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When the fed is spending $7.4 trillion to clean up the wreckage, you know someone’s gotta take the blame. So who should shoulder it? Scientific American thinks at least some of the fault belongs with the physics and math whizzes who built the risk models that dug our grave.

In a byline-free editorial, the magazine traces our woes back to a 2004 meeting in which the SEC agreed to lift a rule specifying debt limits and capital reserves “needed for a rainy day.” This move provided the requisite billions that banks pumped into mortgage-backed securities and derivatives. And who created the structures for these impossibly complex schemes that caused the mass bank implosion? Wall Street’s band of “lapsed physicists and mathematical virtuosos,” also known as “quants,” who “both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio.”

Given that hindsight is 20-20, we now realize that all these models are really only accurate for a limited period of time, at a very narrow confidence level—meaning that whenever those conditions aren’t fantasy-scenario optimal, the actual risk can be enough to incite a global meltdown. Good to know!

So should we be tarring and feathering the brains who built the beam we used to hang ourselves? It’s hardly that simple, a fact that Sci Am acknowledges while still laying on the heavy guilt:

The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame. After the crash, the quants and traders they serve need to accept the necessity for a total makeover…

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers.

In other words, maybe we should start calculating risk using models that take into account actual human behavior, as opposed to some nebulous dreamland where markets don’t freeze solid and eras don’t go down in a haze of napalm.

Related:
RB: When the Economy Tanks, We Suddenly “Develop” ESP
RB: As the Economy Plummets, So Do U.S. Driving Miles

November 24th, 2008 Tags: economy, financial crisis, the fall of capitalism
by Melissa Lafsky in Science Goes to Washington | 4 comments | RSS feed | Trackback >