What Happens When Machine Learning Finance Models Fail

These are some strange times. Look, we have $16 trillion of negative yielding bonds, that’s T, for trillion. I’m asked by non-financial people why anyone would want to buy negative yields (you pay to hold them, btw) and I reply, it’s not about income, it’s about trading that rates will fall further.
 
Which got me thinking: If we are in some liquidity trap world and negative interest rate environment, what does that do to all these invoice financial models being built using the latest and greatest in artificial intelligence and machine learning?
 
For some insights, I look back at 2007-08, a period when things were getting weird, and that was the mortgage backed security (MBS) crisis, perhaps the biggest market disaster in terms of leverage and securitization tied into securitizing non-conforming mortgages and selling them to hungry investors looking for yield. Sound familiar?
 
Back when this asset class mushroomed to almost $10 trillion (yes, another T), it was supposed to be different because the Gaussian Copula formula underlying the securitizing and tranching of these mortgages works. See The Formula That Killed Wall Street
 
But it didn’t this time, as it didn’t anticipate a significant decline in home prices.
 
We are now building new models using technology to finance invoices. It’s supposed to be different this time because we are clever, we are smarter, we are using artificial intelligence and machine learning algorithms, and can assess the likelihood that invoices will be paid as soon as they are submitted.
 
For those not familiar with invoice finance, there are three stages where it can be done, each with different risks: invoice submission, when delivery has been verified, and when invoice has been approved by the buyer and scheduled for payment based on payment terms. See: Can Source-to-Pay Networks Go Beyond the Approved Invoice?
 
Look I am not saying any of the emerging models will fail. Sure, if I have 1,000 invoices submitted to Pacific Gas and they were assessed for a payment, all were paid (most in full), then yes, you can assess that risk. If I am a new supplier, or there is a track record of invoice disputes between the buyer and their sellers, that risk gets harder to assess.
 
What I am saying about these emerging models are three things:

  1. These models are built without significant credit cycle information.
  2. These models may work for a period of time, but when they don’t, it can become ugly — think back to MBS and the Gaussian Copula formula.
  3. You need more information than just a buyer and their sellers transaction history — that is necessary but not sufficient credit information.

The reality is we are in unchartered waters today, led by central bankers who are increasingly concerned by a liquidity trap and have made qualitative-easing programs worldwide permanent policy.
 
I’m all for innovative underwriting and bringing automation to the invoice finance market, but models are not bulletproof.