How to Lie to Computers

How Wall Street Lied to Its Computers
New York Times (09/18/08) Hansell, Saul

Most Wall Street computer models radically underestimated the risk of complex mortgage securities, partially because the level of financial distress is “the equivalent of the 100-year flood,” says Capital Market Risk Advisors president Leslie Rahl.

Rahl, and others, say that the people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to provide those systems with oversimplified data, preventing the systems from detecting the problem before it was too late. Top bankers cannot simply ignore computer models, because after the last round of significant financial losses, regulators required financial institutions to monitor their risk positions. If a model says a firm’s risk has increased, the firm must either reduce its risk or provide more capital as a cushion should things turn south.

“There was a willful designing of the system to measure the risks in a certain way that would not necessarily pick up all the right risks,” says RiskMetrics’ Gregg Berman. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”

Berman says one way this was accomplished was to make sure the computer models looked at several years of trading history instead of just the last few months, which made the computers slow to report that risk had increased as defaults started to rise because the markets had been placid for several years.

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