Friday, July 4, 2008

The Nerds Who Cried "Wolf"!!!

(Gillian Tett in the FT) A few years ago, Ron den Braber, an outspoken Dutch maths geek, was working in the risk department at the Royal Bank of Scotland when he became alarmed about the models being used to price collateralised debt obligations.

Most notably, he concluded that the so-called Gaussian Copula approach then in use at RBS (and many other banks) significantly underplayed risks attached to the most senior pieces of debt – creating a danger of future, large losses.

So he duly tried to raise the alarm. But, as he tells the tale, he faced hostility. “I started saying things gently – in banks you don’t use the word ”error” but the problem is that in banks …people just don’t want to listen to bad news,” den Braber recalls.

Now, every corporate tale has many sides – and RBS, for its part, vehemently denies it ever ignores challenges or stifled debate. It says it could not find any record of strong warnings about the Gaussian Copula model, is aware of its shortcomings, and while it has recently suffered CDO losses, these relate to products acquired after den Braber’s time.

However, the story is worth noting, since echoes of this saga now seem to be emanating from numerous banks. In particular, many other bankers have also recently told me that they knew that structured finance models were mis-pricing risk at an early date – and yet in many cases the attempts to raise the alarm were crushed.

Or as one senior risk manager writes (anonymously since he remains employed): “[My] institution has now taken multi billion write downs - job losses result and significant share price erosion - and I wonder how this can have happened? Upfront we did express to senior management that we lacked the analytical skills…and highlighted deep concerns about the approach colleagues in the market risk area had taken … I feel responsible for not doing more, but I really did push my views, risking my immediate career.”

So can anything be done to redress this? (or prevent it playing out again now in the commodities world, say?).

Perhaps not.

Few bankers want to hear dissent about the models when they are enjoying a profit bonanza. Greed is what drives much of the modern financial world – combined with fear of getting sacked.

But, if nothing else, this saga shows the great blind spot that still haunts many banks. This decade, financiers have invented so many brilliantly clever mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that “credit” is a collection of abstract equations, stripped from any human context.

Thus banks have become so dazzled with their powers that they have ignored how they interact with the rest of society – or how the tribal aspects of their own institutions can create dangerous traps.

Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense. Yet, as any Latin scholar knows, the word “credit” hails from the phrase “he/she/it trusts”; it is, in other words, also a social construct.

And bankers forget this human dimension to their cost – no matter how impressive the abstract numbers might seem. Or as the same risk officer says: “The billions involved were so hard to contemplate that we almost certainly lost sight of the possible consequences [of our credit business] until it was too late.”

So, as the banks nurse their credit losses, they certainly do need to review why some of their clever math models failed. That geeky Gaussian Copula stuff, in other words, matters hugely.

But most important of all, they need to work out why the human processes around the models failed too – and not just in the eyes of den Braber, but also in the experience of numerous other junior employees, who are now hugging their war stories, but far too nervous to speak out.

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