Eureka, I Lost It, or When Risk Stayed at Zero Forever
The actual story of the real math formula that every bank and brokerage in the U.S., Britain, and most of Europe decided to use to price risk and hence caused this particular crash is HERE in Wired Mag. It's an amazing story about how everyone on the world wide Wall Street adopted the same formula, one which the inventor warned would blow up if all home prices ever dropped at the same time. Called the Gaussian copula formula, a math exercise that will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees. Of course nobody paid attention to continual warnings that housing prices might fall. That was bullshit, after all there was money to be made. The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. Oh fuck. The market grew like Jack's beanstalk. The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.
All the goodies are in the Wired piece, it's an easy to understand article about a very complicated math problem that nobody understood or bothered to try to understand. The actual formula is in the post below.
2 comments:
not only is it as bad as all that, it might be worse. didn't i read somewhere that when they finally got around to double-checking li's math in re the risk formula - maybe they were getting ready to give him the nobel or make him fed chairman or something - didn't i read they found he'd done the math **wrong**??
put the 'x' in the wrong column; or forget to carry the 'y'?
wouldn't that be just about perfect? "wall street dipshits destroy financial world using incorrect formula"?
"of COURSE i'm sure it's e=mp squared! buy! buy!"
The formula was correct for as far as it was designed to go. The guy warned from almost the beginning that if 100 people failed to meet their mortgages at the same time the formula would blow up. He was a fucking scientist/mathematician not a stock market guy. He was just calculating correlations (hunting high and low for them) and stumbled onto this one, which when put into practice worked like crazy---until a hundred people defaulted all at once. There are all sorts of correlations which we all know by looking are bullshit: when the old AFL wins the super bowl the market goes up; in Sweden they have one where if the storks fly south for the winter in September the market will fall; and how about ground hog day? Then there are those that work for a while; the soybean silver ratio held true until everyone believed it. This is simply a case of too many cooks.
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