2009-02-25

Recipe for Disaster: The Formula That Killed Wall Street

Posted in models tagged stimulus, thought virus at 10:03 by Richard

The question I take away from this article in Wired (17.3, March 2007) is how we can hope to avoid events like the current melt-down of the financial system in the future. What can we learn from this? Felix Salmon quotes Janet Tavakoli, a derivatives guru, who wrote in 2006 that correlation trading based on David X. Li’s ingenious formula “has spread through the psyche of the financial markets like a highly infectious thought virus.” Well, if the Federal Reserve and the SEC are supposed to act like the Centers for Disease Control for the financial system, how can they eradicate this virus? How can they develop a vaccine against future virus outbreaks like this one? How can we protect the economy against the threat of new thought viruses that we cannot predict today?

One approach might be to create an innovation zone separate from the actual economy of commercial trading, where traders can test new instruments under the scrutiny of regulators. There should be clearly defined rules for moving these new instruments from R&D to commercial use, including standards for evaluating their claims, authorization for specific uses, and mechanisms for monitoring their effects over time, especially towards the beginning of their adoption. This would allow for innovation while circumscribing some of the risks involved for the broader system.

Rather than play the role of regulator, Ben Bernanke testified yesterday before Congress that the approach of the Federal Reserve would be to shore up the reserves of the investment groups hardest hit by their exposure to these junk derivatives. When pressed on the question of how this would introduce new rules of the game, to change the way these investors did their business, Bernanke evaded a clear answer, saying that the stimulus measures would be accompanied by [unspecified] measures to ensure that the banks and holding companies would over time get back to more sustainable business plans. This is not very reassuring.

Posted from Diigo. The rest of my favorite links are here.

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