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The Almighty Buck Math Science

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."
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The Formula That Killed Wall Street

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  • by Shakrai ( 717556 ) on Tuesday March 03, 2009 @09:14AM (#27050041) Journal


    • by gravos ( 912628 ) on Tuesday March 03, 2009 @09:17AM (#27050063) Homepage
      There is nothing wrong with using a model. Models are good. They help us simplify the world so that we can understand it. For example, we have hundreds of competing climate change models that explain what is going on and predict what we should expect. We model the weather for forecasts. And so on.

      But. And it is a big but. You must know the limitations of your model. By definition, a model is a simplification of a complex phenomenon. That does not make it flawed: that makes it a model. Overreliance on the model is your fault, not the fault of the model.
      • by morgan_greywolf ( 835522 ) on Tuesday March 03, 2009 @09:24AM (#27050113) Homepage Journal

        However, there are some models that are just bad. If we take your climate change model example, simply going outside and measuring the temperature, and then comparing it to a temperature you took one the same day three years in a row and then plotting the statistical trend is a very poor model. Using that model, one might assume that we have drastic global cooling going on. It doesn't matter how much you rely on that model, if you rely on it all, you're going to be dead flat wrong.

      • by wjh31 ( 1372867 ) on Tuesday March 03, 2009 @09:28AM (#27050143) Homepage
        Even more important that the limitations of a model are the assumtions taken in developing the model and/or feeding the data into the model, these should always be made clear to whomever the user of the model is, and it is then up to the user to decide if those assumtions are reasonable for their use of it.
        • by umghhh ( 965931 ) on Tuesday March 03, 2009 @09:46AM (#27050295)

          it does not matter what model you use. Apparently they all created virtual worlds in big numbers (total value of derivatives and such is few times more than summed up gross domestic product of all countries on our planet) - this had to crash independently of the model - problem being that they used the same one. in other words: if all sheeple use the same model of reality then to make profit you need to use different one. Or to say it yet differently: if all sheeple do the same they create the bubble. nature of bubbles is that they burst when they reach physical limits of the stuff of which they are made. In our case it was human gullibility.

          • Preposterous! (Score:5, Insightful)

            by Comboman ( 895500 ) on Tuesday March 03, 2009 @10:47AM (#27050929)
            nature of bubbles is that they burst when they reach physical limits of the stuff of which they are made. In our case it was human gullibility.

            Preposterous! Human gullibility is one of the few things that has no limits.

          • by commodore64_love ( 1445365 ) on Tuesday March 03, 2009 @10:55AM (#27051023) Journal

            >>>they all created virtual worlds in big numbers - [the real world] had to crash independently of the model

            Maybe we should invent a game for these bankers. World of Real Estate - where the goal is to get as many poor people into as many houses as possible, without investors learning the real housing value is only half the retail value. That way they can watch their virtual bubble go "boom" without affecting the rest of us in the real world.

            • by peragrin ( 659227 ) on Tuesday March 03, 2009 @12:41PM (#27052461)

              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: (Score:3, Insightful)

              by nine-times ( 778537 )

              Trying to blame this economic/financial meltdown on the housing market is like trying to blame the cards when you lose at 3-card monte. Sure, they're involved in the problem, but the root of the problem is the game itself, and the guy behind the game.

              If it weren't housing, there would have been some other bull crap that everyone poured their money into because some financial model said it couldn't fail. There still would have been a bubble, and worse yet people would have still been involved in back room

              • Re: (Score:3, Insightful)

                >>>If it weren't housing, there would have been some other bull crap that everyone poured their money into

                Right. In 2000 it was internet companies. In 1991 it was savings-and-loans. And today, it's houses. They overvalued at $200,000 average when the true historical value is only $120,000. It was a bubble and it burst. Housing values plummeting (dropping about $40,000) is what caused banking stocks to lose value as investors fled.

                Also you can't blame everything on the model. If a banker

          • by OeLeWaPpErKe ( 412765 ) on Tuesday March 03, 2009 @11:01AM (#27051103) Homepage

            Exactly. EVERY model that only sees rising house prices during it's data collection phase WILL assume that house prices will keep rising, and therefore tell bankers that dodgy mortgages are ok.

            After all, as long as house prices keep rising, there is NO risk whatsoever in dodgy mortgages. Either you get the stated intrest (buyer pays mortgage) or you get the price rise of the house since the buyer bought it with your money (in the case of default) ... the risk of losing money in the deal is EXACTLY the chance that house prices drop. And house prices never dropped (significantly) in over 50 years ... obviously any statistical algorithm would have told you the risk was minimal.

