Friday, February 27, 2009

Can We Blame the Credit Crisis on the Quants?

The quants are the financial analysts that base their view of the market on highly sophisticated statistical models. The problem with this approach is that it is only as good as the underlying assumptions. Felix Salmon in an interesting article in Wired Magazine, "Recipe for Disaster: The Formula That Killed Wall Street," argues that the models used to predict the risk of holding securitized assets were grossly inadequate in modeling the interrelationship between various loans that made up the credit pool. In addition, the financial managers that applied the models lacked the requisite mathematical sophistication and did not understand that their calculations were built on a house of cards.
They didn't know, or didn't ask. One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.

This article discusses risk analysis related to credit default swaps. If you want to understand the basics of credit default swaps, you can view this video.
AmericanPublicMedia October 08, 2008

When the analysts and experts talk about the current financial crisis, they often refer to credit default swaps. So, what exactly is a credit default swap? Marketplace Senior Editor Paddy Hirsch goes to the whiteboard for this explanation.

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