This financial crisis has many people saying it was this that or the other thing. I want to present this FAQ as a reference point of what happened. If anybody wishes to add something please send me an email or comment and we can discuss it.
Who is at fault
There are two main culprits, the regulators and politicians, and the quants. Some like to argue that Alan Greenspan is the main culprit because of his low interest rate policy. I personally believe Alan Greenspan is an actor, but not a main actor. I like to think that the Fed is a catalyst.
Why are the regulators and politicians at fault?
The regulators and politicians dropped the ball and let people like Casey Serin get loans. Casey wanted to consider himself a real estate mogule and flipped one house successfully. Then he went full hog and decided to buy 7 more houses that all went into foreclosure. Casey did misrepresent his situation on paper and the banks went right along with it.
You could say, well the bank should not have given him the loan. Yes, yes all true, but like Alan Greenspan a catalyst, not the main problem.
Put this into a bigger context imagine a client that buys a large amount of widgets from you. Would you let them without any down payment, without any real proof of who they are?
Those types of loans are not allowed in countries like Canada, Germany, France, and Switzerland. They had no place in America, and the regulators / politicians should have known better. Note had these other countries allowed these practices the same thing would have resulted.
Why did the regulators and politicians drop the ball? Who knows.
Why are the quants at fault?
On this topic I am not going to get any love from my peers. The problem with the quants is that they misrepresented the risk. Let me illustrate.
Imagine setting up a credit risk profile. And in that profile you have different risk groups. You would have the people with the best credit, and then you have people with ok credit, and then unknown risk credit.
Take these risk profiles and apply some statistical analysis where 99.9999% of the people in the best credit pay their loans, and 96% of the people in the unknown risk pay their loans. A bank could then say if they have unknown risk loans on their books 4% will go belly up. Thus people in this risk profile have to pay for those that do belly up. In real life you know about this by your credit score. You know that the lower the credit score you have the more you have to pay.
The problem is that Statisticians have repeatedly said that statistics is for telling you what happened in the past and not what will happen in the future.
The quants created elaborate structures and instruments based on the 4% default rate with some play for error. When the defaults go beyond this boundary the structures collapse and due to the leverage causes a domino effect.
What happened is that as the prices of real estate went up more people wanted in and more people misrepresented their backgrounds. Thus people gamed the statistics and threw the models into a tailspin. After all it is not statistically possible to all of the sudden have everybody seem to be a millionaire.
Will the consumer suffer and end the consumer?
I actually think the consumer will pull this market out of the doldrums. Up to now it has been the hedge funds, investment banks and so on playing games with the markets. Now with the investment banks and hedge funds being squeezed we will get back to fundamentals.
Did we not go through this with LTCM?
For those wondering about LTCM please go to wikipedia and read it. And the answer is that yes we went through it with LTCM. The problem is that the quants still managed to convince enough people that their system worked.
Statistics do work, until they don’t work. To understand that you need to look at Taleb’s work "Fooled by Randomness" or "The Black Swan". I myself use statistics and probabilities when doing calculations. And I do the exact same thing as the quants. Though I like to keep my greed and risk profile in check.
Of course you could argue that, "Christian that is what the other quants said." You are right, and time will tell, but as I said statistics work so long as you are aware that things can go awfully wrong.
Is this the end of the financial system?
No, not at all. Anybody who yells and cries that the financial system will collapse does not understand the financial system. Those who participated in the risk will have problems.
I would actually argue that we will get back to normal. I think finally commodity prices will fall because those investment banks and traders that drove up the prices will have no money. Now the price of commodities will reflect the true demand. We will not get 40 USD oil, but I could easily see 80 USD oil. And that would be good.