            • by Sloppy ( 14984 ) on Tuesday March 03, 2009 @12:13PM (#27052051) Homepage Journal

              EVERY model that only sees rising house prices during it's data collection phase WILL assume that house prices will keep rising, and therefore tell bankers that dodgy mortgages are ok.

              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.

        • by dcollins ( 135727 ) on Tuesday March 03, 2009 @11:12AM (#27051265) Homepage

          Even more important that the limitations of a model are the assumtions taken in developing the model and/or feeding the data into the model, these should always be made clear to whomever the user of the model is, and it is then up to the user to decide if those assumtions are reasonable for their use of it.

          The problem with this is most people's "just give me what I need to get the job done today" attitude. I've taught statistics in community college for a number of years, and I grapple with this a lot. Difficult enough to get people to perform the calculations for z-interval/test. Almost impossible to get them to consider the meta-analysis on whether the test is legitimate (simple random sample, assessment of normal population if sample size small, known standard deviation, etc.)

          If most days they can get away with ignoring the model's assumptions, then folks wind up doing so, and then that knowledge degenerates. Ultimately the exceptional day that they need that skill, they don't have it. People function very, very poorly in relation to very infrequent (once a generation?), catastrophic events.

      • 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.

        There you have it. The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.

        • by Colin Smith ( 2679 ) on Tuesday March 03, 2009 @11:51AM (#27051721)

          It has been broken since 1694.

          Credit is an exponential function. Go check the national debt (in any country) for the last couple of centuries. It's an exponential growth curve. Credit has an exponential function built in to to it. When credit is created, it is created with an equivalent amount of debt attached, which pays interest.

          So you have : credit on one side | debt + interest on the other.

          So in order to work AT ALL, the supply of credit must grow exponentially every year to pay the interest on the previous year's debt. If it doesn't, there is a monetary collapse as the debt consumes the credit.

          Li's function simply allowed the process to continue until they ran out of people to lend money to. The problem has been there as long as money lenders.


          • Who modded this insightful?

            Lenders set the interest rate to be higher than monetary expansion. If they didn't do this, they'd lose real value.

            Money is credit. If the parent was correct, the money supply would be expanding at around a typical debt interest rate (say 5%). Yet there are many stable economies where this has not been the case for a long while--every economy that ever used gold, for instance. Moneylenders didn't conjure gold into existence by setting interest rates.

            The answer is even simpler than

          • Re: (Score:3, Informative)

            by shma ( 863063 )

            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 [] 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.

        • by smellsofbikes ( 890263 ) on Tuesday March 03, 2009 @12:16PM (#27052109) Journal

          >The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.

          Or the managers didn't understand their explanations -- or more likely yet, didn't *want* to understand their explanations.
          This doesn't look fundamentally different than the Challenger explosion: the technical staff knows there's a problem, keeps saying that there's a problem, but their upper management is invested in there not being a problem. It's really difficult to explain something to someone whose job depends on ideas that conflict with what you're explaining.

      • by ShakaUVM ( 157947 ) on Tuesday March 03, 2009 @09:47AM (#27050317) Homepage Journal

        >>There is nothing wrong with using a model. Models are good.

        Not in economics, they're not. The book Black Swan, which should be read by anyone interested in this topic, says that the hideous lie is that people claim that "they're better than nothing", when, in fact, they're worse than not having any model at all.

        The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model to quantify risk. IIRC, they used some sort of guassian model, taking the standard deviation of price movement as "risk". ( This of course looked good until, quite suddenly, it wasn't and there was an event that their model predicted shouldn't have happened within the lifetime of the universe (that's the problem with using gaussians instead of cauchy curves or other fat-tailed distributions) and the company crashed and burned, and did a lot of collateral damage as well.

        From the wikipedia article on LTC ( Merrill Lynch observed in its annual reports that mathematical risk models, "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."

        • Re: (Score:3, Insightful)

          by timeOday ( 582209 )
          It's not clear to me that computer models have made bubbles any more severe or frequent than they were beforehand. Depressions/recessions/"panics" were fairly common in US history until the great depression. After than govt adopted a stronger approach to regulating the markets through the money supply which decreased the frequency of recessions.
          • by e2d2 ( 115622 ) on Tuesday March 03, 2009 @10:42AM (#27050867)

            Considering how much impact human emotion and irrationality has on the markets I would tend to agree. Is today's bubble burst any more significant because of their use of models? Not really. The simple fact is they used a tool incorrectly and in their job, instead of sawing a finger off, they lose billions. But what drove this? Human emotions. Perhaps one day we can accurately model this, but I'm not so sure.

