A Friend Stopped By | 02/25/2009 11:15 am

Obama's Financial Adviser Is Wrong: Malfeasance – Not Models – Killed Wall Street

By Janet Tavakoli

Courtesy of Janet Tavakoli

Editor’s Note: Janet Tavakoli is the president of Chicago-based Tavakoli Structured Finance and the author of Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street.

Paul Volker, former U.S. Federal Reserve Board chairman and member of President Obama’s economic advisory team, gave a speech in Toronto on February 11 at the Grano Salon Speakers Series on the U.S. economic crisis. He made the mistake of blaming mathematical models instead of malfeasance as the key source of the financial meltdown:

They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events happen once every hundred years. But we have ‘once every hundred years’ events happening every year or two, which tells me something is the matter with the analysis.

Volker was only partly right; there is something wrong with his analysis. The models would have failed to capture unexpected "hundred year events," the outliers Mr. Volker referred to in his speech, but that was not the cause of the U.S. financial meltdown. There were no outliers; there were outright liars. The models crunched misleading data fed to them by Wall Street’s financiers. The events that keep happening every year or two are the effects of massive unchecked malfeasance.

Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, and more.

The global meltdown was not caused by an unfortunate mistake; it was caused by malicious mischief. Every problem related to the current financial meltdown was discoverable in the course of competent work. Our financial malaise was caused by bad behavior deliberately hidden behind the opaque veil of models and hard-to-pronounce financial products like collateralized debt obligations and credit derivatives. There is no innocent explanation, and the problem was massive.

Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, misleading loan documents, failed business models, overleveraged hedge-fund clients, shoddy ratings on Wall Street deals and more. Any finance professional worth their salt knew the data being fed the models in no way represented the risk.

Our problem is different than bad models. This is a classic case of garbage in/garbage out, and Wall Street pros selling the garbage out knew what they were doing. As hundreds of mortgage lenders failed, Wall Street sped up — instead of halting — its sales of overrated deals. It rushed garbage out the door and into investment funds all over the globe. That would be bad enough, but investment banks lent money against this garbage, and just as Archimedes told us it would, leverage (borrowed money) moved the world. But not in a good way.

WIRED compounded Volker’s error in its most recent article: Recipe for Disaster: The Formula That Killed Wall Street. It blames a model called the Gaussian copula saying it could not capture extreme "black swan" events or "gray swan" events that happen more frequently than the model predicted. It is true that Wall Street’s models are flawed, but even if the models had been changed, we would still have had our financial meltdown. All models are flawed, and the suggested replacement models would not have captured the problem either. I have been a decades-long critic of the limitations of Wall Street’s models, but to blame models for our current debacle dodges the real issue: malfeasance.

Perhaps Volker and WIRED offered an explanation that is strictly for the birds because they cannot interpret what they are seeing. At a loss for a reasonable explanation, they claim this was an unexpected "black swan." Richard Feynman, the Nobel Prize-winning physicist who worked on the Manhattan Project, would not have been a fan of Volker or WIRED because he believed in understanding his birds:

You can know the name of a bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird … So let’s look at the bird and see what it’s doing — that’s what counts. I learned very early the difference between knowing the name of something and knowing something.

20 Reader Comments (so far…) Sign In or Register to comment

I don’t know about this article Janet, I think you’re parsing Volker’s words. You’re providing a quote of something he made and using that as the focus of your opinion piece and that seems short sided to me. Especially when you take into consideration 95% of what you have written are opinions and beliefs held by those on the Obama economic advisory team. Do you really believe they don’t hold to the “garbage in/garbage out” theory as it relates to Wall Street pros selling the garbage and the fact they knew what they were doing? Do you really believe that the Obama administration has no desire to see those who are to blame for the financial debacle brought to justice for their actions? Really? Your complaint that “we were told we would make money. How is that working out so far? We have lost hundreds of billions of dollars in market value and the oversight panels have lost track of our money.” This is a valid complaint but you’re forgetting one important and key point, this was done under the Bush Administration. The Obama administration that has been at work for 5 weeks has only begun the work of attempting to fix the problems left by the past administration. Your article I believe touches on the opinions most Americans including myself feel as it relates to the economic crises and Wall Street specifically. My point is that what you are saying are (from what I have read and heard) opinions shared by the Obama advisory team. And based on what the President had to say last night and from what Geitner has said as well. So your argument is lost on me. I think you’re placing too much weight on a comment and belief held by Volker. Especially if that belief does not in the final analysis impede on the progress his team will make toward turning things around for our country and seeing that those who caused this mess are brought to task for their deeds.

By BelindaJoy on 02/25/2009 11:46 am

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Well maybe so but I do know that English economists gave up on algorithmic models ages ago because they don’t essentially work—but yes—malfeasence and the inanities of Ayn Rand did play a huge part in this disaster thanks to Greenspan who is in fact basically responsible for it IMO.

By fp1 on 02/25/2009 11:51 am

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One other thing Ms Tavakoki, The SEC is alsoresponsible for a great part of this. Frankly I’d like to see it disbanded and a new agency, under the FBI, created. Checks and balances need to be instituted once again in government after 8 years of Bush’s malfeasance.

By fp1 on 02/25/2009 12:49 pm

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greed is not good evidently

By BuhBye on 02/25/2009 12:10 pm

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Excuse me, Ms. Tavakoki, but your article indicates that it would certainly be bad models that led to bad behaviour. So, in a sense, you are contradicting yourself. I think you are posing a chicken/egg question…and greed needs to be legislated because it is always lurking deep within the hearts of all of us.

