Preventing Financial Meltdowns: Mathematical Models

I would like to review why vaunted mathematical models have done so poorly in preventing recent financial meltdowns.

I refer, as examples, to the LTCM debacle of 1998 and the subprime mortgage disaster of 2008.

Could they have been prevented or mitigated? Who and what were to blame?

These math models were made up by top researchers, mathematicians, and celebrated “quants,” who figured they had anticipated all cyclic contingencies.

Yet, bond markets eventually fell apart despite their calculations. Afterward, they found they should have looked at contingencies even further back than they had.

But I see a bottom line weakness in math models, no matter how much research is done. It happened with the LTCM breakdown. It very definitely is what I feel was a factor in the subprime crisis, which haunts America and the world to this day.

There is a common thread between the two breakdowns which has to do with the fact that we react to problems in a panic mode. That is because our “experts” who come to the rescue are unfortunately from the financial community, attuned only to the short term and cannot see how caution and avoiding panic can overcome the danger of acting in haste.

There was a human error in these instances, other than in mathematical calculations. Often that error is enforced by government in the form of strict regulation that is actually a reaction to the very panic that such regulation supposedly has been developed to suppress.

The formulae probably would have worked over the longer term, had that panic not arisen. These are never successful for short-term markets that regulation overlooks.

I will have more in the future.