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.