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Rajiv
02-26-09, 10:39 AM
Recipe for Disaster: The Formula That Killed Wall Street (http://www.wired.com/techbiz/it/magazine/17-03/wp_quant)


A year ago, it was hardly unthinkable that a math wizard like David X. Li (http://en.wikipedia.org/wiki/David_X._Li) might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function (http://en.wikipedia.org/wiki/Copula_%28statistics%29), looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

How could one formula pack such a devastating punch? The answer lies in the bond market (http://en.wikipedia.org/wiki/Credit_market)
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cjppjc
02-26-09, 10:05 PM
Ok. Help me out please. 1 $10,000,000 of bundled mortages can lead to an infinate number of credit default swaps. If I sell 1,000 of these and get a 1 time fee or a cash flow amount, I'm prospering and someone else is hedging or gambling. Now the market turns. The $10,000.000 bundled mortages are worth less. The CDS is now my problem because I have to pay insurance to the people I got the 1 time fee, or cash flow from.

But isn't this a zero sum game? If I'm out a lot of money, someone else is ahead a lot of money. If the amount of money lost in CDS' is 5 trillion. Isn't the amount of money won 5 trillion?

Rajiv
02-26-09, 10:16 PM
In theory yes -- however you cannot collect on your winnings because the party you were going to collect from is bankrupt and has no assets to cover the bet! -- because 300 other bets went south at the same time for him! -- that is where the copula model was supposed to help -- but didn't! If the copula model was correct, that event (300 bets going south at the same time) would have showed up as a risk factor. The copula model depended on the existence of perfect markets -- in that the risk of a financial asset is totally reflected in the price charged for it.

This theoretical assumption lay behind the cupola model -- and this has been generally accepted as gospel in modern economic theory.

cjppjc
02-26-09, 10:53 PM
In theory yes -- however you cannot collect on your winnings because the party you were going to collect from is bankrupt and has no assets to cover the bet! -- because 300 other bets went south at the same time for him! -- that is where the copula model was supposed to help -- but didn't! If the copula model was correct, that event (300 bets going south at the same time) would have showed up as a risk factor. The copula model depended on the existence of perfect markets -- in that the risk of a financial asset is totally reflected in the price charged for it.

This theoretical assumption lay behind the cupola model -- and this has been generally accepted as gospel in modern economic theory.

I was hoping I was right. So instead of screwing the taxpayer. Void the game. All bets are off the board. Let the chips fall where they may. Nobody loses and nobody wins. Nobody seems to be winning anyway. Who would object?

Chomsky
02-27-09, 10:14 AM
I was hoping I was right. So instead of screwing the taxpayer. Void the game. All bets are off the board. Let the chips fall where they may. Nobody loses and nobody wins. Nobody seems to be winning anyway. Who would object?

All the holders of synthetic CDOs -- bonds backed not by assets, but by the cash flows of credit default swaps. Cancel all the CDS and the synthetic CDOs backed by them go to zero.

cjppjc
02-27-09, 10:40 AM
All the holders of synthetic CDOs -- bonds backed not by assets, but by the cash flows of credit default swaps. Cancel all the CDS and the synthetic CDOs backed by them go to zero.


What is the downside in dollars do you think? I say take the game off the board, and let the chips fall where they may.

Chomsky
02-27-09, 12:10 PM
Hundreds of billions in losses.

cjppjc
02-27-09, 12:25 PM
Hundreds of billions in losses.

Losses to "safe funds. Safe bond funds? Pension funds? Municipalities?" So the taxpayer steps up with the money so these safe funds don't loose capital?

GRG55
02-27-09, 04:41 PM
Losses to "safe funds. Safe bond funds? Pension funds? Municipalities?" So the taxpayer steps up with the money so these safe funds don't loose capital?

It's just as Martin Mayer said...the systemic risk is not from debtors unable to pay; it is from creditors who cannot afford not to be paid back.

Rajiv
02-27-09, 08:07 PM
It's just as Martin Mayer said...the systemic risk is not from debtors unable to pay; it is from creditors who cannot afford not to be paid back.

