The greatest failure of the last two years is not the collapse of the securitized mortgage markets or the housing collapse that spawned them, but the failure of faulty risk analysis that continues to permeate the financial industry.
The financial industry became enomored of quantification modeling as a strict denominator of risk, and it largely collapsed as a result. Wall Street embraced modeling techniques that attempted to quantify risk by placing numeric valuations on the amount of risk they were holding. Wall Street investment banks, and the “quants” that wrote the programs, truly became enamored of the “simplification” of risk analysis that these models offered.
Finally it seemed, there appeared an easily understood evaluation technique that anyone could understand. Just run the “program”, and a daily benchmark would assess the entities’ risk, which was then comparable and quantifiable. These models became the Holy Grail of risk analysis on Wall Street. One such model, the VaR, or Value at Risk model, expresses risk as a number, or dollar valuation to be precise. VaR, and the hundreds of models like it, became a crutch, a lazy method of quantifying risk and compartmentalizing this part of their operation.
It also became a convenient way of transferring blame should the risks materialize. No one could, after all, shoulder blame when their “quant models” incorrectly assessed their exposure. Reliance on these models was intellectually lazy, a function of ignorance and of management’s inability to perform critical analysis. It may have been unrealistic to believe that many of these Wall Street analysts, most bred as political science, history, or English majors, could realistically understand the dynamics of corporate risk and perform in-depth analysis of their firms’ balance sheets or profit and loss statements.
Models are subject to the same limitations that auditors face, reliance on “cookbook” audit programs or other sampling techniques that provide limited assurance of an entity’s exposure or risk of financial misstatement. The parallels between the audit professions’ failures of the past 20 years and the current failures are striking. Audit firms, especially the “Big 8”, “Big 6” and now the “Big 4”, have spent the last 30 years developing audit “tools” that attempted to quantify risk at a basic level: just plug the numbers and the other miscellaneous variables into the model and the resulting output would quantify the risk, without the need for any independent judgment or critical thinking.
The beauty of these audit models was that any junior auditor could “run” them and divine the financial statement impacts or risk. Auditors became cogs, uniquely interchangeable and completely replaceable. If, after all, anyone could run these models or perform the sampling analysis required without the need for additional analysis, the audit firm could claim that it had established the “knowledge base” required to properly analyze risk. Human analysis and due diligence were divorced from risk quantification. The models could purportedly assess risk independently of their human operators. We know how this story ended, and witnessed the resulting avalanche of audit failures which ultimately led to the collapse of Arthur Andersen, the storied audit house.
What did we learn from these repeated audit failures? Not much it seems, because Wall Street also attempted to compartmentalize risk and develop “programs” that neatly assessed exposure and risk. Why no one has drawn these parallels and linked the two failures is perplexing. Enterprise risk, whether operational or financial, cannot be isolated into unique and disparate fragments of information, analyzed independently from the whole or divorced from human judgment.
The increasing sophistication of today’s business landscape and the financial statement ramifications demands due diligence that defies easy quantification. The failure of Wall Street models was a failure to understand the impact of human behavior, their financial statement impacts, and a failure to acknowledge that if even a few “input” variables were materially incorrect, the entire model and its analysis would be rendered meaningless.
Humans have always been fascinated by “universal” theories that attempt to unite and explain behavior, and these models were merely mirroring this desire. Until we understand that no singular theory completely embraces all behavior, both audit failures and Wall Street failures will continue to occur. Unfortunately, audits have become highly mechanized and automated, given the economic incentives of the audit business model. The high turnover at the Big 4 firms provides an even greater incentive to automate the audits as much as possible. I am not hopeful that this behavior will be significantly altered or modified.

Denial is a powerful emotion, especially when coupled with an avalanche of media hype and feel-good sensationalism.
Our economy has just weathered the most severe downturn in 70 years, and it’s business as usual for Wall Street and bankers. The increasing disconnect between the pain of Main Street and Wall Street’s prosperity is numbing, given the increasingly dour news befalling consumers. The current pain merely illustrates that for average Americans, the last 8 years was a mirage, an episode of magical thinking where debt became income and homes became assets.
Truth be told, though, this illusion has been repeated in every asset bubble of the last thousand years. The resulting collapse, was, sadly, completely predictable. Because humans have such short memories, the past repeats itself in almost eery lock-step, just ask the Dutch about those thousand-dollar tulips.
The housing debacle was an especially prominent episode of magical thinking in our country, which caused wide-spread hysteria and illogical consumerism. Wall-Street, which required vast quantities of loans to bundle and securitize, was happy to oblige in this spectacle. Once banks shredded their loan underwriting processes sufficiently, and loans became available to nearly everyone, the “American dream” became enshrined as a rite of adulthood, and homes became commodities.
The banks, which no longer held these loans on their balance sheets, provided loans to vast segments of the population which could not afford to carry these loans under typical loan underwriting criteria, but which were given “magic” options such as negative amortization loan payments, interest only loan terms, and other Orwellian terms. These magical terms ensured that their owners could remain in the homes long enough to enable the homes to sufficiently rise in market value before they would have to sell the house, at a gain, of course.
