Hat tip to David Brooks for his article in the NYT today.

http://american.com/archive/2009/our-epistemological-depression

Our Epistemological Depression, by Jerry Z. Muller

Professor Muller makes some excellent points here about the collective thought process which allowed risk to build in an uncontrolled manner. To it I would add my personal recollection:

As a CDO manager in 2007, one of my pitches was that anyone who thought that their models were spitting out anything close to the truth was kidding themselves. Yet manager after manager would tell us their story and brag about the quants and PhD’s who they had on their payroll or how much they spent on the latest computer. I reminded them that although you might be able to put a mortgage backed security’s loan information into a statistical model which you thought could access various databases of historical performance, nothing could change the fact that what you were really talking about was hundreds or thousands of stories, families, and properties – each of which could behave in a completely different manner than anything you’ve seen before. As a result, I always said that the models were nice, and we had them too, but the model output had to make sense in the real world, and when it said that the majority of 100 LTV loans made to stated income borrowers for investment properties would pay off no problem, I said the model needed to be recalibrated – with a hammer probably.

Of course, we fell into the same trap. We thought that since we were “smarter” than a lot of the other CDO managers, we would survive and they would fail. We didn’t realize that everyone was operating on the greater fool theory – that somehow they would survive while the other idiot failed. We didn’t realize how pervasive the stupidity was. In fact, we couldn’t even issue our first CDO at all, because we couldn’t find any assets worth buying. But, at the same time in 2007, plenty of other CDO managers were issuing CDOs. Assets were being created simply to feed the machine, and the machine was feeding on itself: a clearly unsustainable situation.

We all tricked ourselves into thinking someone had a model which worked. Unfortunately, it turned out that the models themselves were the tricks.