Posted by Jay Livingston
I’ve blogged before about my skepticism of the wisdom of crowds (here for example). I had been thinking about sports betting and line shifts. But I’d missed the 800-pound gorilla that could make the wisdom-of-crowds crowd run for the exits: bubbles. Bubbles like the one that got us into the current mess. The Obama administration is calling for more “transparency” for swaps and derivatives. But was opacity the problem? True, these instruments weren’t traded on an open market, but the people who did trade them weren’t keeping stuff secret. The problem with these instruments – instruments designed to manage risk – was that nobody really knew how risky they were. Worse, they thought they knew, and they greatly underestimated the risk. Why? Back in February, Felix Salmon, in an article in Wired, put the blame here:
It’s the Gaussian copula, a simple (as these things go) formula for evaluating the risk of a derivative.
Derivatives and swaps are complex combinations of risk elements, but those elements are not independent of one another. To figure out the true risk of a tranche of one of these instruments, you’d have to know the myriad of correlations among all the elements.
Falling house prices, affect a large number of people at once. . . . If . . . you default on your mortgage, there’s a higher probability [others] will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are.But defaults are relatively rare, so how could you assess the degree of correlation? Along comes David X. Li, a quant. The formula, the Gaussian copula, is his claim to fame (or now, infamy).*
Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. . . .Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly). Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.The copula uses price. But price, as graduates of Father Guido Sarducci’s Five-Minute University know, is a product of “supply ana demand.” Price, at least in the short run, is based not on some true underlying value. It’s based on what people think. It’s pure social construction. The construction fed on itself.
You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn't matter. All you needed was Li's copula function.The socially constructed reality of price eventually came up against the economic reality of value: the Wile E. Coyote moment.**
the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.*As the article makes clear, Li is not to be blamed for the way the Wall Street predators misused his formula.
**Is there actually a Road Runner cartoon with such a moment? There must be, but I could not find it on YouTube.
