People cause crises (incentive structure edition) April 30, 2012 at 2:19 pm

Lisa Pollack has an interesting, if rather too fair minded post on Alphaville about the dubious claim that the Black-Scholes formula somehow caused the crisis.

Let’s be clear. Black-Scholes is about options pricing, and hedging in particular. It has nothing to do with securitization, and little with tranching. So the claim that Black-Scholes caused the crisis is BS.

There is a boarder claim that somehow mathematical finance in general – and risk models in particular – were to blame. Certainly many VAR models under-estimated risk before the crisis, while some models of tranches were response for assigning great ratings to assets that didn’t perform well. But no model went out on a wet Wednesday about bought fifty billion of sub-prime ABS. A trader did that. Blame them, and the incentive structure in their firm that encouraged them.

3 Responses to “People cause crises (incentive structure edition)”

  1. Wonder where these people get these ideas from. I read an article that said Intex – a tool kit that allows you to structure securitisation cashflows was to blame for the crisis. Its been 5 years and we are still seeing some disturbingly amateur attempts at finding a scape goat.

  2. If you dig around in Eric Falkenstein makes a pretty good case (against the likes of Taleb) that VAR and Black-Scholes etc. are perfectly good tools if used properly.

    But even so, the dots were there just waiting to be connected without the aid of formulas and models. Who doesn’t remember seeing evidence of the following on a daily basis: dingbat mortgage originators making huge $, crap real estate skyrocketing in price, clueless pension funds buying securities they didn’t understand or even bother to read the prospectus of, FNM/FRE offering easy money in Superbowl ads, your cat getting a credit card in the mail, your next door neighbor suddenly behaving “rich” for no apparent reason, and pretty much everyone in a position to tap the breaks at the institutional/government/financial/fiduciary level being incentivized instead to just keep the ball rolling.

    Really, I’m embarrassed I didn’t take better advantage of this disaster beyond just getting out of the way.

  3. In “trader” you should probably include sales people, structurers and risk managers. But intermediaries can’t survive without end users – what of the people buying houses they couldn’t afford and investors hungry for yield?