Tuesday, January 6, 2009

A Look Inside AIG's "Beautiful Machine"

The Post did a three-part article about the rise and fall of AIG's Financial Products group. These are the guys who brought down AIG and with it a lot of our interconnected financial system.

Part 1: The Beautiful Machine
Part 2: A Crack in the System
Part 3: Downgrades and Downfall

This series reminds me of all the stories, movies, and books about Enron after its fall. Like the guys at Enron, these people were seen as being the best and the brightest. Those who wanted to regulate them were backwards-thinking anti free market types. You can argue that the folks who started all these derivatives and intricate credit-default swaps could have handled them, but it got into the wrong hands. My point is that we need regulation because anything that complicated is bound to end up being managed by people who have an incomplete understanding of its workings and implications.

The "quants" who come up with mathematical models for risk think that if they can come up with a number for the risk, then they can control the risk. This sort of hubris will never completely go away. A brilliant mind with a ton of precise numbers can be very compelling.

There are several problems with building a business on mathematical models of risk. Here are a couple that come to mind:
  • Models are built on historical data, but today's global and electronic economy is more interconnected and fast than any economy in the past. It's like making predictions about car accidents based on the number of horse-and-buggy accidents.
  • Outcomes of complicated systems can't be controlled well. Just ask the guys who made Jurassic Park. Any time someone comes up with a really complex system, we should all be wary of the eventual ramifications.
It's also interesting to me that the two guys who got it all started worked at Drexel Burnham Lambert while my sister was there. She had to have known them. She knew the bubble was bound to burst, but I wonder if she knew that these former co-workers were part of the reason it went so bad.

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