Newspaper article Pittsburgh Post-Gazette (Pittsburgh, PA)

A Broken System What Did We Learn from the Great Recession?

Newspaper article Pittsburgh Post-Gazette (Pittsburgh, PA)

A Broken System What Did We Learn from the Great Recession?

Article excerpt

Ten years after a crisis that brought the world to the brink of Armageddon, the people overseeing the world's largest economy insist they've reduced the risk of another financial disaster. Just one problem: We need a different financial system, not just better risk management.

I had a front-row seat for the watershed event of the 2008 crisis, the failure of the investment bank Lehman Brothers Holdings Inc. I was a quantitative analyst for the hedge fund D.E. Shaw, of which Lehman owned 20 percent. I worked on modeling futures markets with Larry Summers, who at the time was a managing director. The crisis caught us unawares, as it did the most of the economic community. Our mathematical models had told us that such a disaster was vanishingly unlikely.

So what has changed? Not enough. To a troubling extent, the same models dominate. Banks use them to estimate how much they might lose on any given day. Regulators employ them to verify that banks aren't engaging in illegal speculation, and to ensure that they have enough capital to weather the next crisis.

There are two kinds of algorithms in finance: those that are meant to work, and those that aren't. The former are typically for trading. Their creators want them to work because they generate profits, at least in good times. The latter -risk models -are supposed to predict the bad times. Nobody really wants to think about that, so they are designed to be functionally weak: wrong enough to take advantage of the rules, but not so wrong that it's obvious. It's called juicing your Sharpe ratio, emphasizing your returns and obscuring your risks.

Better risk models are no solution. As I realized after a few years working on credit-derivative models, it's a matter of politics, not math. Experience has taught bankers not to worry about the downside. The government bailed them out with no personal repercussions and without fundamentally changing the system. …

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