- Bad modelling and policies
- Conflicts of interest, Moral hazard
- Bad governance in Insurance Companies
- Overly complex derivatives and financial instruments
- Incorrect diversification
- Incorrect assumptions
Bad modelling and policies
Misunderstanding of model features
- E.g. long-term vs short-term credit history: customers who had just taken their first loan and made a single payment mistakenly had stellar short-term credit history
Models used by rating agencies could be gamed by the banks via trial and error
Lumping together individual loans into a single rate then using the mean of the whole thing to describe the group
Assuming Gaussian distributions in Option pricing models.
- E.g. Capital One stock bimodal distribution: If Capital One solved its regulatory problems the stock would go higher (in case of a win) or it would go a lot deeper (in case of a loss).
The distribution of outcomes in this Capital One case was bimodal—not at all Gaussian.
Conflicts of interest, Moral hazard
Fund managers with no skin in the game. Took risks with other people's money without bearing any cost or risk
Rating agencies need to be honest but they are incentivized to get more lax so they can have more deals in the short-term.
- This workds because agencies know that many institutional clients are restricted to buying high-rate bonds. Higher ratings == more deals.
Some managers only had short-term incentives
- No penalty if their deals went bad long-term
Some managers got paid by volume, rather than performance
Bad governance in Insurance Companies
Not knowing what exactly they were insuring, lack of understading of the intricacies of real estate structured products.
Overly complex derivatives and financial instruments
Very few people understood structured financial products so it was easier to hide risk
- Not many people were even reading the prospects
Several apparently different bonds with the same underlying characteristics
- Had very high correlation, so there was no real diversification
- Assumption/belief that real state prices just don't go down, ever.