The Formula That Killed Wall Street

[CompoundInterestFan]

Recipe for Disaster: The Formula That Killed Wall Street

Still trying to digest it all, but an interesting read.

 

[free4now]

If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall

I haven't digested the article either, but the above quote from the author makes me suspect that he doesn't understand risk very well either. Taking a 1% risk of default every year over say a 60 year timeframe means you are more likely than not to lose everything. Not what most bond investors would consider "ahead of the game".

 

[W2R]

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.

In hindsight, ignoring those warnings looks foolhardy.

Sure does!! (gulp!) Foolhardy, and amazing. But then I suppose this is simply human nature.

 

[FIRE'd@51]

Interesting article. Thanks for posting.

I haven't digested the article either, but the above quote from the author makes me suspect that he doesn't understand risk very well either. Taking a 1% risk of default every year over say a 60 year timeframe means you are more likely than not to lose everything. Not what most bond investors would consider "ahead of the game".

Not if the bond defaults are uncorrelated, since you would be increasing the number of bonds at a faster rate (2%) than the rate at which they would be defaulting (1%). The article asserts that it's the mis-estimate of the correlation of default between the securities (e.g. mortgages) which the pool comprises that essentially led to the meltdown we have today.

 

[audreyh1]

Whatever the models actually were, it's definitely the models that killed Wall Street. No matter what they did with tranching, they might have been able to suffer through the losses if there hadn't been excessive leverage. Not only did they go hog wild with the securitization of loans through faulty models, but they levered up enormously.

The investment banks thought they could leverage up to 40X without disastrous repercussions? Huh?!?!? Such blind faith in their models! Didn't the Long Term Capital fiasco teach anyone on Wall Street anything? [ For those unfamiliar with it, the 1997 Long Term Capital mess was a a classic case of model failure turned disaster by extreme leverage.] That was a clear warning shot across the bow!!! Human hubris never ceases to amaze me.

Audrey

 

[Gpond]

Paul Volcker says the current U.S. form of capitalism has failed:

YouTube - Former Fed Chairman Paul Volcker says that this is the Mother of all Crises Feb 20, 2009

 

[cantlogin]

Paul Volcker says the current U.S. form of capitalism has failed:

According to this clip, that isn’t true.

What he says is:

"...I think capitalism will survive this crisis. Capitalism in most respects, I'm not so sure about these financial respects. That will take a little revision..."

That’s a lot different than saying it has failed.

 

[Independent]

Whatever the models actually were, it's definitely the models that killed Wall Street. No matter what they did with tranching, they might have been able to suffer through the losses if there hadn't been excessive leverage. Not only did they go hog wild with the securitization of loans through faulty models, but they levered up enormously.

The investment banks thought they could leverage up to 40X without disastrous repercussions? Huh?!?!? Such blind faith in their models! Didn't the Long Term Capital fiasco teach anyone on Wall Street anything? [ For those unfamiliar with it, the 1997 Long Term Capital mess was a a classic case of model failure turned disaster by extreme leverage.] That was a clear warning shot across the bow!!! Human hubris never ceases to amaze me.

Audrey

Right. I recently saw something on LTCM that took the same angle as this article. The root enabler was the Black-Scholes option pricing formula. It was a tremendous breakthrough. However, it made Scholes, Merton, and other very smart people over confident. They made big bets on the belief that asset relationships would always return to historic levels. That turned out to be true almost all the time. The "almost" wiped them out.

They nearly brought down the financial system because they were so heavily leveraged. If they had just been betting their investors' money, it wouldn't have been a big deal. But they were operating an unregulated fund, so they could crank the leverage as high as they wanted.

Sound familiar?

The difference this time is that everyone in any postion of authority should have known about LTCM. In fact, some of the quotes in the article show that people knew their history. I'd guess it was just too much fun making all that money in the short term.

A few quotes from this article:

… in the CDO market, 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. Those explosions may have been rare, but they could destroy all previous gains, and then some.

…. because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.

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 ….

 

[Gpond]

According to this clip, that isn’t true.

What he says is:

"...I think capitalism will survive this crisis. Capitalism in most respects, I'm not so sure about these financial respects. That will take a little revision..."

That’s a lot different than saying it has failed.

...and it's current form.

If you listen to him, he says capitalism has been broken down and can not be replicated in the current form.

I.E. FAILED.

 

[Culture]

I haven't digested the article either, but the above quote from the author makes me suspect that he doesn't understand risk very well either. Taking a 1% risk of default every year over say a 60 year timeframe means you are more likely than not to lose everything. Not what most bond investors would consider "ahead of the game".

I did not read it this way. It appeared to me he is referring to the risk of default over hte life of the bond.

 

[al_bundy]

the mistake he made was that instead of spending years and analyzing historical data to make a model he used the prices of credit default swaps as an easy way out

 

[Frugality_of_Apathy]

I haven't digested the article either, but the above quote from the author makes me suspect that he doesn't understand risk very well either. Taking a 1% risk of default every year over say a 60 year timeframe means you are more likely than not to lose everything. Not what most bond investors would consider "ahead of the game".

nah, with a 1% risk of failure every year for 60 years that's still a 54.7% chance of success over a 60 year period. Still most likely to succeed but not with 99% certainty certainly. Besides, by that point they've already paid the loan back and monetarily and the last 20 years are all interest.