The Secret Formula That Destroyed Wall Street

Wired:

A year ago, it was hardly unthinkable that a math wizard like 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, 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.

Read the whole story: Wired

Comments

[Motes]

The truth is that the mathematical model described in this article is not horribly complex for modeling purposes and it is rather unbelievable that anyone who actually thought about its representation and what it was being applied to could of honestly thought that it would be accurate in all the cases that our or the world's economy can have. Yes I am saying this in retrospect, but it shows that the work needed to verify the assumptions of the modeling just was not done or comprehended. Unless people have learned how to read other people's minds and represent that in all of its gory detail mathematically you can only use something like this as a guideline of what might happened given what you have seen before. In other words it is an educated guess.
It is the quants job to point out the validity of the formulae that they create to model a given feature and what are its assumptions and how far their model will deviate when the assumptions are invalid.

[spinns17]

the best and the brightest.­lol

[dutch163]

the key word in the article is "legerdema­in".."slig­ht of hand"..usu­ally used in reference to magic tricks..wh­ich deceive the spectator

I am afraid this is what got us into this mess..whil­e the majority of us were going about our business, doing our jobs to the best of our abilities, unaware...­..people like him .Bernie Madoff and Andrew Krieger were creating a deadly potion in the financial world
(see "Infectious Greed"..
"patient zero"

http://www.amazon.com/Infectious-Greed-Corrupted-Financial-Markets/dp/0805072675 )

[Skeetshooter]

It sounds like we're scapegoating Bernie Madoff; the real Ponzi scheme is civilzation itself as practiced under free market capitalism, and it's been driven not by banks or Bernie, but by the greed of us all. Greed for a life we were willing to borrow, but not pay for.

[norkas]

WALL STREET is pro America----------- No way and they have not been in more then 50 years.

We are tired of wall street and the fact that it is located in NYC the third world country of billion and trillion coverups lets you know that they could do anything they wanted.

[unite4change]

Are you or anyone you know in foreclosure, tell them to ask their bank or lender to produce the note. Use the link below to get additional info:

http://www.youtube.com/watch?v=fx7YkiH79nw&eurl=http://www.abovetopsecret.com/forum/thread440137/pg1&feature=player_embedded

[RobinSeattle]

"Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on."

Those of you who have more knowledge of the financial markets than I do as well as those of you in law enforcement, doesn't the above quote smell of a pyramid scheme? Or am I just being paranoid?

[spinns17]

yes it is a pyramid sceme . i call it a game of hot potatoe,or music chairs .let the markets work now, i say.

[ThePeacemakers]

Yes, it's a pyramid scheme...t­he whole stock market. The top of the pyramid are the wealthiest families and the Ivy League co-horts that give each other jobs and the biggest loans. The ones with that use insider info (that's really illegal only if you aren't one of the "insiders") make off like fatter cats.

The average American belongs nowhere near the stock market without the support of corporate funds (matching dollars for 401Ks). And even that is in doubt to many.

[Morpheus008]

My 5 year old paints pictures by the numbers and we learn that wall street was trading by numbers that popped out of a black box that no one understood. The quants sit far from the trading desks of these firms. Using the tools from the quants, traders just pushed the computer keys and money flowed and flowed for everyone. Nice and simple until the black box ran out of common sense. The best and the brightest? Take a tour of some trading desks one day. Its sobering, very sobering.

[sposton]

Copula turned into copulation. ;-)

[RobinSeattle]

You mean "cluster copulation­."

[ObjectiveRealist]

The mathematical "innovation" is badly overstated by 'Wired' magazine; the Drake Equation http://www.youtube.com/watch?v==RB_v99FSTYc], "developed by Frank Drake in 1961 as a way to focus on the factors which determine how many intelligent, communicating civilizations there are in our galaxy" http://www.activemind.com//Mysterious/Topics/SETI/drake_equation.html], likewise proposes that a single probability, the one described above, is the product of a number of different probabilities multiplied together. Li's trick, ignoring correlations, *should* have included a feedback mechanism -- what mathematicians call "differential equations" are often suitable -- to model the effect of his new means of obtaining financial profit, on the real estate markets from which those profits were to be taken. Oops.

quote:
Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps.
/quote

It's only "ingenious" if it's sustainable. Evading reality is a gimmick, not an invention.

[Luv2Purple]

GREED and ARROGANCE. That's what created this economic disaster. I now own a small business but used to work in the investment field. I saw so much corruption it amazed me. Brokers doing cocaine, churning accounts to raise money for their drugs. Senior VP's of firms allowing criminal violations to pump up the firm's volume. The bankers and loan writers fraudulently created mythological numbers to get loans approved. All this was due to massive GREED and the ARROGANCE to believe they could get away with it. The Bush years led to an anything goes mentality. Those in corporate positions knew their backs were covered by the Republicans in office. This meltdown clearly shows one measure of how INEPT the bush team was. They RAPED our treasury. They VIOLATED our Constitution. The LIED and CHEATED and STOLE from America. Now we all have to clean up this putrid mess theat junior left us. And now we learn that Laura couldn't even be bothered to listen to our new President? What a pathetic lot of human beings have led us to this disaster!

