" Except that last part wasn't true."

Barbara Kiviat of Curious Capitalist fame, around these parts, did a wonderful post, I like calling everything a post nowadays, on the recent evaluation of financial risk:

"Over the past two decades, wall street and the rest of the financial ecosystem became obsessed with the quantification of risk. Assigning numbers to the chance of something bad happening is a centuries-old endeavor--mortality tables have been used to devise insurance premiums since the 18th century. With modern computing power, though, financial engineers captured, packaged and sold risk exposure in startlingly new ways. Buying protection against a bad corn harvest or a spike in interest rates was just the beginning. Over time, as instruments became more complex, a huge shift occurred. Risk itself became the thing to trade--and to make money on. In the process, risk was redistributed to the people who could best handle it, making everyone safer.

Except that last part wasn't true."

Now, Barbara accepts that the models fooled people. I don't. You can only be fooled by models if you're prepared to be fooled. This is similar to the idea that an invention can only work in the right circumstances, or, better yet, a scientific theory can only be accepted with the right outlook by scientists. It's a matter of explaining human agency.

"There are many lenses through which to view the worldwide financial crisis as it has rippled from soured loans to banks' balance sheets to the credit markets and, finally, into the real economy. Lenders were greedy, people lived beyond their means, government abdicated its responsibility to regulate. Through all those explanations runs the thread of risk--and how it was mismanaged. Financiers, as well as the investors who bought their wares and the ratings agencies that evaluated them, agreed that by applying the proper equations it was possible to, say, bundle a bunch of subprime mortgages, chop them up and sell the pieces as fairly safe securities, even as they were leveraged to the hilt. Why? The mathematical models--backward-looking and based on just a few years' data from an asset bubble--said so. "As an industry, we let financial tools be a substitute for human judgment," says Kevin Blakely, CEO of the trade group Risk Management Association. "There's been such an earthquake in the industry, people are saying we have to do it differently."

Actually, I think this says more or less what I'm saying. Let's try putting it another way. Why were people so loathe to accept that there was no ether, relativity, the uncertainly principle, and Godel's proof,were true, but they're jumping overboard in accepting math models predicting markets? I think that you see where I'm going.

"And so risk morphs from a slop trough of moneymaking into a business line like any other, one that requires human beings to ask the big-picture questions that computer models don't, like, What would happen if fundamental assumptions--house prices go up, institutions are too big to fail--prove to be wrong?"

I guess the good news is that we've at least answered that question.

"What was important was that the firm also made a deliberate decision that risk was not something that could be reduced to a number. "We have a much more holistic discussion about a business and why we have it," says vice president and treasurer Helen Shan. "It becomes strategic, instead of simply, Do we get insurance to cover a potential loss?" In a speech at an industry conference in October, Federal Reserve governor Randall Kroszner urged financial firms to take a similar tack. Weighing risks, as well as potential returns, he said, "should be part of the calculus for all decision-making," and "assessing potential returns without fully assessing the corresponding risks to the organization is incomplete, and potentially hazardous, strategic analysis."

I don't like holistic. How about more complete? It's amazing how useful the calculus is. A little note: The planets don't exactly follow the movements of the math. It's simply close enough to be useful to us.

"Taking on risk from instruments like credit-default swaps and collateralized debt obligations (CDOs) was treated as a profit center, often with little oversight of the mathematical models that spit out numbers about what it was all worth. The models proved spectacularly wrong because they precluded the possibility of an outsize event. Once big shocks, like declining home prices, started hitting, the models broke down. According to a report by a group of U.S. and international regulators, while some firms tried to understand what would happen to their models in truly adverse conditions, plenty of others didn't. In some cases, finance outfits barely examined their products, instead relying on the evaluations of outside ratings agencies, even as they accumulated more and more of those assets."

Okay. Let's be AIG. We're in the insurance industry. We now offer credit default swaps. What makes us think we're competent to do that. So, let's write a CDS: You're the lender of $600,000 to borrower to buy a house. If the borrower defaults, and you foreclose upon the house, and the house re-sells for $500,000, I , AIG, will pay you $100,000, for which protection you've been paying premiums. My, it looks like insurance. Which it basically is, except that, for technical reasons, it allows you, with your AAA rating, to put up less capital than on regular insurance, and, indeed, it's that lower capital threshold that led you to CDS's in the first place. Riskier? You bet. See, there's less capital. That's why they have those levels mandated on regular insurance. So, did I say that it was riskier.

Now, when you have insurance on your house, it can include disaster relief. If it does, the insurer usually hopes to have enough money to take care of this, and they charge premiums based on that. It is usually the case that a disaster happens in one particular area of the country, so an insurer can usually handle that. But what would happen if a hurricane hit the whole U.S.? That's basically what happened in the housing crisis.

One caveat that should scare us: Often, in a disaster area, the government spends a lot of money over and above personal insurance. In some areas, we make people whole who live in areas that can't really even be insured properly without enormous premiums.

So, the question is simple: Why didn't AIG prepare for this? It's the models. Fine. Did the models check for this U.S. hurricane? Well, sadly no. We forgot that. What's the model for that? You might want to model, or, at least study, human agency and behavior. Just a thought.

"When managers did articulate problems, they were often ignored. In August 2007, one of Merrill Lynch's top risk managers warned his boss that a decision to wager $3 billion on indexes of mortgage-related securities was too risky. The firm made the bet anyway; three months later, the risk manager left. "The psychology during a boom makes it very difficult to come up with large stress scenarios and get management to consider them to be credible," says Ed Hida, a partner in Deloitte & Touche's risk- and capital-management practice."

I agree with this. It's not a problem of math models though.

"When firms did steer clear of what was, in retrospect, excessive risk, the tone typically came from the top"

Barbara's just a more decent soul than I am. I don't buy it.

"Sage advice, that. But for how long will it be followed? "Risk gets forgotten in all bubbles," says Peter Bernstein, an investment adviser and the author of Against the Gods: The Remarkable Story of Risk. "We've been down this particular road before." Indeed, we have. After every other trauma--the 1987 stock-market crash, the savings-and-loan crisis, the meltdown of the Long-Term Capital Management hedge fund--boisterous, unchecked risk-taking eventually rushed back in. "In times like this, people do listen to risk managers," says John Hull, professor of derivatives and risk management at the University of Toronto. "The problem is, times will become good again, and then you listen to the trader who is making a big profit."

Once again, I agree. Nothing to do with math models.

"It is tempting to say that this time is different, that the pain has been so severe and ongoing, the lessons will be remembered."

I think they said that after WW I.

"But there is also reason to be skeptical. Take, for instance, the idea of risk-adjusted employee pay as a way to keep people, including rank-and-file traders, from following personal incentives to the exclusion of a company's broader interest. It is a compelling idea. But so far it hasn't happened."

Actually, there are fiduciary responsibilty laws on the books. We might try enforcing those.

"And maybe right now we shouldn't be trying quite so hard. With lending locked up the world round, we desperately need some risk-taking. We just don't have to risk everything."

That's one of the most intelligent statements I've read lately.