Robert Merton on the Credit Crisis

Robert Merton, Harvard Economist, helped create the Black-Scholes formula and was a partner in Long-Term Capital Management.  He's a smart man.

Download 2009-4-20 Crovitz_ In Finance, Too, Learning Entails Risk – WSJ.com

Merton: Why the Financial Train Went Off the Rails Video referenced in article above.

In his lecture, Mr. Merton said this crisis was not a failure like
the space shuttle Challenger disaster that could be blamed on the
single factor of a faulty O-ring. Instead, many factors we're just
beginning to understand, sparked by the housing bubble, led to the
collapse. Risk grew across interconnected financial institutions as
they bundled together assets such as mortgage-backed securities that
collapsed together when volatility exceeded what the history-based
models considered remotely possible. Government guarantees of deposits
held by these banks, he noted, means "the government is writing a put
option on a put option," making the plunge deeper.

Our fundamental problem is what Mr. Merton called the structural
tension "between financial innovation and crisis." We know a lot about
risk, information and probabilities, but not enough. "We've created
instruments for manipulating financial risk without a thorough
understanding of the underlying engineering." He compared innovations
in finance to a new fast train running along tracks not yet redesigned
for the speed. The value of the innovation, once perfected, outweighs
the problems in the meantime.

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