Monday, March 16, 2009

More on how the finance industry collectively ran off of a cliff

Conde Naste's Portfolio has a great article on a key factor that underlies the entire finance industry mess that has hobbled our economy. Turns out that in 2000 mathematician David Li came up with a formula for simplifying the process of determining the risk of a pool of assets. The banks, hedge funds, rating agencies, and other financial institutions all adopted his so-called "Gaussian copula function."

Turns out that doing so was a recipe for disaster, as the formula only produced useful information as long as certain key assumptions remained true.

Such as, you may ask?

Such as the idea that house prices will keep going up.

Some time ago, Li himself had this to say about his formula: "The most dangerous part is when people believe everything coming out of it."


It's a three page article, and rather than excerpt it I'll just link to it here. It's a good read and really helped me to understand the collective mindset that allowed so many otherwise smart people to totally screw us all. (UPDATE: the same article is in Wired but comes with a graphic showing the actual formula.)

And one final thought: Li grew up in China but studied and worked in Canada (eventually for Barclays Capital, though I'm not sure where). He's now employed back in China.

I'm no Chinese xenophobe... but I have to admit to having "Manchurian candidate" thoughts. Hey, we're all capable of a little idle conspiracy theory spinning now and then, no? :-)

ALSO IN PORTFOLIO, an article on the housing mess makes this observation with respect to the comparative risk of investing in the stock and housing markets:

The house-price decline that we've seen to date feels particularly bad because so many Americans bought or refinanced their houses during the boom years, leaving a thin sliver of equity which has long since evaporated. If you put your life savings into buying a house, then a 20% price decline can wipe those savings out entirely; if you put your life savings into an S&P 500 index fund, then a 50% price decline still leaves you with half your money.

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