Citi, the FCIC, and The End of History

Yesterday I saw a preteen kid wearing a T-shirt that said: “I’m surrounded by idiots.” Bill Thomas, Vice Chair of the Financial Crisis Inquiry Commission, should totally have worn that shirt to the Commission’s last hearing.

As former high-paid Citi execs explained how the housing market's shocking, unforeseeable fall made them lose billions on what they'd thought were super-safe "super senior" CDO tranches, Mr. Thomas could barely contain himself. (Here’s the video from the hearing; Thomas gets rolling around 24 minutes in.) I’m not sure if the tone he took while questioning Citi’s former Chief Risk Officer, David Bushnell, is best described as Contempt Spiked With Incredulity or Incredulity Spiked With Contempt:

None of you ever heard the phrase ‘what comes up must come down’? You thought somehow housing was unique? Or are you familiar with other areas that never go down? Or why in the world would you pay anybody for risk management in the area of dealing with these securities if housing NEVER GOES DOWN?

To be fair, Citi’s risk models didn’t actually assume that housing prices would never go down, just that they wouldn’t go down quite so much. As Bushnell said in his written testimony:

Risk models, which primarily use history as their guide, assumed that any annual decline in real estate values would not exceed the worst case historical precedent. And since the beginning of World War II, nominal home prices in the United States had never decreased by more than five percent in any given year.

If I could pose my own questions to Mr. Bushnell and his fellow Wall Street risk managers, my tone would be one of bewilderment:

Question 1: Um, Mr. Risk Manager, does “history” only go back to the beginning of World War II? If so, kids sure are doing a lot of unnecessary homework.

Question 2: Did you happen to notice that your model historical period excluded the Great Depression?

Question 3: Forgetting all that, is it possible that the history of the housing market before the invention of mortgage-backed securities and CDOs wasn't even relevant? I mean, would you forecast the risk of airplane crashes based on how often they occurred in the 17th century?

Question 4: Did you ever hear that joke about what happens when you assume?

Later in the hearing, Mr. Bushnell confessed that he hadn't understood the need to stress-test for “things that have never happened before.” OK, sure, the people building financial risk models were math majors, not history majors. Still, I find it singularly odd that folks on Wall Street, the place that experienced 9/11 firsthand, would so readily believe that something catastrophic wouldn’t happen merely because it hadn’t happened before. I was in downtown Manhattan that day, and it sure changed my personal risk models.