        • by commodore64_love ( 1445365 ) on Tuesday March 03, 2009 @11:02AM (#27051129) Journal

          >>>The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model

          Smart people always think they are so smart - until they discover that they too can make mistakes. I was just watching a video wherein a Cop explained how he outsmarted a lawyer - or more correctly the lawyer outsmarted himself. The lawyer was so absolutely certain that he knew the law & couldn't be caught, but then he bragged about it ("I know you can't trace sales in flea markets, because it's forbidden by law"), and off the cop went and bought the murder weapon. The lawyer was correct about the law, but overlooked the cop's willingness to do some old-fashioned footwork. Ooops.

          No matter how smart you are, you can still make mistakes. Your real estate model had a mistake in it - as you just discovered with this market bust.

        • by sjbe ( 173966 ) on Tuesday March 03, 2009 @01:33PM (#27053211)

          The book Black Swan, which should be read by anyone interested in this topic, says that the hideous lie is that people claim that "they're better than nothing", when, in fact, they're worse than not having any model at all.

          Say it with me: "All models are wrong. Some models are useful". A bad model CAN be worse than no model but it doesn't follow that all models are worse than no model. In fact it would be impossible to do anything without creating models of the world around you. You do it all the time without even being conscious of what your are doing. Newtonian physics is technically a less accurate model than Einstein's general relativity but it remains very useful for a wide variety of applications IF you understand its limitations. In the economic realm Modigliani-Miller [] and Black-Scholes [] are very useful models so long as you understand their limitations - and they do have limitations like every model.

          The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model to quantify risk.

          They didn't blow up because they had a model. They blew up because they had an inappropriately applied model. LTCM applied their models which apparently worked well for the narrow field of fixed income arbitrage [] to other areas like equity and currency arbitrage where the models assumptions combined with their excessive appetite for risk caused a catastrophe.

          You correctly note that they failed to account adequately for extremely rare events but had they stayed within their original model parameters (fixed income arbitrage) and more reasonable levels of leverage it likely would not have been a big issue. Instead they applied their models to inappropriate financial instruments and levered up heavily which greatly compounded the problem. Worse, the financial institutions which lent them the cash failed because, like in the current financial crisis, they did not adequately consider the risks they were taking.

      • by Anonymous Coward on Tuesday March 03, 2009 @09:53AM (#27050375)

        And it is a big but. You must know the limitations of your model.

        Is that you, Sir Mix-A-Lot?

      • Re: (Score:3, Funny)

        by corbettw ( 214229 )

        There is nothing wrong with using a model.

        I'll say, especially if you're a single guy just looking for a good time.

      • Re: (Score:3, Insightful)

        by renoX ( 11677 )

        The things is are the exception of a model 'normal' vs 'abnormal'?

        Benoit Mandelbrot and other think that the economy is 'wildly random', see this 2006 paper:,dwp_uuid=77a9a0e8-b442-11da-bd61-0000779e2340.html []

        Current crisis is one more proof that economy is 'wildly random' and that a stock market is even less reliable than a casino (where the randomness here is just 'normal'), so stock markets are like adding oil in a fire, they make crisis worse.

      • by maraist ( 68387 ) * <[michael.maraist ...]> on Tuesday March 03, 2009 @10:44AM (#27050905) Homepage

        I disagree. A model defines a static or pseduo-static system. It takes the non-linearities out of a system to make them as close to a linear, 1st order or 2nd order system as much as possible, such that you can produce matrices of inputs to outputs. All models also are accompanied by regions of legitimacy.. Namely the non-linear (or super non-linear) components press close to zero in these regions. Outside the regions, those non-linearities become too much 'error' for the model to be valid. Ideally, you can use separate models for different regions, and you have a nice continuum. But for that, you need to be able to first measure a region parameter.

        The problem here is that you're talking about a model for an investment strategy that is inherently non-deterministic, non-linear and more importantly recursively adaptive. The region you're operating in, is part of the outcome variables.

        Consider 3 investors each with equivalent information systems (including risk modeling, present-valuation, and product-viability forecast, whatever).

        In a vaccum, a model, assuming a static system might be appropriate. Balance-sheets, due-dilligence, market trends, geo-politics, etc. are all valid. But consider that the other two investors have the power to effect the system. Consider that they can manipulate, propping up an industry, or willfully collapsing it (over-buying, or short-selling). By acting irrationally in the short term, they can sufficiently distort all the measureable parameters to your equation to force you to act inappropriately.

        Thus by taking a short-term hit, one of your competitors can gain a much greater long term advantage.

        Thus, KNOWING that you use certain models, allows your competitors to game the system.. Note they need to have significant resources in which to do this.. But the old addage that you need money to make money exactly applies here. Why would a wealthy person only accept 3% to 15% ROI when they can control certain markets and earn 500%.

