Tom Cuddy writes:

The Greenspan quote has intrigued me since he made it, and I find the phenomenon an interesting one to ponder and to plumb for social causes and effects.  Greenspan's quote was that he always assumed that banks (read "the markets") would act to protect their own self- interests.  By this he meant that they wouldn't get themselves into such financial straights because there was a limit, or floor, to how much risk they were willing to assume.  This concept assumes that these businesses have a set of standards against which they evaluate investment decisions, and they may have felt that they did have such standards.  However, in the current financial turmoil it appears that there was a collective standard and not individual standards.  That is to say, there was a mindset of "everyone else is doing it so it must be OK."  When the mortgage-backed securities were found to be worthless no one was sure who to blame or how they got there. 

 

By extension, it seems correct to say there was a social pressure on businesses that compelled them to act in ways that were not, ultimately, in their own self-interest.  If someone out there in the group is writing about business practice, they may explore this idea of how a collective "group thinking" among banks pressured them to make decisions that were not good ones.  Was this a case of too much systems perspective and not enough consideration of self within the system? 

 

Kent Myers responds: 

 

Regarding the technical issue, Greenspan says that risk models used by the financial institutions were incorrect, and that they could have been corrected by basing them on longer history.  By saying this he is holding on to his prior assumptions.  Soros agrees that the risk models are flawed, but not because of the base data.  They are flawed because systemic risk was ignored, and that there is no way to estimate that systemic risk with any confidence.  Such models work only when the context is stable.  The context is unlikely to remain stable when exotic securities are in a bubble.  Soros adds that this bubble might not have been so destructive except that its collapse also threatens the collapse of a super-bubble of credit has built up over a much longer time.

 

To argue about the details of a risk model suggests that the model can be fixed.  Our point, which I think Soros makes, is that a complex practitioner won't be misled by decision rules that require false assumptions be made about the environment. Instead: watch for environment shifts, be ready to drop the rules, build in resiliency, and reduce systemic risk.  

 

 

========Reference material

 

Quotations from the Oct 23 hearing: 

Waxman: "Do you feel that your ideology pushed you to make decisions that you wish you had not made?"

Greenspan: "Yes, I've found a flaw. I don't know how significant or permanent it is. But I've been very distressed by that fact."

 

From Greenspan's written testimony:

"…those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets' state of balance. If it fails, as occurred this year, market stability is undermined…..

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year…."

 

The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer. But subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world…. To the most sophisticated investors in the world, they were wrongly viewed as a "steal."

 

------prior message--- In SystemsThinkers "Kent Myers" wrote:

Input to the Business Applications chapter.  Story line: a seemingly sober but ultimately risky practice runs aground.  A complex practice, viewed as unorthodox ( "unprincipled" to some,  "technically deficient" to others) is ultimately more successful in the turbulent environment:  Alan Greenspan says that for forty years he operated on the principle that the market always adjusts, and that it is best to let it settle by itself.  He says that he was shaken to realize that this principle was wrong, and that he is unable to explain current events. George Soros, on the other hand, has read the environment accurately as turbulent.  He has drawn implications that qualify him as a master of complex practice. 

 

===CORRECTION ======

The response web site for this job announcement was cut off:

 

Service Innovation Research Scientist

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