Letters to the Editor: Predicting the Financial Crisis—View from the Real World

By Steve Hellinger

I liked the review of Nate Silver’s book by James Case (“Foxes, Hedgehogs, and the Art of Prediction,” SIAM News, April 2013), although I feel that Silver’s comments on the financial crisis, as related by Case, were too academic. I’d like to provide some real-world perspective.

First, the paragraph of concern in the book review:

“Many of humankind’s misfortunes, Silver writes, result from failure to predict clearly foreseeable events. The recent financial crisis is a case in point. He identifies four separate failures: that of homeowners and investors to foresee that housing prices could not continue to rise indefinitely, that of the ratings agencies to foresee that a fall in housing prices would cause a crisis in U.S. financial markets, that of economists to foresee that a financial crisis in the U.S. was tantamount to a global financial crisis, and that of leadership to foresee that a financial crisis would produce an unusually long and deep recession. None of the four qualifies as a “black swan”—all were readily apparent to anyone who cared to look “under the hood” of the models then in use.”

Second, my perspective:

1. Whether the average homeowner thought that housing prices would rise indefinitely is surely debatable. But it is not debatable that many people who could not afford to buy a home were able to do so because the mortgage brokers did not perform the proper due diligence. The mortgage brokers knew that they were going to sell off the mortgage to a financial institution and collect a commission. The risk would be passed along to someone else.
2. Some of the financial institutions passed these questionable mortgages and their derivatives to investors and collected the commissions. The risk was passed on to the investors.
3. There were people at the ratings agencies who knew of the flaws in the models. But when they voiced their concerns to “senior management,” they were told: “Shut up, we’re making lots of money.”
4. The U.S. Congress dismantled much of the previous regulatory structure (think Glass–Steagall Act).
5. The regulators failed to prevent the fraud in the system. However, to some extent their power to do so was inadequate.
6. Whether economists and leadership could have foreseen a global financial crisis is debatable, but vision is always more clear in hindsight.

Steve Hellinger spent nine years at JP Morgan Chase, most recently in Risk Technology.