Vanity Fair published an excellent article in December by Niall Ferguson entitled, Wall Street Lays Another Egg. It provides an in-depth look at the causes of the financial crisis/recession/depression we are now in. Mr. Ferguson is a Harvard historian and takes a historical view of the crisis and its implications. Here's how the in-depth article starts:
"This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth."
The article is long,8 pages of text and takes the reader through the creation of the subprime mess, the engineering of CDOs, CDSs, and other esoteric instruments that magnified the impact of a wave of mortgage defaults. His analysis shows how many were complicit in the creation of a credit and real estate bubble the likes of which have not been seen before.
If there's any consolation to the grim view of the the article, it is the fact that financial bubbles are nothing new. They have existed since the dawn of capitalism, stock markets, and banking. They are, in a sense a price to pay for the overall growth in the world economy and reflect the whims, vagaries, hopes, and fears of human nature.
The other point that I think comes out in the article, is that as much as investors will always try to use quantitative tools to minimize risk and project returns, they are only as good as the tools used to predict human decision making. Economic theories are good, but they pretend that people always make rational decisions. We do not. That, combined with the comflict of interest and greed in the system make it very difficult for a quantitative model to accurately make predictions.
The fall of Planet Finance is the fall of the quant gods, who once thought they could model our behavior. Turns out they were wrong.