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

[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)...