        Now explicit market manipulation is illegal. But there is nothing illegal about gambling (sadly). Thus betting against the 'known wisdom' is perfectly legal.

        So now you have two camps.. Conservatives that trust their models (blind to the fact that people can manipulate them in the long-run). And advanced speculators who bet against the market. Over time, if one is considered unbalanced, then more and more itchy investors will switch from one side to another.. Until an equilibrium is reached where any and all metrics become meaningless - An equal proportion of investors will honor measureable data as there are people betting against the data. The raw data therefore has no material impact as to the future valuation of an asset. Note, as such a system evolves, the 'measureable' data will change over time. Namely instead of measuring the viability of a company, you measure the prospects for news and bet based on historical trends of the news outlets, not whether the news is good or not.

        This can only happen if you have a gaussian distribution of strategies. Namely a massive pool of investors operating independently with an equal liklihood of choosing one of an infinite number of strategies, such that an equal ration of buy/sell decisions could be produced.

        You can think of it as the classic "Is the poison in your drink or mine" attempt at gaming the system. Any number of strategies can be employed to decide which action is best, but the more you employ, the greater resemblance to random-decisions is created.

        The short is, no formula can adequately valuate a market that is based on such a recursively adaptive system. Determining the risk of a car accident, a plane accident, a flood, etc. These are deterministic to a large degree (short of global warming and legalizing pot). But the college that first advocated investment strategies based on such finite metrics should be unaccredited in my view. A car owner isn't trying to game the insurance market, but a stock holder or company seeking stock value is.

    • by aurispector ( 530273 ) on Tuesday March 03, 2009 @09:43AM (#27050267)

      Greed is a motivator. Greedy people will work hard to acquire money. Capitalism & free enterprise allow a society to harness greedy people for positive ends like the creation of jobs to produce valuable goods and services. This is a good thing. Unfortunately, greedy people are not necessarily *smart*. And even the smart greedy people are not necessarily *correct* when they do things a particular way.

      The story sums it up nicely - this formula oversimplifies a complex market creating a classic bursting bubble. There's an economist named Taleb [] lecturing about how the market will basically always be more complex than you think.

      The best part about his message is in not trusting your data too much. I think of this every time people start talking confidently about geoengineering. We don't know as much as we think we do.

  • by Samschnooks ( 1415697 ) on Tuesday March 03, 2009 @09:15AM (#27050047)

    Enter Li, a star mathematician who grew up in rural China in the 1960s. He excelled in school and eventually got a master's degree in economics from Nankai University before leaving the country to get an MBA from Laval University in Quebec. That was followed by two more degrees: a master's in actuarial science and a PhD in statistics, both from Ontario's University of Waterloo.

    He has more degrees than a thermometer!

  • Citation, please (Score:5, Interesting)

    by dlcarrol ( 712729 ) on Tuesday March 03, 2009 @09:16AM (#27050057)
    In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

    Citation? Booms and busts are caused by, respectively, expansion and contraction of the money supply (usually in the form of bank credit), often accompanied by manipulated interest rates. The formulas used by lots of investing firms could cause clusters of errors, but the extent of types of companies (and governments) affected points to a more Austrian-style, systemic boom/bust rather than a single-(important-)sector miscalculation.
    • Re: (Score:3, Interesting)

      by Dunbal ( 464142 )

      Classical economics cannot explain what is happening right now. It's without precedent. There is a little graph I would like to show [] you...

      It's interesting to note the near exponential shape of the graph pre dot com bust era, and how the exponential part resumes around 2005. Now, imagine the impact on everyone with money to invest, from corporations to banks to retirement and pension funds faced with a choice. You can earn 4% or less, per annum, in bonds or (LAUGH) CD's, etc. OR you ca

      • Re:Citation, please (Score:5, Informative)

        by dlcarrol ( 712729 ) on Tuesday March 03, 2009 @09:46AM (#27050301)
        With respect, classical economics and Austrian economics are not quite the same thing, and the Austrian school of economics explains this quite well.

        Notice any similarities here []? 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
        • by Dunbal ( 464142 ) on Tuesday March 03, 2009 @10:12AM (#27050557)

          With respect, classical economics and Austrian economics are not quite the same thing

                Sorry, I'm not an economist. Therefore if I said something incorrect through ignorance I apologize. I merely wished to emphasize that truly we live in interesting times. I think it's when the world (and especially the consumer intensive US) finds out we've bumped into the limits of our resources on this planet. We can't all have an SUV. We can't all waste electricity. We can't all have a worry free life, and independence, and a nice house, and a big screen tv, and eat in good restaurants, etc. The boom in commodity prices - in part fueled by massive demand from the BRICIT countries that are also expanding their middle classes and trying to adopt an "American" standard of living - has another side to it. Not only was demand increased - but supply is at or near maximum. There IS no more copper, there IS no more gold, platinum WILL run out in 20 years or so, etc.

