Pax Arcana
The worst parts of our accelerating economic depression are pretty obvious — joblessness, retirement insecurity, loss of national confidence, eating sawdust pancakes, etc… But there are bright spots, if only you look hard enough. For one thing, it gives us a sterling opportunity to BLAME THE SHIT OUT OF SOMEBODY for our misfortune. Lord knows we love a good scapegoating in these parts.
Narrowing the list of suspects has proven difficult, however. First there were the predatory lenders, then the idiots who borrowed beyond their means, then the investment banking community that threw caution to the wind and let it ride on risky investments, then the regulators for failing to stop the nonsense before it got this far.
Unfortunately it’s really difficult to scapegoat a diverse and faceless crowd, so we looked for individual people to pin the blame on. Bernie Madoff worked for a while, but too many of the people he ripped off were seen as high rollers in an exclusive club — and let’s face it, they can go fuck themselves. Alan Greenspan was a popular target, too, but then he taught Luke to lift the X-Wing out of the muck in the Dagobah System and we forgave him.
Thankfully, Wired has found us another guy to blame. Now, I don’t want to get too excited here, but this guy might be perfect. For one thing, he’s Chinese, and you know how they are. Also, he’s a mathematician, and like most right-thinking Americans I have long distrusted anyone who tries to rearrange the numbers that God himself has put in order.
Meet David X. Li:
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 breakthrough of Li’s formula is that instead of modeling default correlation based on historical data of defaults (they were too rare to gather much data), he pegged correlation to historical price data. Wired says the flaw in this plan was that it assumed the market could accurately price the risk of default:
The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li’s copula approach meant that ratings agencies like Moody’s—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.
As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function.
Let’s cut that motherfucker!
David Li is like Jet Li, only with math. Pictured above, Jet Li.
Of course there are some that say Li isn’t to blame. After all, he simply invented a model that had limitations that should have been obvious to anyone with a firm grasp of the math and some common sense. Li himself told the Wall Street Journal in 2005 that Wall Street had misinterpreted the model and should not always believe the results it seemed to give. Of course the people who run banks are less into common sense and more into eating diamonds to make their own shit sparkle, so the results were pretty predictable:
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.
Anyway, at least we have finally found a root cause for much of the quagmire. And even if we can’t run Li out of the country (he already did that, moving back to China last year), at least we can finally ditch the faulty formula that he created. Next on the list, by the way, is Formula 44D. WHY ARE YOU HIDING FORMULA 44E WHEN YOU KNOW IT’S ONE LETTER BETTER?
Recipe for Disaster: The Formula That Killed Wall Street [Wired]
The shushy and well-balanced Mrs. Pax Arcana are alighting for the hills of Vermont later today to go skiing with my parents and some family friends. I don’t have anything clever or interesting for today’s random 10, but my mind has been on skiing all day so maybe I’ll just share with you a story from my days as a ski bum in the gorgeous mountains of Colorado.
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