The Cognitive Financial Crisis

Financial Crisis
Financial Crisis

The fines issued to Merrill Lynch and Credit Suisse by Finra this week provide some evidence for one of NetNet’s key propositions about the financial crisis: that it was caused by error and ignorance rather than perverse compensation incentives.

Here’s what Finra says happened at Merrill Lynch:

"In or about February 2006, Merrill Lynch learned that one of its master servicers and trustees had provided erroneous mortgage delinquency data in its trustee reports for certain subprime RMBS securitizations that Merrill Lynch had underwritten in 2004 and 2005.

The Firm brought the errors to the Master Servicer/Trustee’s attention and the Master Servicer/ Trustee informed the Firm that it had corrected its delinquency calculations in its trustee reports for these securitizations."

Halah Touryalai of Forbes describes what happened next:

"About a year later, Merrill fired the third party vendor it had hired to help with a website (called a Reg AB website) that firms use to disclose information about RMBS to investors. Merrill decided to take that task in-house but in doing so made errors in the information it was using to describe the quality of the RMBS."

And back to Finra:

"These errors in delinquency reporting had been caused by an incorrect data feed that populated information from the wrong column of the database that Merrill Lynch used to populate the Reg AB website after Merrill Lynch took this function in-house. These errors, which variously understated or overstated mortgage pool delinquencies, affected static pool information for 61 subprime securitizations posted on the Reg AB website from January 2006 through June 2007."

The important thing to notice here is that Merril wasn’t consistently understating delinquencies—which is what you’d expect if its RMBS sales guys were just trying to juice their bonuses by fudging the data on mortgage qualities. The data was wrong in both directions—sometimes overstating delinquencies, sometimes understating them.

The truth is that these guys just didn’t really know what was going on in the mortgages that underpinned their securities.


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