                Therefore commodities (including petroleum) priced themselves right out of the market. This triggered, and is triggering, financial default from everyone who was living "the dream" on credit. And now the cards keep tumbling. Oh, we will reach a new equilibrium some day - but our population keeps expanding, and those resources keep getting more scarce.

          • Re: (Score:3, Interesting)

            by FiloEleven ( 602040 )

            I keep posting the link in my sig when I feel it is appropriate, and while I fear I'm beginning to sound like a broken record, now is one of those times.

            The Crash Course [] is a 20-part video series, most chapters under 7 minutes long, that explores the various issues that are all coming to a head, including peak oil, world population, global warming, the money supply, and a few others. It's full of exponential curves that would be exciting except for the ceilings they are approaching at an increasingly alarm

      • Re: (Score:3, Informative)

        by Technician ( 215283 )

        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

      • Classical economics cannot explain what is happening right now. It's without precedent. There is a little graph I would like to show [] you...

        Try looking at that chart in log base 10 format [] 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.

  • One word (Score:5, Insightful)

    by DigiShaman ( 671371 ) on Tuesday March 03, 2009 @09:19AM (#27050071) Homepage


  • by jace48 ( 566123 ) on Tuesday March 03, 2009 @09:19AM (#27050077)
  • by Rosco P. Coltrane ( 209368 ) on Tuesday March 03, 2009 @09:26AM (#27050121)

    - Don't spend the money you don't have
    - Don't do credit unless you absolutely have to

    I know I know, Wall Street are these big finance hotshots who do complicated things that have nothing to do with personal finances, but what is it they do apart from speculating and playing with money they don't have, or other people's money? They just hide that simple fact under abconce financial constructs, but that's all they do in the end.

    Bring back some morals sanity in the credit business and there won't be anymore crisis of this magnitude. No need for math here...

    • Re: (Score:3, Insightful)

      by internerdj ( 1319281 )
      While I agree with you on a personal finance level and that a lack of moral sanity is a problem on the larger scale, the personal goals at a larger level would constrict the economy. In fact it is what is happening right now: the banks unsure of what their holdings are really valued at are unwilling to loan money. Due to that unwillingness to loan, many businesses are struggling to obtain the money they don't have yet, but businesses rely on credit to at the very least even out the financial bumps in the
      • Re: (Score:3, Insightful)

        by Hatta ( 162192 )

        While I agree with you on a personal finance level and that a lack of moral sanity is a problem on the larger scale, the personal goals at a larger level would constrict the economy.

        No. Responsible behavior by our financial institutions would not constrict the economy. It would simply not artificially inflate the growth of the economy. This is a good thing, artificial growth cannot continue forever, and we all suffer when the market corrects. Slow and steady wins the race.

    • Re: (Score:3, Insightful)

      by Abcd1234 ( 188840 )

      - Don't spend the money you don't have

      So... no mortgages for anyone, then? Or small business loans? Or raising funds for large capital expenditures (say, building a new chip fab)?

      - Don't do credit unless you absolutely have to

      Wait... doesn't that fly in the face of your first "rule"?

      Here's an interesting rule about absolutisms: they're rarely all that absolute.

      As an aside, leveraged investment, which includes all the things I listed above, among many other things, is a very good thing. The problem is, y

  • by computersareevil ( 244846 ) on Tuesday March 03, 2009 @09:26AM (#27050123)

    It isn't killing Wall Street. Those jokers are getting $billions$ in free money.

    It's killing us, the people who work for a living and have to provide all those $billions$ or suffer the inflationary consequences when the Feds just print it.

    • by Notquitecajun ( 1073646 ) on Tuesday March 03, 2009 @09:35AM (#27050201)
      A BIG part of the problem is Washington's tendency to reward economic losers at the expense of the people who know what they're doing, and I'm NOT just talking about the poor. There are plenty of the high-salary types who have some sort of governmental loophole or backing that saves them when they screw a big company up.

      It's one reason we don't need to be bailing out bad companies, and instead rewarding or backing up the good ones with incentives and tax cuts so that they can really succeed and push forward.
      • Re:Economic Stimulus (Score:3, Interesting)

        by conureman ( 748753 )

        In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?

        • Re:Economic Stimulus (Score:5, Interesting)

          by Hemogoblin ( 982564 ) on Tuesday March 03, 2009 @10:07AM (#27050517)

          In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?

          Not the millions of migrant chinese workers who have lost their jobs, which will probably also cause civil unrest. Also, the Chinese holding trillions of dollars in U.S. treasuries will also be slightly annoyed when the U.S. government inflates away their debts.