As housing values increased exponentially, consumers also tapped their home loans for massive cash withdrawals, falsely fueling our economy to staggering heights. The only fly in this ointment was the expectation (indeed homeowners were financially at the mercy of this increase)  that home values would always increase and had never before decreased, another grand instance of magical thinking. Again, the result of this asset bubble was predictable and completely foreseeable: Home values collapsed and homeowners had no higher-price “bailout” to liberate them from their albatross. Game over.
The long-term horizon does not portend good fortune for our medical system, either. Our health-care “reforms” are full of magical thinking and fairy dust. Runaway medical costs will ensure that insurance will, within 5 years, cost each family an average of $30,000 per year. Yet none of the health care reforms being proposed address the issue of cost containment, which is the third-rail of our “free-market” medical system. Without cost containment, price-caps or massive volume discounting, the medical reforms being proposed will fail within 5-10 years, and are merely a band-aid.
Cost containment, as a category of reform, is anathema to the free market advocates, which reason that the markets are more efficient and can lower costs through free market competition. This is false, as many studies have demonstrated that communities having excess medical providers also have extremely high medical costs. But cost containment and price-caps have been removed from the national dialogue on health care reform, and remain off-limits due to their purportedly anti-free-market attributes. Americans continue to be seduced by advocates of the free-market into believing that only free-market reforms will ensure a healthy, viable and unrestricted medical system for all.
What do the housing bubble and the proposed medical reforms have in common? They are both the product of magical thinking, illogical reasoning and America’s seduction by large, multi-national corporations who do not have our best interests at heart. The unregulated, uncontrolled housing free-market caused the single-greatest asset bubble in the history of the world, and it will likewise bankrupt American families anew with a similarly flawed, yet “reformed”, medical system. Unless we acknowledge our individual and collective failures and our responsibilities to future generations, we will soon face another economic debacle foisted upon us.

The collective failures of the Bernie Madoff ponzi scheme and the collapse of the real estate markets share one common thread: the unwillingness of most commercial investors to perform even basic due diligence on their asset purchases.
I’ll start with Bernie Madoff’s ponzi scheme. Madoff’s scheme continually raised red-flags which were ignored, even by his most sophisticated clients, the feeder-funds which funneled huge sums of money into his ponzi scheme. Even a cursory examination would have revealed that his auditor was a local CPA who was housed in a tiny office. That fact alone should have sent prospective investors running for the exits.
Any individual or organization with millions of dollars to invest is surely sophisticated enough to understand that comprehensive audits of large organizations, such as Mr. Madoff’s, require teams of auditors and large audit firms with the organizational background and experience to complete the audits. A two-person office, even working 60 hours a week for an entire year, likely could not have completed an audit of Madoff’s organization.
Sophisticated feeder funds should have performed extensive due diligence, verifying and independently confirming trade tickets. Their failure to do this is inexcusable, given the purported “monitoring” services being provided to their clients and the fees collected. This, in addition to the most obvious flags of all: that Madoff’s operation would have consumed more options than those publicly traded and purchased on a daily basis. Surely, this calculation could not have been too difficult for these sophisticated organizations. Let’s not even discuss the most obvious flag of all: the near flawless, steady returns that never wavered or spiked. These “smooth” returns should have spurred current and prospective investors to dig deeper and fact-check their portfolios.
Commercial real estate investors, at least those attempting to flip condo’s and other commercial properties, continue to ignore the most obvious red-flag of all: how will they make money from this asset purchase? Assets make money only when they appreciate in value, or, they produce a steady stream of revenue that is non-volatile and which will increase over time. Those investors wading back into the real estate market must ask themselves: if few bulk condo deals have occurred, at least in South Florida, do the largest institutional investors understand basic principles, which other buyers have ignored?
The answer is easily yes, most institutional buyers certainly do understand market fundamentals, which “momentum” investors have ignored or rationalized. This understanding has led institutional investors to conclude that most condo developers are still selling their units at prices which will not ensure positive cash flow and even marginal returns on these bulk purchases. They also understand that rising notices of defaults (at least in South Florida) will eventually lead to increased foreclosure activity, and that the coming Option Arm loan tsunami could swamp the real estate market more painfully than even the subprime debacle. Finally, they understand that in some real estate markets, no asset appreciation will occur for years, perhaps decades.
The common thread between Bernie Madoff and real estate investing is that both investor groups failed (and continue to fail) to perform even minimal due diligence or exercise common sense, choosing instead to rely on the momentum generated by “word-of-mouth” or their “trusted” business advisors. Whether the red-flag is a badge of fraud or merely an indicator of poor business judgment, “market momentum” seems to have replaced judgment. In an increasingly complex world, due diligence and common sense have now been largely abandoned or ignored.
Even sophisticated investor groups oftentimes rely on “check-the-box” due diligence, largely performed by inadequately trained foot soldiers. In isolation, numbers, figures and statistics mean very little, and provide false security when their context is ignored. Counter-intuitively, it seems like the more money requested, the less questions people ask. These failures and frauds will continue to occur as long as investors continue to ignore the red flags that always appear in the face of danger, but which are nearly always rationalized or dismissed.