The Formula That Killed Wall Street 561
We recently discussed the perspective that the harrowing of Wall Street was caused by over-reliance on computer models that produced a single number to characterize risk. Wired has a piece profiling David X. Li, the quant behind the formula that enabled the creation of such simple risk models. "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. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. ... [T]he real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust."
yeah...not so good (Score:5, Informative)
An interesting article, for sure. The issue with the Gaussian Copula model for pools of mortgages in CDOs is how sensitive they are to the assumptions of the model. If, for example, the annual growth rate of home prices is 2% instead of 10%, things look tremendously different. If correlations between housing prices in different cities is 50% instead of 10% -- disaster. The lack of stress testing of these models (checking what the results are for different inputs into the model) was a huge issue. Even if a model is decent (which in principle, copula models are), if they are too sensitive to inputs, then the prices it produces are not trustworthy. If the proper uncertainty was taken into consideration, then perhaps everyone would have been a little less gung-ho about CDOs.
Like the (worthless) Value-at-Risk figure, the (also pretty worthless in the end) Gaussian Copula was "easy" to understand. Given that the dynamics of financial markets are not simple and easy to understand, reliance on simple models that are easy to explain to the MBAs is probably not the best idea.
Re:Citation, please (Score:5, Informative)
Notice any similarities here [stlouisfed.org]? No, it's not a perfect fit, but it's the best I could do on short notice.
No one is saying that these models have nothing to do with malinvestment, but it's likely the inputs to the model are also obfuscated by distorted monetary signals
slightly inaccurate (Score:2, Informative)
FTA: "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."
The problem wasn't that the Triple A accounts were defaulting rather Moody's and other companies were stamping these ratings while they were combined with Triple B and other more riskier loans. All it took is several loans to fail while rotting the entire bushel and therefore the Investor is stuck with securities that have no value.
Re:G+A+M+B+L+I+N+G (Score:2, Informative)
You don't have them? Here in Australia, we pay CGT on any capital gain, but there is a 50% discount on that if you have had the investments for more than 2 years.
Re:Citation, please (Score:5, Informative)
You didn't LOOK at the graph, did you? That's my citation.
This [msn.com] is the last 2 years, with that "almost completely VERTICAL" drop.
This [msn.com] is a 2 year span at 1929, that little tiny blip on the left of your zoomed out chart. Notice how it's actually more vertical than the current drop?
This [msn.com] is your chart, redrawn to have a log scale vertical axis instead of linear. It looks like "now" is roughly comparable to 1938 or the early 1970s.
The Real Formula that Killed us All (Score:2, Informative)
The real root of this problem is and has been the federal government all along, and I'm not just talking about between the years 2000 and 2008. This goes back all the way to the 1970s, the Carter Administration. A very good article to read: http://www.cnn.com/2008/POLITICS/09/29/miron.bailout/index.html?iref=mpstoryview
Re:Citation, please (Score:3, Informative)
No, they were intertwined from the beginning, because they were the "safest" "surest" bets, and that's where all the wealth was going.
For those who fail to learn from history and are banking on Gold, keep an eye on this overpriced security when it is time to sell. When the silver market was cornered about 25 years ago, it happened once again. If you have Gold, now is a great time to sell to greedy investors.
Remember in any market, Buy LOW and Sell HIGH. If it is already high, don't buy. If it is already low, don't sell. Too many investors are not concerned about price, only the direction it is going. Late buyers are almost always stuck holding the bag on the way down.
If you follow Christianity at all, there is a prediction that a bag of gold will buy a loaf of bread.
Re:Nothing wrong with models. (Score:5, Informative)
Here's a link to Taleb's views on the financial crisis:
http://www.edge.org/3rd_culture/taleb08/taleb08_index.html [edge.org]
It's an easy read with nice quotes like " The banking system (betting AGAINST rare events) just lost > 1 Trillion dollars (so far) on a single error, more than was ever earned in the history of banking."
and "I have nothing against economists: ... But beware: they can be plain wrong, yet frame things in a way to make you feel stupid arguing with them. So make sure you do not give any of them risk-management responsibilities."
I can't find the quote (I think it is in "The Black Swan" or "Fooled by Randomness") but I'm pretty sure that Taleb's comment on Li's Cupola is that it is a pretty piece of mathematics whose essential problem is that it never worked for what people were trying to use it for.
Re:Nothing wrong with models. (Score:5, Informative)
This is why you can't build a model by looking at a list of numbers. You have to actually understand the source of the data. For example, to go back to the weather example: you can't forecast temperature by looking at a temperature log. You have to actually know something about the sun and oceans and wind and stuff. ;-)
It is foolish to look at investments abstractly. They're not just numbers. They're businesses (or houses or whatever) and they exist in the real world.
