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The terminator comes to Wall Street: how computer modeling worsened the financial crisis and what we ought to do about it.

Article Excerpt
You've seen this story in countless Hollywood science-fiction movies, from The Terminator to War Games. Scientists develop a ophisticated computer or robot to assure the nation's security, but something goes wrong and the technology itself mutates into a catastrophic threat. Unfortunately, the U.S. economic system now finds itself crippled by a real-life technology-gone-wrong story line. In this case, the culprit is not a Pentagon fighting machine, but rather the computer-based modeling and trading programs developed for Wall Street over the last quarter century.

Business models--whether they are models for analyzing market trends or running a major auto manufacturer--typically assume that history provides a guide to future outcomes. Such an assumption is usually reliable, but whenever events fall outside historical norms, the results can be catastrophic. Against this background, consider the introduction of computer-based program trading, arguably the most important change in global investing since the founding of the first mutual fund--the Massachusetts Investors Trust--in 1924. Over the past 20 years on Wall Street, computer-based models have gradually replaced human networks of strategists and traders. Quantitative analysts ("Quants") trained in mathematics and physics have used sophisticated data analytics and modeling skills to evaluate securities and develop portfolio-management theories. The advent of Quants has allowed firms of all stripes to trade ever-larger volumes of securities and to extend their activities to new and exotic instruments. Using either mathematical or statistical models, firms have also been able to trade huge volumes of securities globally. In many cases, the computers didn't just provide advice, they actually executed stock trades. By the end of September 2008, the global stock exchange NYSE Euronext reported that so-called program trading, in which computers execute trades based on programs developed by Quants without specific human intervention, represented almost 17 percent of trades--more than 900 million shares per day.

Since the data that feed these analytical formulas come from the past, the models can have trouble responding to extraordinary or unprecedented events. When credit markets began to seize up in mid-2008 and the securities markets went into free fall, the models tried to figure out a suitable response. They had...

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