Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy by Cathy O'Neil Read Free Book Online Page B

Shaw lost a bit of their swagger. Troubled markets, after all, were entwined. For example, rumors were already circulating about the vulnerability of Lehman Brothers, which owned 20 percent of D. E. Shaw and handled many of our transactions. As the markets continued to rattle and shake, the internal mood turned fretful. We could crunch numbers with the best of the best. But what if the frightening tomorrow on the horizon didn’t resemble any of the yesterdays? What if it was something entirely new and different?
    That was a concern, because mathematical models, by their nature, are based on the past, and on the assumption that patterns will repeat. Before long, the equities group liquidated its holdings, at substantial cost. And the hiring spree for new quants, which had brought me to the firm, ended. Although people tried to laugh off this new climate, there was a growing fear. All eyes were on securitized products, especially the mortgage-backed securities Greenspan had warned us about.
    For decades, mortgage securities had been the opposite of scary. They were boring financial instruments that individuals and investment funds alike used to diversify their portfolios. The idea behind them was that quantity could offset risk. Each single mortgage held potential for default: the home owner coulddeclare bankruptcy, meaning the bank would never be able to recover all of the money it had loaned. At the other extreme, the borrower could pay back the mortgage ahead of schedule, bringing the flow of interest payments to a halt.
    And so in the 1980s, investment bankers started to buy thousands of mortgages and package them into securities—a kind of bond, which is to say an instrument that pays regular dividends, often at quarterly intervals. A few of the home owners would default, of course. But most people would stay afloat and keep paying their mortgages, generating a smooth and predictable flow of revenue. In time, these bonds grew into an entire industry, a pillar of the capital markets. Experts grouped the mortgages into different classes, or tranches. Some were considered rock solid. Others carried more risk—and higher interest rates. Investors had reason to feel confident because the credit-rating agencies, Standard & Poor’s, Moody’s, and Fitch, had studied the securities and scored them for risk. They considered them sensible investments. But consider the opacity. Investors remained blind to the quality of the mortgages in the securities. Their only glimpse of what lurked inside came from analyst ratings. And these analysts collected fees from the very companies whose products they were rating. Mortgage-backed securities, needless to say, were an ideal platform for fraud.
    If you want a metaphor, one commonly used in this field comes from sausages. Think of the mortgages as little pieces of meat of varying quality, and think of the mortgage-backed securities as bundles of the sausage that result from throwing everything together and adding a bunch of strong spices. Of course, sausages can vary in quality, and it’s hard to tell from the outside what went into them, but since they have a stamp from the USDA saying they’re safe to eat, our worries are put aside.
    As the world later learned, mortgage companies were makingrich profits during the boom by loaning money to people for homes they couldn’t afford. The strategy was simply to write unsustainable mortgages, snarf up the fees, and then unload the resulting securities—the sausages—into the booming mortgage security market. In one notorious case, a strawberry picker namedAlberto Ramirez, who made $14,000 a year, managed to finance a $720,000 house in Rancho Grande, California. His broker apparently told him that he could refinance in a few months and later flip the house and make a tidy profit. Months later, he defaulted on the loan.
    In the run-up to the housing collapse, mortgage banks were not only offering unsustainable deals but actively prospecting