Some people say if you diversify enough, then you add so much noise that the sum becomes abstract, and you can start to treat it as a statistical problem rather than an intell problem. *sigh* Yeah, I guess you might get away with that.
For a while.
Re:Nothing wrong with models. (Score:5, Informative)
Maybe you should get the facts before opening your mouth. Less than 5% of the mortages failed.
The banks however over extended themselves with the hope of using future profit to pay past due debt. Think of it this way. Balance your budget so you can pay all your bills. Now go max out your credit cards, take a second mortage and buy a couple more cars. Does it make sense? If so you have a future in banking, or government.
Re:Economic Stimulus (Score:2, Informative)
Try the Chinese news sources, there were a few good pieces on Sohu and Xinlang when it was announced.
Though, what he should say is most of the stimulus package was already planned spending- they are simply rushing the schedule. Indeed, most of our own stimulus package (and many others) are mostly made up of already-planned packages, moving future spending to now rather than upping spending too much.
I'll dig through my history to get you citations, but much of the Chinese plan is provincial governments announcing they are breaking ground sooner rather than later, moving up a few billion in planned investments to today to absorb the newly-freed labor force from the export factories.
Re:Nothing wrong with models. (Score:4, Informative)
You are wrong to blame only the democrats.
The biggest share of the blame goes to Phil Gramm and two bills that GOP idiot got passed.
1. The Gramm-Leach-Bliley Act that rolled back the 1933 reforms and let us just REPEAT the same problem... morons... absolute morons
2. The Commodity Futures Act of 2000, which made CDOs and CDSs legal even though they were ILLEGAL in almost all states since the 1907 crash, and for good reason..
Then lastly, blame the GOP controlled SEC which allowed banks to leverage 33 to 1!!!!!!! in 2004.
Talk about absolute insanity. Nothing the Dems did in encouraging low cost home ownership is even in the same ball park as the stupidity I listed above.
Re:Yes, it bloody well is. (Score:2, Informative)
The money in the above economy comes from being able to grow food/produce energy and to be able to do something with it (cook the meal).
My example was to show that you can create and pay off debt and interest without having to magic more money into existence.
The graphs could be exponential because production is exponential.
What you may be alluding to is that the debt the food producer holds could also have been traded, as money. This HAS been magicked into existence and will continue to exist until the debt is paid or defaulted on.
Use the right graph to compare (Score:3, Informative)
Classical economics cannot explain what is happening right now. It's without precedent. There is a little graph I would like to show [msn.com] you...
Try looking at that chart in log base 10 format [msn.com] which will provide an apples to apples comparison. The dip in 1929 was MUCH bigger percentage wise than the one we are experiencing presently. Furthermore despite tremendous volatility we basically find ourselves in a decade of more or less flat growth. The DJIA is at roughly the same levels it was 10 years ago. This HAS happened before from the late 1960s to the early 1980s where the stock market remained flat for nearly 20 years.
Re:Nothing wrong with models. (Score:5, Informative)
Re:It wasn't li's fault because money is broken. (Score:3, Informative)
Go check the national debt (in any country) for the last couple of centuries. It's an exponential growth curve.
Are you looking at debt in real dollars or debt/GDP? Because if not, even a tiny constant deficit in real dollars would look like an exponential growth curve thanks to inflation. Here's [budget.gc.ca] what my country's debt looks like when you plot it as a percentage of GDP over the last 15 years. Hardly an exponential curve.
Re:The government shouldn't take any money (Score:3, Informative)
That Swedish formula sounds pretty sensible. In America, a congressmember (can't recall their name at the moment, but a Democrat, perhaps Barney Frank) proposed last month that any bonuses paid bank execs be paid only on a multiyear basis, and paid only in the bank's own stock, tying it to the longterm performance. Which would also require forcing holding the stock for a long time, like until retirement (or maybe 8-10 years, whichever is longer). Perhaps a combination, where the bonuses are paid into a "401k" investing in only the bank itself, for all employees, is the best value/protection for everyone.
So far, though, America's regulation of that nature is being discussed only for those banks taking the TARP government bailout money. It should be universal. Perhaps the new regulations that Barney Frank is writing now, for probably reintroduction perhaps this Summer, will govern all bank bonuses that way.
FWIW, the shareholders in these banks should of course be wiped out. They own nothing but epic debt, and ran their corps into the ground (violating "fiduciary responsibility" laws). The government should own these banks now, rehab them with capital and governance, then sell them off (with their shares of the debt they generated) to private owners once the industry is stabilized. And tax the entire banking industry what it cost to get their industry under control.