Here's The Math Formula That Ruined Our Economy
Now if your kids ask you why they have to learn math, you can tell them, "Because if you don't, you could ruin the global economy, you little beast." Wired has just published an article that traces the entire clusterfrak back to a formula published in 2000 by a mathemetician working for JPMorgan Chase. Bankers loved its simplicity but completely misused it—despite warnings from academics that it was flawed—to turn pretty much every security into a triple-A, no-risk fabrication.
At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.
"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee. The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations. "Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus," wrote derivatives guru Janet Tavakoli in 2006.
So why did banks keep following it? Because times were good, and because they didn't understand the flaws in the formula in the first place:
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.
In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.
And then the housing market imploded.
Read the full article at Wired.com. Also, if you're the type who'd rather watch a cartoon, check out this great animated explanation of the credit crisis posted a few days ago by Ben.
"Recipe for Disaster: The Formula That Killed Wall Street" [Wired]
(Photo: David Paul Ohmer and Wired)
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Comments:
So the money managers heard "Blah blah blah formula to make big bucks blah blah blah no blah risk blah blah simple blah blah suitable"?
It's amazing what can be accomplished with selective hearing.
@HIV 2 Elway Resurrected: I can't see how $800B of bacon, ham, sausage and roast could possibly be a nightmare.
@HIV 2 Elway Resurrected: I love how people are trying to blame Obama for this...
Obama is your hope in this matter, the republicans with their heads so far up their asses counting $$$ and crusading against "terrorists" were the straw that broke the camels back. Not to mention how conveneintly everything fell apart just in time for it to be handed off without making one ounce of effort in attempting to create a solution.
True the new "stimulus" has plenty of ridiculous factors to it, but it is at least something.
Everyone laughed at Noah when he was building an ark... (And I'm not even a heavily religious person...)
It's a good article, I find it interesting that Li now works in Beijing and he's not talking. But really, people saw something that looked good and, without fully understanding it, put it in place. Humanity is like that.
@lonestarbl: Anybody who thinks the the woes of the economoy or the salvation of it can be pinned on one political party is an idiot.
It took a lot of people to get us where we are today and will take a lot to get us out.
ah GWB loving trolls. How quaint. Is it 2004? Did I step in a time machine? What color is the sky in your reality? Fail.
@darkjedi26: Sorry about that, that was kind of my point, just went about it in the wrong way. I totally agree with you, it's a team effort. I was aiming for "We at least have a plan, no lets do our best to support it and make it work"
The truth is that politicians on both sides of the aisle are to blame. It's important to identify the real causes and apply them to those who are guilty for them.
@HIV 2 Elway Resurrected: I like how rethuglicans find it so easy to ignore their mantra of, "if you're not with the president, you're against America," now.
Well, except, Noah built the Ark, BEFORE the flood, not at it's peak.
Also, this DO something mantra that has been reverberating in the echo chamber, is silly. Maybe Nero fiddled because he knew he was just going to make things worse.
I am not saying anyone should fiddle, I am just saying that to give credence to ideas (good or bad) by simply saying, "Well, at least he did something" is silly.
@darkjedi26: I'm not convinced the politicians from any party can be blamed or praised for the economy, they are just puppets that sing and dance to distract us from the people holding their strings and making each other rich.
Wait, wait, wait, wait... You mean a small formula that a child could calculate (if he were given the variables) couldn't be used to manage the trillions of dollars that make up the worldwide economy without some kind of mass implosion that sends once great institutions to the abyss and hundreds of thousands (maybe even millions when this is all said and done) of people to the unemployment line?!
Whoduhthunkit?
...
re my own post:
I think I just got my answer. I can't believe you all fell for this.
@Oranges w/ Cheese: It might have changed, but I remember hearing that even after one year in Iraq the war was costing approximately 100B/year.
(admittedly the article I read may have been exagerating, but from what I know it seems fairly accurate)
@Oranges w/ Cheese: While it's a lot, the cost of the wars (Iraq & Afghansitan) since 2002 is less than that of this single stimulus package put forward.
@zark169: Sorry for the double post but my point above applies here as well:
I'm not convinced the politicians from any party can be blamed or praised for the economy, they are just puppets that sing and dance to distract us from the people holding their strings and making each other rich.
