A good talk by Andrew Lo, Director of the MIT Laboratory of Financial Engineering, on the merit of blaming quantitative methods for the subprime crisis.
Lo main assertion is that,
"blaming quantitative methods for the financial crisis is like blaming accounting and the real number system for accounting fraud"
Instead, he suggests blaming the people that used the methods inappropriately rather than the methods themselves. From what I've read of the subprime crisis, I agree.
Lo partially demystifies the subprime crisis by using a simple example to explain collateralized debt obligations. He demonstrates how pooling loans and securitizing them into new bonds in multiple traunches can produce both higher and lower quality investments. He explains that it was securitization that allowed subprime loans to find their way into low risk funds like pensions and money markets. He also demonstrates how the method fails when the underlying loans are highly correlated.
Lo then discusses the crisis preconditions that Charles Perrow puts forth in his book "Normal Accidents",
- Complexity
- Tight Coupling
To this Lo adds an additional precondition,
- The lack of (frequent) negative feedback
Lo asserts that under these conditions, human behavior naturally leads to crises like the one in 2008. His points greatly reminded of those made by Richard Bookstaber in his book "A Demon of Our Own Design". I found Lo's argument compelling. Without frequent negative feedback, conditions build to a point where proactively unwinding them becomes impossible - the cost is too great to actively decide to incur. The cost inevitably comes but without conscious action.
In closing, a great talk worth watching.
