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...