One of the most perplexing things I have not been able to get my arms around in the aftermath of the mortgage securitization/CDO collapse is: how did some many smart people get it so wrong?
Felix Salmon, one of my favorite econ writers and prolific blogger at Portfolio writes an amaziningly clear piece on this subject in Wired Magazine (I’m a long-time fan, but how many years can they go before they make money on it?) called Recipe for Disaster: The Formula That Killed Wall Street. It’s worth a thorough reading. I’d even consider reading it more than once.
It talks about the increased reliance on “brainy financial engineers” called quants and how they were focused on modeling risk without paying attention to historical trends as it relates to mortgage securitization (and we now understand the ultimate impact on housing markets).
In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled “On Default Correlation: A Copula Function Approach.” (In statistics, a copula is used to couple the behavior of two or more variables.) 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.
The phrase “don’t kill the messenger” (probably used by many ethical appraisers commiserating about delivering bad news to a lender who didn’t want to hear it) applies here. This engineer profiled created a formula and the masses loved for its simplicity and were blinded by high profits, never looked deep enough to understand its misapplication.
Nassim Nicholas Taleb, hedge fund manager and author of The Black Swan, is particularly harsh when it comes to the copula. “People got very excited about the Gaussian copula because of its mathematical elegance, but the thing never worked,” he says. “Co-association between securities is not measurable using correlation,” because past history can never prepare you for that one day when everything goes south. “Anything that relies on correlation is charlatanism.”
It seems that smart people do not have all the answers. Here’s a nobel laureate in economics on Wall Street whose firm just filed for bankruptcy.
I am not sure this article is about how quants didn’t take into consideration historical data in their analysis. The quants did the opposite — they assumed that what had been happening would continue to happen (eg housing prices will continue to go up). Taleb’s book, “The Black Swan” is largely an exercise about how historical data is often crap and our assumptions that the past is the best predictor of the future is highly suspect. Rather, the lesson is we shouldn’t rely on on a factor, that either is static or doesn’t change when conditions change, to connect the behavior of one or more assets. There probably is that one formula which connects all the dots — and is dynamic enough to account for conditions changing — but none of us will be smart enough to figure it out. You wouldn’t appraise a condo based on the relationship between condo and co-op prices that existed 10 years ago any more than housing defaults should be based on what we observed when prices were only going up. This isn’t about historical trends repeating — rather about the folly of historical relationships being used to anticpate the future.
Merton is known for a more famous blow-up: Long Term Capital Management.
My impression from the article is that Wall Street (or the quants) considered the connection between derivatives and the housing market to be nominal at most. As explained, it seems the major effort was to maximize profit while minimizing risk, which of course makes sense up to a point.
But, the derivatives were real smoky stuff from the beginning. I have no idea how to read the Li formula, but Salmon says there is no factor for cracks in the foundation. Then, in the ensuing euphoria of limitless profit, which is attributed to the Li way of figuring, consideration of the old foundations of collateral value, jobs and the ability of the borrowers to pay was eliminated.
Indeed, foundations the consistency and durability of meringue became preferred. If I understand the article correctly, the thing didn’t collapse. It was never there. Are there enough smoke and mirrors to start up the US/Global economy again? It seems the system chronically needs more than there ever can be.
Did the article wrap Jonathan’s arms around why so many smart people were so dumb? I think if you just follow the money you’ll be there. Who other than the hedge fund guy (can’t remember his name) had time to sit around and worry what was to become of it all when you had to jump in it to catch the big bucks?
I am not a math wiz, but anytime a Wall St. guy has me buying into a “copula”, well my liberal arts background tells me that this is just latin for a f*cking.