          Finally, the vast majority of China's stimulus package was already announced before this major recession. You have the order backwards.

          • Re:Economic Stimulus (Score:4, Interesting)

            by mike2R ( 721965 ) on Tuesday March 03, 2009 @12:29PM (#27052283)

            Also, the Chinese holding trillions of dollars in U.S. treasuries

            You know I've been hearing this for years, so I actually looked it up. As far as I can see [] China "only" has about $700 billion of US government debt. A huge amount certainly, but really enough to cause the kind of financial armageddon that people talk about?

  • by ahodgkinson ( 662233 ) on Tuesday March 03, 2009 @09:29AM (#27050149) Homepage Journal
    Engineers are taught: Your model is only a model, and does not necessarily capture the complete behavior of the thing being modeled. You must understand the limitations of the model.

    That Gaussian curves are a poor model for unlikely events has been known for quite some time. This is best explained by Nassim Taleb in the following books:

    • Fooled by Randomness
    • The Black Swan

    His main thesis is that the markets are essentially random and are basically impossible to predict in any meaningful way. Further there are unlikely unknown unknowns can cannot be predicted until the they occur, usually with disastrous consequences.

    • by nedlohs ( 1335013 ) on Tuesday March 03, 2009 @09:52AM (#27050369)

      Except that the current economic woes don't fit into Taleb's "Black Swan" category. It was obvious that his was going to happen to anyone with one brain cell 5 years ago, and to anyone with two brain cells a decade ago.

      I'm pretty sure I heard an interview with Taleb in which he mentioned this. Of course his strategy of investing to break even in the expected conditions and make out like a bandit when a black swan appears would have done very well as risk was repriced.

    • by Wite_Noiz ( 887188 ) on Tuesday March 03, 2009 @09:56AM (#27050397)
      As someone who works with traders, I'd say that the randomness/unpredictability of the markets is part of the reason *why* traders are so reliant on their models.
      Otherwise, it's all just blind gambling (which it isn't far off, anyway).
      The advent of full on algo trading means that random events in the market have the ability to wipe out tons of capital because the models predict (e.g.) a global crash when it's just a blip. (Extreme example)

      The other part of the problem is that traders are nowadays just glorified clerks in that all (well, 90%+) of the actual calculation and predictive work is done by complex platforms (or Excel), so they don't really care or have exposure to the real risks behind their trading.
      Coupled with the huge bonuses they used to get (I'm in London where bonuses are being denied; is it the same elsewhere?) as long as they showed *quantity* of trades, it was always a recipe for disaster.
    • The contribution of mathematical models to the present crisis has been vastly overblown. The breast-beating and mea culpas from the likes of Derman and Wilmott are self-flattering: after all, if you caused the problem, you must be important! In reality, the quant is at the bottom of the pecking order on most trading floors. The people who trafficked in securitized garbage did so not because they were fooled by their models, but because they were paid to. You can't tell me that the guy who lent $750,000 to a

    • Re: (Score:3, Insightful)

      by Comatose51 ( 687974 )
      I think you may have misrepresented his views or oversimplified them. Part of Taleb's claim is that these models are based on historical data which doesn't account for future disastrous events. He gives the example of a turkey, who having been fed for many days, would conclude that the humans is his friends based on its historical data. He's right up until the day before Thanksgiving. Worse yet, these models give traders a misguided sense of security so they make huge bets that would give them pennies f
  • yeah...not so good (Score:5, Informative)

    by portscan ( 140282 ) on Tuesday March 03, 2009 @09:30AM (#27050169)

    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.

  • by ProfM ( 91314 ) on Tuesday March 03, 2009 @09:33AM (#27050185)

    This story reminds me of "Long-Term Capital Management" story back in the late 1990's. []

    These guys did the EXACT same thing using computer models to predict what funds they should be investing in so that they never have a loss ...

    Unfortunately, they were bailed out, but folded in 2000. []

    There was a PBS special about these guys and the computer models they used. []

  • by conureman ( 748753 ) on Tuesday March 03, 2009 @09:40AM (#27050247)

    My grandfather woulda thought this guy was a Red infiltrator. Good job if he was.

  • by Anonymous Coward on Tuesday March 03, 2009 @09:43AM (#27050269)

    This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.
    It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

    Hayek. Nobel Prize Lecture, 1974.

  • by mothlos ( 832302 ) on Tuesday March 03, 2009 @09:46AM (#27050303)

    This seems to be a popular story for the past few weeks, but it is a mistake to blame the statistical method used. The problem wasn't that they were all using the equaton, it is that they were all mis-using the equation. All statistical tools can fail to be sensitive to certain aspects which may be critical to an application.

