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| The Formula that killed Wall St. |
| 2009-02-25 |
| I have tried to explain how the "risk management" models on Wall St. failed so completely. This article explains it (in English) better than I could. The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation. People used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up. Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They didn't notice. One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem. "The relationship between two assets can never be captured by a single scalar quantity," Wilmott says. In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. |
| Posted by:Frozen Al |
| #5 if you have a currency monopoly, you have to regulate credit volume (through changing reserve requirements) as well as interest rates. Basel 2 FIXED reserve requirements hence the boom in credit. |
| Posted by: Bright Pebbles the flatulent 2009-02-25 17:30 |
| #4 When that bank blew up in the late '90's (BCI or some such...the mind is a terrible thing) that should have been the signal that this crap was too dangerous to play with. Clinton has now said that he should have increased regulation on derivatives at this point and he is right. Bush should have done so when he came into office. Neither party did squat to limit this stuff. As I've said before, it is one thing to make a crappy mortgage loan, but it is another to securitize that loan and creat 50+ obligations based upon it. That was what the geniuses on Wall Street, at the hedge funds and at the big insurance companies did. Too smart for their own good by far. |
| Posted by: remoteman 2009-02-25 13:48 |
| #3 Greed masks risks. Greed is good. It stimulates productivity. But if it's not tempered by fear, the greedy eventually destroy themselves. Fear is good. It pulls people back from the edge. But unchecked it destroys productivity. It's time for a nap, now. Naps are good... |
| Posted by: Richard of Oregon 2009-02-25 13:23 |
| #2 Let's see. Any profit from borrowed and leveraged money you keep. When it goes south, the nation's taxpayers pick up the mess. What's not to like, including the view from the Manhattan penthouse? |
| Posted by: ed 2009-02-25 13:14 |
| #1 Most views of the world--in particular the views of Democrats--rely upon a static analysis of that world. Then they only look at one variable at a time. It's easy, then, to predict how changes in law will effect the economy. But money is a slippery devil. It never seems to go where "it should." Failure to understand the math seems to be the biggest deficit in Washington. Dynamic models are hard, but they are better. (Most of the time.) |
| Posted by: OregonGuy 2009-02-25 12:48 |