A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.I finally got what tranching is from this article, and the explanation of how Li's formula was used by the financial world to blind themselves to risk is stellar.
For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.
His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.
Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.
And the article isn't hard on Li at all. It's not like he's John Yoo, out there perverting the Constitution so Bush could play Jack Bauer. Even he warned against the shortcomings of his formula.
Something keeps bothering me about all of this.
The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.Should this fact in and of itself be a red flag to people? How can two associated markets grow 6740% and 1710% respectively in five or six years and somebody not say, "Whoa, whoa, whoa," especially when the one growing 6740% is basically unregulated? Are there no adults that could see that and think, "What are those crazy kids doing over there?"
I'm thinking that, although the article didn't say it, Li's formula amounted to a dangerous procyclical effect in the markets. Procyclicality is bad news. It turbocharges the effects of the market. An example in the physical world: let's say the market is a roller coaster. The market goes up and down in the normal course of events, just like the roller coaster. Some markets are kiddie rides, and some are whacked-out scream machines. But you know the risks when you get on them.
Well, supposing that instead of seats on the little trains, the owners of the roller coaster attached contraptions that dangled bungee cords on either side of the little trains? Now every time you go up, you really go up, and when you go down, you're plummeting. That's procyclicality in action.
And now suppose some stupid teenagers with their pot and acid decide to leap from bungee cord to bungee cord, from roller coaster to roller coaster, maintaining that high as long as possible? "Whee! Whee! I'm never coming down! Whee!"
That essentially was our marketplace over the past few years, thanks to the jumbo-sizing of the credit default swap market. And then the the markets went down, and some people hit the pavement in rather ugly messes, and everyone else got the notion that being on a roller coaster dangling from bungee cords isn't such a hot thing to do, they threw the brakes.
And now the roller coasters are stopped, little trains are stuck in every place imaginable, and Geithner and Bernanke are climbing up, disentangling all of these people, getting them back down to the ground...
...and then refunding them the price of admission.
After all, we don't want to stifle innovative recreation park ride creation, now, do we?