    People in finance applied these statistical tools believing that they would be able to master risk with them. Unfortunately, they made assumptions that certain things would continue to be the same in the future, plugged the information into the equation, and now science was telling them that everything would be alright. If everybody on Wall Street was making decisions based on the Magic 8 Ball would we blame the ball or the foolishness of those misapplying it?

  • Yeah right. (Score:4, Insightful)

    by msormune ( 808119 ) on Tuesday March 03, 2009 @09:51AM (#27050353)

    Complete BS. The Wall Street knew all along the bubble would burst, and cashed in all the time while knowing it. In essence, they kept milking while perfectly well knowing it would come to a disaster.

    There's a crisis every 10-15 years. Huge crisis in every 30 years. How can some one be that gullible as to believe the economics would NOT see this coming? Of course they did, but saying and doing something about it would be bad business. It would scare off the suckers... who end up paying the bill.

  • by OneSmartFellow ( 716217 ) on Tuesday March 03, 2009 @09:51AM (#27050363)

    1.) Encourage Joe the delivery man to re-mortgage up to %125 of his property value
    2.) Transfer the mortgage to the in-house hedge fund.
    3.) Encourgae Joe the delivery man to use his funds (from the re-mortgage) to purchase shares in the hedge fund
    4.) ???
    5.) Profit

    Sorry, I'm new to this meme.
  • by mcgrew ( 92797 ) * on Tuesday March 03, 2009 @09:54AM (#27050391) Homepage Journal

    The love of money is the square root of all evil.

    This formula may have and probably did help crash the world's stock markets (yesterday's Dow Jones was HALF of its worth at its high last June), but the reality is that high energy prices drained everyone's wallets.

    When Bush took office, gasoiline here in Springfield was $1 per gallon. At Wall Street's high last summer it was nearly $4.50, over four times as high. We talk about elders living on a "fixed income" but the fact is almost all wage earners' incomes are fixed. We can't demand raises or overtime and have to live within our means. But when that $20 per week gasoline budget quadruples to $80 per week, with heating and electric costs going up as well, that takes money out of other aspects of the economy. Sooner or later people are over their heads and behind on bills, and things spiral out of control.

    The result of that and other factors is what you see now.

    Happy square root day, everyone.

  • by Max Romantschuk ( 132276 ) <> on Tuesday March 03, 2009 @09:57AM (#27050417) Homepage

    Any sufficiently complex system should be heterogeneous, so that not all parts of the system can fail due to the same flaw.

    Any homogeneous system will inevitably be at greater risk of failure due to a flaw in the common "gene pool" so to speak.

    Biology, computers, economics, politics... I could go on.

  • by chelsel ( 1140907 ) on Tuesday March 03, 2009 @09:57AM (#27050421) Homepage
    "produced a single number to characterize risk" isn't this what Equifax, TransUnion, Experian and others have been doing for decades?
  • by Ronald Dumsfeld ( 723277 ) on Tuesday March 03, 2009 @10:08AM (#27050523)
    When I think of Wall Street, one of the first things that springs to mind is a photo I saw sometime late last year. In it, a protester is holding a home-made sign with the text, "Jump you bastards".

    They didn't jump, and I have only seen one or two articles mentioning trader or banker suicides.

    I can only conclude that those working on Wall Street are so utterly detached from the riskier-than-roulette gambling they were engaged in, that the losses are meaningless to them. It wasn't their money, they had no real stake in any investment being viable in the long-term, and - what's worse - is I see zero effort to move away from the "must profit in the next quarter" philosophy.

    I really don't care about any 'magic formula', and I doubt you can squarely lay the blame for the current problems at the foot of any. The issue is the drive to profit right now.

    What is perhaps more worrying for the average person is that governments have been sucked into this mindset too - but perhaps not surprising when the only people who can get elected are those who have made the money to campaign from their own short-term investments, or by accepting backing from others who did so in exchange for perpetuating the system.
  • by Lawrence_Bird ( 67278 ) on Tuesday March 03, 2009 @10:09AM (#27050527) Homepage

    So if the Street were all one way (hypothetically) then the
    counterparts are the otherway.

    The genesis of this debacle lies as much with the buy side
    - pension funds, mutual funds, etc who were willing to buy
    anything so long as they got a pickup of 15-25bp over the
    comparable treasuries. In effect, they asked for this
    stuff and they got it.

    As to VaR - its a great way to model relatively stable
    markets and to quantify short term risks of a large move
    based on recent historical returns, volatility and asset
    correlations. It's not meant to predict trends nor to
    quantify 'what if the market for X tanks every day for Y
    months'. Thats what managers and traders are for - to
    realize there has been some change, perhaps fundamental,
    which will have a long term negative effect on their
    positions and to take what action is necessary to reduce
    that risk. Instead, they froze.