[ObjectiveRealist]

It reminds me of Microsoft Windows ...

quote:
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..
Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?

They didn't know, or didn't ask. 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.
/quote

So simple that any idiot can use it, but so fragile that only an idiot would.

[rugbymom]

Why is HuffPost allowing the fraudulent spam ads on this page touting that alleged $12,000 stimulus payment? We readers rely on HuffPost for reliable economic news, not aiding and abetting fraudsters.

[Goliadkin]

Those ads are placed there by Google. If HuffPo had to monitor every Google ad, they'd be out of business. If you have a complaint, talk to Google.

[Shebeezies]

That was a good article -- but some of it is over my head. And that's the point isn't it? So many of us don't understand complex math that it's easy to slice and dice mortgages so as to sell us triple-A investments.

We trusted those ratings. Well, I recently found out that ratings firms like Moody's are paid by the entity submitting the instrument for a rating. Isn't that like the wicked witch paying the mirror to tell her she's the most beautiful? It also appears that those doing the ratings had no clue what were in the mortgage securities.

It's my opinion that the triple-A ratings lies to investors will be the biggest obstacle to a market turnaround. If investors don't trust those ratings, they won't invest. The ratings are meaningless at this point.

[mountainweb]

Harvard, Yale Princeton, Stanford, University of Chicago, etc, have never developed a method of teaching common sense, basic business ethics and honesty! Therein lies part of the current problem.

[G8R4Obama]

As a classically trained mathematician and long-time instructor (trained and teaching at U.S. public colleges and universities), it's interesting to me to see that all of these business leaders who attended the high-dollar, "best of the best" U.S. private universities (Harvard, Yale, etc.), including their vaunted business schools, are no better educated mathematic­ally/stati­stically than those coming out of "dumbed-down" public institutions. These business leaders also likely graduated from high-dollar private prep schools as well.

Given that both Harvard and Yale gave baccalaureate and graduate degrees to George W. Bush and many of these business leaders were graduates of business schools at private universities such as Princeton, Stanford, University of Chicago, etc., perhaps it's time that some of the bias in favor of these private institutions (and indeed, private schools generally) should be re-examined, since the results seem to show that these private schools don't do any better than public institutions in educating their graduates to understand basic mathematic­s/statisti­cs, or public speaking, for that matter.

[gemzenith]

Is that like paying too much for a knock-off designer Gucci bag?

[ObjectiveRealist]

Okay, for sake of discussion let's hypothesize that what you say is true; the more expensive and more prestigious colleges and universities graduate students who are, taken as a whole, not a whit more competent than the graduates of less expensive and less prestigious, mostly public, colleges and universities. Where were the graduates of those public institutions, the past 20 years (or just the past 8 years or any interval in between, as you prefer)? As 'DrVeruju' asked below http://www.huffingtonpost.com/2009/02/27/the-secret-formula-that-d_n_170713.html?show_comment_id=214181933#comment_21418193], where was the "due diligence"?

One does not expect exploiters to report themselves, one expects such from the honest competitors of those exploiters. The fact that the less prestigious graduates of public schools did not blow the whistle (or did not do so emphatically enough or eloquently enough to effect regulatory action) suggests to me either that (A) they didn't "get it" [contradicting your hypothesis of equivalent skill] or (B) they were "in on it" [which does not necessarily say anything about their competence, although the article suggests a large number of "black box" users, also contradicting your equivalent skill hypothesis].

quote:
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.
/quote

[RobinSeattle]

I've got a question for you GBR and I am being perfectly serious here:

Is the education at Ivy League colleges worth the tuition? With all the boobs you see nowadays in the media and in politics who have supposedly been to Harvard and Yale and etc, it strikes me that graduates of state colleges are likely to emerge from their educational experience just as intelligent, insightful and effective as a Harvard grad. Am I wrong?

It seems to me that the only benefit of going to the Ivy League is for networking purposes and social prestige. But substantively, they are no better than a Cal State grad. Is that fair?

[G8R4Obama]

That is fair - Harvard, Yale, etc., are primarily the social networking playgrounds for the rich and well-connected, especially the business schools. If you look at the major players in this economic fiasco (from Bush through Paulson, Geithner, and the CEOs of the major banks), you'll find that almost everyone of them attended or graduated from a private institution, mostly the Ivy League or adjunct institutions like Duke, Stanford, etc.

This tends to suggest that there are serious problems with the education provided at the Ivies and their private school adjuncts (Duke, Stanford, etc.), particularly in the business schools. Perhaps having a business degree from one of these institutions should be a cause for great concern, especially for government jobs, where they can enable and/or cover up for their B-school buddies when they act against the interests of the American people.