A few weeks back I wrote about our Economic Reckoning. I wondered how so much bad debt, in the form of credit default swaps backed by risky mortgage debt, could get rated in the AAA tranche by the various rating agencies.
I might have that answer now.
This article, Recipe for Disaster: The Formula that Killed Wall Street by Felix Salmon, explains the story of an industry deathly afraid of unquantified risk, that fell in love with a new formula, and bet the ranch on it.
This new formula is called a Gaussian copula function, and it attempts to assign a discrete number X to represent a complete picture of the risk of insanely complicated financial instruments.
A simple, beautiful, and, in my mind, ultimately vain concept.
Impossibly, insanely complicated financial instruments. Built on layers of other impossibly, insanely complicated financial instruments. All with basically an unknown level of risk. These had been confounding Wall St. for years. But using this new formula enabled entire new markets to open up, which means more revenue. Lots and lots of revenue.
Unfortunately, it was all based on a correlation model.
Even the credit rating bureaus, like Moody’s and Standard & Poors, bought into it. A correlation model.
Turns out, there were flaws in that correlation model. Imagine that.
Seems it isn’t possible to account for every possible risk factor and every variable when modeling the real world that is populated by humans, not machines that live by algebraic equations. Who knew?
Still, the article is interesting, and well worth reading. But it seems to assign all, or most, of the blame on quants (slang for Wall St. financial wizards that use very advanced mathematics). And that, I believe, is wrong.
As I learn more and more about this crisis, I continue to probe two main areas: government meddling in the mortgage market, and the role of the credit-rating agencies.
Would any of this be happening now if it weren’t for government meddling in the mortgage market, starting in the mid-90s? Government meddling did two majorly bad things: introduced bed debt into a financial system that had to buy and sell that debt, and created artificial demand that pushed prices up.
And what exactly happened with the credit-rating agencies in all this? Their role is to uncover exactly the kind of shell game that happened here, with the lowest rated (and highest risk) instruments being re-shuffled and re-mixed into the highest tranche for resale to suckers who believed the credit rating and treated it as low risk.
Hey, it would be cheaper and faster to just hire monkeys to stamp everything “AAA” and be done with it.
So, government meddling and credit agency corruption/incompetence. That’s my official line, and I’m sticking to it until I see evidence to move me off of it.
When a system goes wrong, the most rational way to look at the various causes is to trace back to the first one, the one that set the others in motion. Learn what caused it, and develop new laws, policies, safeguards, etc., to avoid that in the future.
And pretty clearly, that first cause of the financial meltdown is government meddling in mortgage markets. It (a) introduced bad debt into the financial system, and it (b) ramped up demand, which pushed prices up to insane levels, creating a bubble that would pop as soon as the artificial demand ended.
So what drove that meddling, then? Some geniuses in government decided — based on one flawed study which drew the wrong conclusions about race bias in lending — that government needed to be in the mortgage business, to fix injustices that the evil markets were allowing.
These idiots thought they could ignore risk in granting credit. Sure, why not? Live fast, die young, leave a good looking corpse.
Or maybe — and this is probably closer to the truth — they just didn’t care about risk, and were willing to lose our money in order to give away free stuff to voters. “Pandering”, I think it’s called.
Or maybe, finally, and most disturbingly, they knew about the risk, and that some lenders would get burned, and that eventually it would fall into the laps of Freddie and Fannie and therefore, you and me, but viewed it as fully justified in their world view. “Sticking it to the man”, I think it’s called.
Let’s be generous, and attribute the mess to all three causes.
Proving, yet again, P.J. O’Rourke’s genius when he said “Giving money and power to government is like giving whiskey and car keys to teenage boys”.
Sadly, unfortunately, here in the real world, you can not just ignore market realities. Doesn’t matter how noble your intentions were. Doesn’t matter how many letters you have after your name. In the old days, we lobotomized people who refused to accept reality in favor of their own little world; today, instead, we’ve apparently elected a bunch of them to run our government.
And the real cherry on the sundae here is that Obama and the entire community organizer mafia was at the forefront of this wave. They threatened to sue the banks until they gave mortgages to a sufficient number of unqualified borrowers. Even the banking regulators got in on this action, threatening to complicate any mergers unless enough bad loans were made to satisfy them. How many? We don’t know! Just do it, man!
Yet Obama today acts like that was all Bush’s fault, somehow. And the media is too busy sitting in his lap and licking his face to explain what really happened to the 80% of the country that has no clue how the current financial crisis happened.
I guess this is what we deserve. We elected the dude. Hey, have you heard? He plays pick-up basketball! How awesome is that?!
What is not so awesome is that he is just getting started on his plan to grow government ever bigger, and meddle in more markets that it doesn’t belong in. Carbon credits? Yeah, great idea. Especially since the science behind all that is silly, unproven, and corrupt.
Oh, my GOD. We really, really ought to get a grip here.
I don’t like being lied to and taken for a fool by the idiots and charlatans in our media and government. You?
Look, I’m willing to give the guy a chance, even though I find nothing appealing about him whatsoever. But it is what it is. And what it is, is this: Obama and his community organizing cronies are the primary cause of the movement that created this entire mess. Yet they won’t admit anything, of course, and the stupid media is too drunk with Obamania to report any of this with any level of useful context.
And now he’s got the car keys. Strap yourselves in, kids!
- Copulas and Cults
- The Gaussian Copula and financial risk calculation
- Recipe for Disaster: The Formula that Killed Wall Street
- A Good Rule for Sportswriters: Stay Away from Politics. Or, Learn to Use a Search Engine. Either Way.