Nobody Could Have Predicted

An interesting observation from John Quiggin:

One ‘black swan’ explanation of the mortgage crisis was that the mortgage derivatives created by Wall Street couldn’t fail except in the event of a simultaneous downturn in all major housing markets in the US, something that had never been observed, and therefore could not be included in the models. But of course the reason such a thing had never occurred was that local housing markets had been separate from each other, with their own sets of banks, S&Ls and other financial institutions. The very banks that were doing the modelling were creating the conditions under which a national bubble and bust could take place. This was both foreseeable and foreseen.

I would also say that if it’s really the case that financial risk models can’t account at all for the possibility that something that’s never happened before will happen, then these models seem really really worthless. It’s not like we have 100,000 years worth of data on what advanced economies look like. You have to expect the unexpected. I suspect that risk modelers understand that perfectly well, and this is just an exercise in post-hoc excuse-making. The fact of the matter looks to be something more like — a firm that followed a sounder risk-model would have gotten much lower short-run returns in a way that would have been bad for bonuses, bad for stock prices, and bad for attracting investors.