@WBrink: While he is a troll, it does raise important questions for discussion, especially since nobody took the obvious political baiting.
@darkjedi26: The blame falls squarely on the shoulders of the industries that have been looting this country for years.
@Jason Schalz: It makes me sad that these financial 'wizards' don't have the mathematical knowhow to recognize that.
@darkjedi26: But it can be pinned down to an ideology: the Conservative, Free Market Fundamentalist one. And they should be pilloried every time they duck their heads up long enough to parrot Rush talking points blaming the people trying to fix the mess they created in the first place.
@Islandkiwi: It reminds me exactly of something I was reading recently, about a 1990s superfund case in Ohio & other midwestern states. 6,000 homes were contaminated because an unlicensed exterminator thought it would be good business to spray inside residences & schools with an agricultural insecticide. On the face of it, a good idea since it's an incredibly potent pesticide, so you get rid of roaches. But it's actually a TERRIBLE idea since the chemical is designed to break down in sunlight, to decontaminate the area so workers can return. Indoors, it never degraded and there were health problems, 2 deaths, and $65 million spent for clean-up.
That's why there are regulations on these kinds of things - pesticides and financial systems. Regulations are supposed to stop things like this from happening - so that our shortcuts, faulty reasoning, or desire to ignore (or be ignorant of) potential downsides don't have catestrophic effects. There should have been more oversight on how the banks were applying the formulas and an aknowledgement of its weaknesses.
(for more on the story of methyl parathion - [www.ehponline.org])
@lonestarbl: Not to mention how conveneintly everything fell apart just in time for it to be handed off without making one ounce of effort in attempting to create a solution.
Couldn't you say the same thing of the falling economy that was handed to Bush in 2000? People seem to forget that the dotcom bubble was bursting/deflating at the end of Clinton, and Bush inherited it.
I really don't care who's in charge as long as it turns around. But I notice that the highest market we had in the past four months was 11/4/08, and it dropped from there. It also seems that whenever Barack talks, the market drops. Yesterday the market rose over 250 points. Barack talked, and it's currently down over 75 points.
@SitDownNancy_GitEmSteveDave: lol, do you really think the market is that correlated to political speeches?
It seems like the problem was the idiot bankers' misuse of the formula to achieve their greedy ends, not the formula itself, that caused the problem.
@GuinevereRucker: Heh (I think).
umm dreamsneverend: did you notice the trolling was based around a single party. No- well go look, I will wait. [taps foot] Ok, you're back. Feel a bit silly? That's ok, now you know- and knowing is half the battle!
@johnva: in an economy driven by 70% consumption, consumer confidence really is everything. if you're a journalist, you might want to rethink the next time you describe the crisis as 'the greatest depression.'
3X2(9YZ)4A
X = mass of bank CEO cock
Y = volume of bank customer anus
Z = speed of penetration
A = force applied to anus
@Trai_Dep: you could say the same of all the market's great successes.
there were also thoughts that the extension of loans to those of poorer credit was a form of social service. and the current economic crisis is directly traceable to that, without conjecture.
but again, there wasn't one single factor that caused this.
@johnva: Actually the article says that it was the historical default correlations that the formula used that was flawed, because it used only a decade's worth of data- and that decade happened to be a boom time.
@Mad Dog McCree: because of deregulation? I mean, weren't there a few actions by Clinton, Bush 2 and possibly others that allowed the sort of environment where CDO's held so much sway?
@johnva: Yes, it is. Over the past few decades the stock market, and by extension the economy in general, have become entirely based on psychology. Brokers scared of something? The NYSE goes down 100 points. Brokers told they're getting free money wrapped in fried bacon? Up 100 points.
@Mad Dog McCree: Yes, but the bankers' whole job was to realize things like that. They were applying it improperly.
@jscott73: Exactly. The banks used some dumb formula thinking it would bring them riches beyond the riches they already had. This is politicians fault how?
Oh wait, when the banks got a free pass and free money sent with love care of our politicians after the banks decided to blow it all on the roulette table with their "system".
@FuryOfFirestorm: That reminds me. Have there been any economy-themed cheesy pornos yet? I don't like porn, but I'd watch for the social commentary.
@WBrink: Trolls don't usually have stars or 60+ followers. While you have no avatar or friends/followers.
Classic misuse of math like E=MC^2.