By DianaT on 02/25/2009 12:20 pm

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Are any of you aware of the Northern Trust Bank of Chicago?

The entertainment Web site TMZ broke the story Tuesday that Northern Trust of Chicago, which got $1.5 billion in bailout money and then laid off 450 workers, flew hundreds of clients and employees to Los Angeles last week and treated them to four days of posh hotel rooms, salmon and filet mignon dinners, music concerts, a PGA golf tournament at the Riviera Country Club with Mercedes shuttle rides and Tiffany swag bags.

The people and I mean that banks and their "managers" need to be held totally accountable and nationalized and sold off. This is totally unacceptable.

By fp1 on 02/25/2009 12:46 pm

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With respect, my friend Ms. Tavokoli, it does not take an impressive amount of prescience to look back on the current situation and discuss the causes. There are many contributors, from profit fixation to unregulated hedges to ARS models that borrowed short to fund long term investments - and much more. The complexity of the problem, I’m afraid, negates any simplistic answer such as "greed." That was a part, and the degree to which it was a part is arguable, but there was much that contributed to this circumstance, and the solution will necessity far more complex thinking than what you provide here, my friend.

By LilyRose1 on 02/25/2009 12:54 pm

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It’s the complexity of any response with which we need to concern ourselves. Over reaction begets over reaction…

I am an "Off with their heads!" kind of guy, though, so I advocate reasonable monetary policy updating (unreasonable would be to keep interest rates at 0% or to up taxes so far that people with money figure out how to keep it) and severely punishing those found guilty of illegal practice.

By JohnG on 02/25/2009 1:08 pm

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How dare she disagree with "The One"..on this. Even though she is an expert she cannot possible know what he does????

By SJMorgan on 02/25/2009 4:38 pm

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How dare she disagree with "The One"..on this. Even though she is an expert she cannot possible know what he does???? By S.J. Morgan on 02/25/2009 4:38 pm Can’t you just express your opinion that you either agree with author or disagree. President Obama inherited this mess. He is trying work through lets wait and see what he does. I am sure greed and incompetence played a role in this debaucle.

By starryNite on 02/25/2009 11:07 pm

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severely punishing those found guilty of illegal practice.

By John G on 02/25/2009 1:08 pm

I have advocated punishment all along of the ones guilty of the illegal practices. Why are they continuing to get away with rubbing their greed in our faces without some type of being brought to justice?

By Dabado on 02/25/2009 5:03 pm

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Finally someone tells it like it REALLY is…and of course it is a woman! Well done WOW!

I knew this was greed, corruption and dishonesty a year and a half ago but I misunderstood the degree.

The question that we really need to be asking ourselves is why are these people being given more money to play with instead of being put behind bars. Eventually we are going to be broke, the government is going to be tapped out, and the only rich people will flee the country to redeem their swiss accounts and move to gated communities in New Zealand.

But if we politicize this moment we will all lose. Like it or not this began w/ Clinton era deregulation and gathered up steam under Bush and "Darth Cheney". Everyone in the political and business class is responsible on some level or another, because those who knew and stayed silent aided and abetted. Take a look at Nancy Pelosi’s financial disclosure forms some time (yes I did, they are online), if you didn’t know her profession you would swear she was in the financial sector.

"We the people" are being taken to the cleaners, and like it or not that isn’t changing with the new administration. And I will not believe that this administration is different than the past until subpoenas are issued, white collar people accused of stealing from their clients are put in jail, and taking money from lobbyists is criminalized

By CYNTHIANEIL on 02/25/2009 6:16 pm

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wall street and all the analysts still don’t get it. Why would anybody trust these people ever again with their hard earned money to invest in what? It was all an elaborate pyramid scheme and you are right, no one has been marched away in handcuffs and charged with any crimes! Why is that? If I steal someones life savings with a gun, I will surely go to jail. But these people did it with pens and computers and they are still begging for more? All of us living on Main Street see the obvious double standard with the law. We want justice, and these people don’t even think they have done anything wrong.

By DianeHamby on 02/25/2009 7:48 pm

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Janet Tavakoli - Thank you for your excellent analysis and top notch article.

I remember Paul Volcker appearing twice on The Charlie Rose Show last year. It is the first appearance that I wish to discuss. The mortgage debacle was just starting to come apart and Charlie Rose asked Mr. Volcker a question along the lines of "how bad is it going to get?". Mr. Volcker said that he expected the crisis to be over by the end of 2008 and there was a good probability that new home construction could begin again by July of 2008. Charlies asked how did he arrive at that conclusion. Mr. Volcker replied that the mortgage crisis was limited only to the real estate market and he did not see any evidence that the crisis would move to the financial markets. Yeah… well, we know now how wrong he was. His economic models were flawed from the beginning.

Again, wonderful and informative article. Thank you so much.

By Bonnie Oliver on 02/25/2009 9:26 pm

I believe that sometimes oversimplification can be a good thing. It keeps us focused on what really matters. No one can argue that greed and lies of ommission and commission were at the core of the issue. As my very southern Big Mama said to me once, "Baby, you got plenty of book sense but you ain’t got a bit of common sense." It is time we used some common sense.

By MarvaMarva on 02/26/2009 3:17 am