  • by Doc Ruby ( 173196 ) on Tuesday March 03, 2009 @10:34AM (#27050775) Homepage Journal

    Yeah, "complex mathematical model". Tell it to the judge.

    They did indeed use this model, and the work of many other PhD mathematicians, physicists, and other geniuses. But any of the bankers could have looked at this whole class of derivatives from mortgages and seen the basics that make the model a joke. They sold millions of mortgages and other loans to people using artificially low initial interest, to get people to take the loans, but which ballooned to rates they couldn't afford, so they'd have to default. Inevitably, a large percentage would certainly default. A losing bet overall for banks holding those loans. Meanwhile, each bad loan was "good" because the banks could sell many times the number of derivatives on it. Which was "good" because they got paid for the derivatives they sold, but was much more "bad" because the derivatives would cost the issuing bank many times more when it came due. The derivatives came due when the mortgages defaulted. Which was inevitable.

    So whatever "gaussian copula" model they use to convince each other it was good, basic business sense would have insisted that the business was bad, horribly bad. These bankers don't get paid for discovering new math, they get paid for their years of experience and business sense. So they should have laughed this model out of the boardroom, even if they didn't understand why it was wrong. They should have known it was wrong, as the past few years proved beyond any doubt. But they embraced it instead, and centuries old banks like Lehman Brothers have gone down, taking us with them (and no end in sight).

    Because ultimately, the model was a way to delay the costs of a business that paid some fat revenue up front. Since bankers are paid in huge bonuses for the initial year of revenue, and then leave before the bills come due , they got paid to make those bad deals, because they paid off up front, before costing many times more their benefit a few years later. By which time the bankers are gone with their early bonuses. Which have a lot more buying power when the economy collapses, and everyone else is holding merely the debt they created.

    Nice work, if you can get it. Since they ruined the banking system and everything else, no one can get any work at all.

    These people are holding the money. Their bonuses often equal the losses that destroy their bank. The government should take back that money to pay for fixing and repairing some of the mess they made. "Fiduciary responsibility" is a requirement of bank execs, and these violated that by the $TRILLIONS. Make them pay for what they did. That's a simple model anyone can understand. Not just a complex conjob to hide behind.

  • Oh Please... (Score:5, Interesting)

    by Arthur B. ( 806360 ) on Tuesday March 03, 2009 @10:37AM (#27050811)

    There's nothing advanced or innovative about a gaussian copula. It's a very simple mathematical trick, it doesn't say anything about finance in itself. It's a programming trick to go from a uniform distribution on a cube (easy to generate, run rnd() for each coordinate) to a multivariate gaussian with a specific covariance matrix. The way to do it is cholesky decomposition. This is OLD stuff.

    Li's paper is a clever way to measure default correlation using correlation matrixes from asset returns. It's quite clever, and yes it's a pretty good model (more on that later)

    This is not journalism, this is a bit of shit where the author decided having an "evil formula" would be cool. Look there's an "equal" sign, how can they be so sure... pffffffffffffffff.

    I said it was a good model, yet it's been proven wrong hasn't it? Well, first of all, what has been shown to be wrong is the guesstimate of correlation that was input into the model. G.I.G.O

    Plus, if you price a fixed income product and it produces higher than market return, you will borrow short term funds to invest them in it. In a free market that quickly drains the pool of saving and raises short term interest rate. Sure you end up losing money but no catastrophe. In a federal reserve system, well the short term rate stays what the fed says it should be and everyone piles on the arbitrage, creating sky high leveraged position.

    Yeah the formula can be misleading, but for a true catastrophe, you need a federal reserve.

  • Let's not forget (Score:3, Interesting)

    by gloryhallelujah ( 1111157 ) on Tuesday March 03, 2009 @10:38AM (#27050821)
    amidst all this chatter about economics and models that what we're really talking about here is gambling. The wealthy made bets on red and black and then they bought insurance on their bets and the bets of others. Ultimately, they gambled that the Casino (America) and it's croupiers (AIG, Morgan Stanley, Citi, etc.) had assets sufficient to pay off the bets. They were wrong and they lost but refuse to hand over their chips. The real problem is that we don't have a couple of guys with baseball bats to do the collections.
  • Greed (Score:5, Insightful)

    by Arthur B. ( 806360 ) on Tuesday March 03, 2009 @10:38AM (#27050823)

    Blaming greed for a financial crisis is like blaming gravity in a plane crash.

God help those who do not help themselves. -- Wilson Mizner