Another piece of the economic puzzle: Seeds of the fall

[unixronin]

Ever heard of a Gaussian copula function?

It turns out to be quite an important thing.  You see, it's a major piece of why the financial sector imploded.

To start with, the inventor of the formula, David X. Li, based his formula on a simplified model of the economic market and an implicit assumption that the market can price the risk of loan default correctly.  By disregarding a lot of the small details, he came up with a single formula that offered a single, simple risk correlation number for almost any pool of securities.  And thus was born the era of the CDO, the Collateralized Debt Obligation.

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.

But the devil is in the details, and the CDO/CDS castle was built on the sand of the idea that correlations are stable, constant, and predictable.  Despite repeated warnings that the copula was "not suitable for use in risk management or valuation", they kept using it anyway — because the piles of ultimately imaginary money meant more to them than warnings from naysayers.

In hindsight, ignoring those warnings looks foolhardy.  But at the time, it was easy.  Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe.  Besides, they were making too much money to stop.

Li himself was among those giving the warnings.  But none of the fund managers and debt traders listened ... until the mortgage bubble burst, the correlations went negative, and suddenly the bottom fell out of all the CDO/CDS instruments.

"Li can't be blamed," says Gilkes of CreditSights.  After all, he just invented the model.  Instead, we should blame the bankers who misinterpreted it.  And even then, the 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.

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."

The writing's been on the wall for anyone to see for years, as in this article from September 2005:

"The most dangerous part," Mr. Li himself says of the model, "is when people believe everything coming out of it."  Investors who put too much trust in it or don't understand all its subtleties may think they've eliminated their risks when they haven't.

Much of that money is riding on Mr. Li's idea, which he freely concedes has important flaws.  For one, it merely relies on a snapshot of current credit curves, rather than taking into account the way they move.  The result:  Actual prices in the market often differ from what the model indicates they should be.

As with any model, forecasts investors make by using the model are only as good as the inputs.  Someone asking the model to indicate how CDO prices will act in the future, for example, must first offer a guess about what will happen to the underlying credit curves - that is, to the market's perception of the riskiness of individual bonds over several years.  Trouble awaits those who blindly trust the model's output instead of recognizing that they are making a bet based partly on what they told the model they think will happen.  Mr. Li worries that "very few people understand the essence of the model."

The "incident" in May 2005 should have been a very clear warning that the investment structure was built on unstable ground.  But traders and investors dismissed it as a fluke and went on just as they had been, assuming that it was a one-off event that would never happen again.  The $275 billion of CDOs — "collateralized debt obligations" — on the market in 2000 grew to $4.7 trillion by 2006.  Worse, the $920 billion in outstanding credit default swaps ballooned to $62 trillion by the end of 2007.

Then house prices stopped rising... and here we are.

Comments

[rosencrantz23.livejournal.com]

That article is a fascinating read, isn't it?

So many ways we all deliberately ignored the inherent risks of what we were doing.

To quote my friend dosferatu, "Only though the coordinated efforts of the world's smartest people could we have achieved something so monumentally stupid."

[unixronin.livejournal.com]

Fascinating in a trainwreck sort of way...

[rosencrantz23.livejournal.com]

agreed. And now if we can figure some way to untie ourselves from the tracks...and maybe even re-track the locomotives?

[ithildae.livejournal.com]

The only thing more scary that a mathematician (economist) with a new model, is someone trying to use that new model without understanding it. This whole thing started back when corporations abandoned five and ten year plans in favor of one year plans, and then next quarter plans. Profit for the next reporting period became the driver for business. I am amazed we have lasted this long before things got busticated. (Of course, that means that we are in a bigger potential hole...)

Still, I think that people are much smarter than we (or the politicians) give them credit for. American cussedness and rock-headed common sense are going to get us out of the problem.

[unixronin.livejournal.com]

This whole thing started back when corporations abandoned five and ten year plans in favor of one year plans, and then next quarter plans. Profit for the next reporting period became the driver for business.

Yup. You can thank the Harvard Business School and its MBA program for that. I'm still of the opinion the Harvard MBA program is among the most destructive single things ever to happen to American business and industry.

