23 Oct 2008 – Quote from Greenspan Calls Financial Crisis A Credit Tsunami:
“It was the failure to properly price such risky assets that precipitated the crisis”
When systemic effects are amplifying correlations and limit violations arise day after day over weeks and weeks, losses tend to spread across financial institutions, and practitioners lost faith in the valuation models as well.
But how can we know what to buy or sell without explicit information about the co-dependence of risk. I have spent many years building mathematical, statistical, and financial models, and it is now clear to me that two problems are at the heart of the crisis: (1) valuation models were so limited in scope that they couldn’t link market prices to the value of securities with mortgages as underlying collateral; (2) an institutionalized lack of disclosure that prevented practitioners from achieving the necessary standard of accuracy.
One important common feature of the financial algorithms I have shared is the neglect or any implicit consideration of contagion effects.
Click here for the Financial Algorithms
As you verify the pricing algorithms you will notice that the complexity could be severe and even the most careful person could put a wide bid-offered spread on any of these types of transaction’s model. Measuring value accurately is at the very heart of successful investing and risk management. The ultimate result would be an end to Gaussian models that don’t explicitly capture such risk spillovers. We could expect new valuation models based on loss aversion and extreme value.
A Must Read: Recipe for Disaster: The Formula That Killed Wall Street
As Samuel Johnson once wrote: “hope is itself a species of happiness, and, perhaps, the chief happiness which this world affords: but, like all other pleasures immoderately enjoyed, the excesses of hope must be expiated by pain; and expectations improperly indulged must end in disappointment.”