Because they put money into a traunch that was supposed to be AAA but turned out to be junk -- in part because of a formula based on faulty assumptions! Of course human greed, Ponzi schemes and outright frauds also played a role!

cjppjc
02-28-09, 12:26 AM
I repeat.

Void the game. All bets are off the board. Let the chips fall where they may. Nobody loses and nobody wins. Nobody seems to be winning anyway. Who would object?

Who's winning now? Those funds that are just praying the Govt. keeps throwing money at the problem long enough to get a bid on this stuff so they can then sell it?<!-- / message -->

Rajiv
02-28-09, 01:08 AM
It isn't as simple as that unfortunately -- the path you suggest could lead to widespread bankrupcy and chaos -- My own company would not have survived beyond April of last year had it not been for the Mass and NY AGs investigations of the practice of selling ARS's -- because the company as a creditor that supposedly invested in "As good as cash" securities (That is what they were sold as!) would have lost a sufficient amount of money and would have caused it to fold -- leading to joblessness for a number of people.

And if what to you suggest were to happen, it definitely would lead to a system wide collapse. So the Government is now acting as the "Insurer of last resort" -- We can argue as to how this insurance should be routed -- but not the necessity of it!

cjppjc
02-28-09, 01:28 AM
It isn't as simple as that unfortunately -- the path you suggest could lead to widespread bankrupcy and chaos -- My own company would not have survived beyond April of last year had it not been for the Mass and NY AGs investigations of the practice of selling ARS's -- because the company as a creditor that supposedly invested in "As good as cash" securities (That is what they were sold as!) would have lost a sufficient amount of money and would have caused it to fold -- leading to joblessness for a number of people.

And if what to you suggest were to happen, it definitely would lead to a system wide collapse. So the Government is now acting as the "Insurer of last resort" -- We can argue as to how this insurance should be routed -- but not the necessity of it!

Your company almost bought ARS's but saw the AG investigations. Am I correct? What does your company do? What is an ARS? How do I make this headache go away? Thank you.

Rajiv
02-28-09, 01:53 AM
We bought the ARS's (Auction Rate Securities (http://en.wikipedia.org/wiki/Auction_rate_security)) which in our case were securitized assets based on federally insured student loans - just as there are assets securitized on real estate loans.

Based on the criminal investigations of the Mass and NY AG's, the banks agreed to make whole a certain class of small investors -- as the auctions for the said assets had dried up -- nobody wanted to buy any securitized assets -- even though there were no problems associated with student loan repayments, as opposed to the real estate securitizations.

Now the bank is left with the long term assets of the student loans -- but they cannot sell those to other parties -- so now they have to take some losses which they did. However, if the solution that you suggested were to have taken place, then those losses would be borne by those least able to afford them - in other words by people who had been sold something other than what they were promised.

How would you feel if somebody agreed to sell you a BMW, took your money, but when the car showed up at the door, it was a Yugo? Who should bear the loss?

cjppjc
02-28-09, 10:08 AM
Thank you all so much for helping me to understand a little bit. It is amazing to me that all these supposedy intelligent people reach for yield and got their heads handed to them. I've always known the higher the potential return the higher the potential risk. It seems that was not forgotten, it was ignored.

Chomsky
02-28-09, 03:48 PM
Here is a very good layman's article on why AIG and its CDS portfolio is being kept alive by endless government bailouts. Really worth reading:

http://www.nytimes.com/2009/02/28/business/28nocera.html?_r=1&ref=business&pagewanted=all

cjppjc
02-28-09, 05:26 PM
Here is the part is like the best:

A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero

Starving Steve
03-03-09, 09:05 PM
Recipe for Disaster: The Formula That Killed Wall Street (http://www.wired.com/techbiz/it/magazine/17-03/wp_quant)

How could one statistical formula cause the trainwreck we see now in world markets, > 30% of the world's wealth to disappear, and the retirement hopes of tens of millions of people to go down the toilet?

The answer lies in the economics departments at our major universities and how economics is being taught. If Zimbabwe's hyper-inflation hasn't answered the question in spades, maybe this trainwreck now in the world markets has answered it.