Credit Crunch Characters (5) - Mathematicians

For most of history, mathematicians have been boring and poor. Then a couple of mathematicians named Black and Scholes were awarded the Nobel prize in economics for coming up with a clever model to assess the value of a security.

No one knew the value of many of the synthetic securities created by the investment bankers. Some clever mathematicians saw an opportunity to escape the ignominy of academia, so they started applying their complex mathematical Black Scholes models to mortgage backed securities. Bankers and financiers did not have a clue what these entities were worth but the mathematical geniuses came up with a number that looked credible.

The wonderful thing is that these models took the risk of default into account. Everyone assumed that risk was under control. This was good for the bankers as they could squeese a little more profit out of the 3% to 5% margin - until the finance markets clogged up. Suddenly the mathematical models no longer produced sensible results and no one had any idea about the value of many securities.

Gretchen Morgensen wrote in the New York Times:

As of last Nov. 30, Bear Stearns had on its books approximately $46 billion of mortgages, mortgage-backed and asset-backed securities. But who knows what those mortgages are really worth? According to Bear Stearns’ annual report, $29 billion of them were valued using computer models ‘derived from’ or ‘supported by’ some kind of observable market data. The value of the remaining $17 billion is an estimate based on ‘internally developed models or methodologies utilizing significant inputs that are generally less readily observable.’

Mathematicians are less dangerous when they are boring.