[ithildae.livejournal.com]

I think it is more than the Harvard MBA attitude infecting business. The investing climate demanded a different kind of result from their investments. Stocks have climbed very consistently for the past 30+ years. Stockholders demanded growth, and fast. The only philosophy that was capable of supplying the demand was the Harvard MBA approach. It kicked risk down the road to the next CEO, and hit quarterly targets. Tenure was shortened to a few years, and, unless CEO's are leaving for a new home, their career is basically over once they leave. So salaries increased to compensate a foreshortened earnings path.

It all comes down to doing what the company owners (shareholders) want. Except that the strategy is not sustainable, it is a great plan. We are seeing the artificial inflation of stock prices coming out of the market now. With pensions gone, the average American now has most of his retirement invested in stocks. I thought the crash would come around 2011, just before the bulk of the baby boomers retired in 2013. I was off. Stocks are not, and never were, for people that cannot afford to lose what they invest there. That part is gonna hurt for a couple of decades. Social Security is going to take it in the shorts.

[skellington.livejournal.com]

I'm not sure how Social Security is going to be impacted.

If lots of people are unemployed, they reduce their future benefits. Net wash for social security.

If lots of people decide to work longer, more money is paid into social security and they wait longer to retire. Net wash for social security.

And social security didn't have any money invested in the stock market, so..

[metahacker.livejournal.com]

GIGO.

This is what happens when you hide truthiness behind a bulwark of "science", this time in the form of numbers that trivialize complex situations.

...just another case of "lies, damn lies, and statistics", and of people *believing* them because they want to be richer. It's the Oldest Con, except everyone's complicit in it -- it's like a traffic jam, apparently causeless but emergent from bad local behaviors.

Hmm. Okay. "Tailgating in the global economy" is going to be my new metaphor for why we're in a trillion-car pile-up right now.

[unixronin.livejournal.com]

QOTD :)

[ithildae.livejournal.com]

Love it!

[house-pundit.livejournal.com]

Finally. Something that makes sense.

My axioms for the market as well as politics--any system where people make decisions as a mob/mass:

I. People are stupid.
II. Eventually they catch on.
III. People tend to get stupid in a herd movement, and then catch on in a herd movement.
IV. When people are being stupid about something in the larger economy, bad things build up. When people catch on all at once, the bill comes due.
V. When people are being stupid about something in politics, people get harmed, repressed, ruined, or killed--generally varying proportions of all four.
VI. Human societies go in waves, sometimes getting more excessive with the stupid than other times.
VII. Human societies, once on that road, only move away from the hot stove of excessively collective stupid when they get burned bad enough to get jarred out of their various self-deceptions and back into reality.

Observation: We live in a time of excessive, collective stupid.

Conclusion: Hold onto your hat with one hand, your ass with the other, and make sure the latter is well covered. If you can.

[skellington.livejournal.com]

The thing is, this doesn't look a whole lot different than any of the other bubbles in the last 300 years or so. See specifically the crash of 1929, but the 1873 panic look pretty similar too.

In theory, there were supposed to be all kinds of regulations put in place to prevent it, but using magic math, and pushing for deregulation, we got around all of those restrictions.

Yes, the exact mechanism is important, so we can plug that whole in the regulations. But mostly this is just another example of not learning from history, I think.

[ithildae.livejournal.com]

There will always be ways to game any system that has enough flexibility to adapt to new market conditions. Unless we want a complete "command and control" economic system to live under, we have to accept that the infrastructure is vulnerable.

Corollary, Regulation will never be able to keep up with a dynamic, growing system.

We are supposed to have responsible people running these institutions to keep gaming the system to a minimum. Why can't we just hold them responsible?

[skellington.livejournal.com]

Well, some places, i.e. Canada, didn't have nearly as many problems as elsewhere in the world because they did have stronger regulation. Arguably their financial system is less mature because of the regulation, but maybe that isn't a bad thing. :-)

At the same time, the people hired to run those institutions are selected on the basis of their ability to maximize shareholder profit. And if they didn't do anything illegal (i.e. against regulation) it is hard to justify prosecuting them. And I'm not sure what else "holding them responsible" means?

The public's interest (because we'll bail them out, have to pay FDIC insurance, etc.) is represented by the regulation. So we have to have a longer collective memory than 75 years (next time)...