Mathematical Financial Models

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

I refer, as just two examples, to the LTCM (1998) and the subprime mortgage (2008) disasters.

The math models behind them failed.

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, the ones responsible 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 with panic. That is because our “experts” who come to the rescue are unfortunately from the financial community, attuned only to the short term. They cannot see how caution and avoiding over-zealous, impulsive action can overcome the danger. So they act 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 was actually a reaction to the very panic that such regulation supposedly had been developed to suppress.

The formulae probably would have worked over the longer term. These are never successful for short-term markets that regulation certainly overlooks. (See the Earl J. Weinreb NewsHole® commentaries.)