Figures Don't Lie

Many years ago, my Uncle Wes was listening to a political commentary on the evening news. About halfway through the piece he got up, turned the TV off and told me: "Figures don't lie but liars sure can figure" This Blog is dedicated to setting things right about a few of the numbers tossed around in today's political discussions.

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Location: Bloomington, Minnesota, United States

How old am I? Well, for much of my career, I had a secretary. And, my best secretary could take shorthand.

Friday, February 27, 2009

Computer Models and Financial Disasters

Once in a while, someone writes a remarkably clear explanation of a complex mathematical subject. Felix Salmon has done just that in an article titled, "Recipe for Disaster: The Formula That Killed Wall Street" in Wired Magazine.

Salmon describes the elegant method that math wizard, David X. Li, published for simply evaluating risk in the bond (and bond derivatives) markets without having to actually look at the underlying securities.

This method, known as the Gaussian copula function, allowed Wall Street to take the $11 trillion worth of mortgages outstanding in the U.S. and build much larger markets of securities "derived" from the mortgages:

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.
Now that is some serious leverage! And all based on the well known fact that home prices only move in one direction, up.

The article is worth reading because it illustrates the fact that even with plenty of warnings, "herd mentality" will drive otherwise reasonable people to believe and act on computer models. How could it be otherwise? Experts build them and the computer says...


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