Earthquakes on Wall Street?

Sept. 15, 2009— -- WASHINGTON (ISNS) -- The computer models used by banks to gauge the risk of each of their investments were partially to blame for last year's financial meltdown and the resulting banking crisis. That was the message delivered to Congress' House Committee on Science Technology by a panel of traders and economists in a hearing Thursday on risk modeling.

"Economics has not been known in the past for mathematical precision," said Brad Miller, chairman of the Subcommittee on Investigations and Oversight, setting the tone for the hearing. "The complex models turn out to have hidden risks rather than protected against them, all at a terrible cost."

Some of the panelists blamed the failure of the risk models on bell-shaped curves they use to grade investments -- curves that tend to leave out the most extreme catastrophes.

"Data shows that banks routinely lose everything they ever made in one single blow-up," said Nassim Taleb, former trader and author of New York Times bestseller "The Black Swan," which explores the impact of highly improbable events. "They make steady income for a long time, and when they blow up, they say 'well it was unexpected.'"

Like many of the other panelists, Taleb argued that the economic collapse was predictable.

One idea proposed by the panel that has some support in scientific community is that the former scientists who build these models on Wall Street could have better prepared the financial world for the big taking a page from scientists who study earthquakes and borrowing the mathematics of natural disasters.

"We have codes to protect buildings in earthquake-prone cities like Toyko," said Eugene Stanley, a physicist who studies economics at Boston University and who was not involved in the hearing. "We don't have anything like that in the financial world."

The use of computer models is standard practice across a number of scientific disciplines. Aeronautical engineers crunch numbers about how fuel burns to design more powerful jet engines; chemists in thepharmaceutical industry develop better drugs by simulating the way they interact with their target and the body; and atmospheric scientists use models to predict the paths of hurricane.

These models are based on things that can be tested in a laboratory.