Tuesday, February 24, 2009

The Formula That Killed Wall Street

Wired has an enlightening piece about a little-known but much relied-upon credit risk formula that contributed, in no small part, to the collapse of the financial markets and served as the aggregator of the pain we're all feeling.

Recipe for Disaster: The Formula That Killed Wall Street lays out the theory behind the Gaussian copula function, a chunk of technology that permitted exceedingly complex risks to be analyzed and articulated in ways previously unavailable to those in the financial community.

Problem was, there were a couple of gaps in the formula that its creator, David X. Li, failed to identify, and these shortcomings became starkly clear, especially in the bond market, which is heavily driven by algorithms of probability.

Since the formula was the darling of investors in the bond market, in addition to banks, credit rating agencies, and even financial regulators, and there was plenty of money being made by everyone involved (sound familiar?), problems in the copula function were essentially ignored until it was too late.

Read the entire article without shaking your head in disgust, if you can. I could not, because I've seen this silly show before - the same cast of characters engaged in the folly of greed above all else. This is the same group of people with their hands out now, complaining that we need to save them or we'll all be doomed to a middle-class lifestyle.

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