says.

In other words... The frigging ratings agencies were using financial models that assumed that house prices would never drop in value.

Whiskey. Tango. Foxtrot.

Wall Street has been flying blind for the past 2 years. Its a mistake to blame automatons for this... the blame rests squarely on the deeply stupid people designing these models... and the equally stupid people who refused to regulate the markets.