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The Formula That Killed Wall Street

kdawson posted more than 5 years ago | from the easy-go dept.

The Almighty Buck 561

We recently discussed the perspective that the harrowing of Wall Street was caused by over-reliance on computer models that produced a single number to characterize risk. Wired has a piece profiling David X. Li, the quant behind the formula that enabled the creation of such simple risk models. "For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. ... [T]he 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."

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the formula that killed wall street: (5, Insightful)

Shakrai (717556) | more than 5 years ago | (#27050041)

G+R+E+E+D

Nothing wrong with models. (5, Insightful)

gravos (912628) | more than 5 years ago | (#27050063)

There is nothing wrong with using a model. Models are good. They help us simplify the world so that we can understand it. For example, we have hundreds of competing climate change models that explain what is going on and predict what we should expect. We model the weather for forecasts. And so on.

But. And it is a big but. You must know the limitations of your model. By definition, a model is a simplification of a complex phenomenon. That does not make it flawed: that makes it a model. Overreliance on the model is your fault, not the fault of the model.

Re:Nothing wrong with models. (5, Insightful)

morgan_greywolf (835522) | more than 5 years ago | (#27050113)

However, there are some models that are just bad. If we take your climate change model example, simply going outside and measuring the temperature, and then comparing it to a temperature you took one the same day three years in a row and then plotting the statistical trend is a very poor model. Using that model, one might assume that we have drastic global cooling going on. It doesn't matter how much you rely on that model, if you rely on it all, you're going to be dead flat wrong.

Re:Nothing wrong with models. (5, Interesting)

larry bagina (561269) | more than 5 years ago | (#27050155)

Is global warming the new replacement for Godwin's Law?

Re:Nothing wrong with models. (1)

Shakrai (717556) | more than 5 years ago | (#27050163)

God I hope so.....

Re:Nothing wrong with models. (5, Funny)

morgan_greywolf (835522) | more than 5 years ago | (#27050207)

In Nazi Germany, global warming Godwins you?

Re:Nothing wrong with models. (4, Insightful)

wjh31 (1372867) | more than 5 years ago | (#27050143)

Even more important that the limitations of a model are the assumtions taken in developing the model and/or feeding the data into the model, these should always be made clear to whomever the user of the model is, and it is then up to the user to decide if those assumtions are reasonable for their use of it.

Re:Nothing wrong with models. (4, Interesting)

umghhh (965931) | more than 5 years ago | (#27050295)

it does not matter what model you use. Apparently they all created virtual worlds in big numbers (total value of derivatives and such is few times more than summed up gross domestic product of all countries on our planet) - this had to crash independently of the model - problem being that they used the same one. in other words: if all sheeple use the same model of reality then to make profit you need to use different one. Or to say it yet differently: if all sheeple do the same they create the bubble. nature of bubbles is that they burst when they reach physical limits of the stuff of which they are made. In our case it was human gullibility.

Re:Nothing wrong with models. (0)

Anonymous Coward | more than 5 years ago | (#27050487)

Modded down for being a mindless twat that insists on using the term "sheeple".

Re:Nothing wrong with models. (0)

Anonymous Coward | more than 5 years ago | (#27050323)

Basically what Nassim Taleb [wikipedia.org] said: [youtube.com]
 
      When using a model, don't forget to consider the black swan [wikipedia.org]

It wasn't Li's fault. (3, Insightful)

Samschnooks (1415697) | more than 5 years ago | (#27050161)

One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.

There you have it. The managers making the decisions didn't know what it all meant and the guys using the model didn't adequately explain the model's limitations.

Re:Nothing wrong with models. (0)

Anonymous Coward | more than 5 years ago | (#27050175)

It also seems pretty clear that they knew the model wasn't appropriate for how they were using it, but because it gave them AAA ratings from junky assets, it was appropriate for increasing profits by screwing the people buying the combined assets. Plenty of people warned this was a problem, that I don't believe ignorance is a valid excuse. How the hell could believe that home loan defaults are independent events (as the model assumes)? You don't need an MBA to know there are bust-boom cycles.

Re:Nothing wrong with models. (5, Insightful)

BrokenHalo (565198) | more than 5 years ago | (#27050339)

You don't need an MBA to know there are bust-boom cycles.

You also don't need an MBA to know that there is a limit to the number of balls a juggler can keep in the air at any time before he drops one. And when one ball drops, the whole thing falls apart. As the truism goes, those who don't learn from history are doomed to repeat it...

Re:Nothing wrong with models. (2, Funny)

Anonymous Coward | more than 5 years ago | (#27050459)

Apparently you do need an MBA to think that growth can be infinite and profit generated indefinitely.

Re:Nothing wrong with models. (0)

Anonymous Coward | more than 5 years ago | (#27050261)

Wow -- a discussion about the social construction of financial markets on Slashdot. Sometimes models aren't simplifications -- they can create a context in which their predictions are more applicable. The Wired article draws from Donald Mackenzie's An engine, not a camera [amazon.com] .

Re:Nothing wrong with models. (5, Interesting)

ShakaUVM (157947) | more than 5 years ago | (#27050317)

>>There is nothing wrong with using a model. Models are good.

Not in economics, they're not. The book Black Swan, which should be read by anyone interested in this topic, says that the hideous lie is that people claim that "they're better than nothing", when, in fact, they're worse than not having any model at all.

The LTC crash was caused by the founders (Nobel Laureates in Economics) having a model to quantify risk. IIRC, they used some sort of guassian model, taking the standard deviation of price movement as "risk". (http://en.wikipedia.org/wiki/Black-Scholes#Black.E2.80.93Scholes_model) This of course looked good until, quite suddenly, it wasn't and there was an event that their model predicted shouldn't have happened within the lifetime of the universe (that's the problem with using gaussians instead of cauchy curves or other fat-tailed distributions) and the company crashed and burned, and did a lot of collateral damage as well.

From the wikipedia article on LTC (http://en.wikipedia.org/wiki/Long-Term_Capital_Management): Merrill Lynch observed in its annual reports that mathematical risk models, "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited."

Re:Nothing wrong with models. (4, Funny)

Anonymous Coward | more than 5 years ago | (#27050375)

And it is a big but. You must know the limitations of your model.

Is that you, Sir Mix-A-Lot?

Re:Nothing wrong with models. (4, Funny)

wezeldog (982156) | more than 5 years ago | (#27050539)

Yes. And he cannot lie, apparently.

Re:the formula that killed wall street: (2, Insightful)

inviolet (797804) | more than 5 years ago | (#27050165)

the formula that killed wall street:

G+R+E+E+D

Then we have the same problem in the real world -- everyone is using the same formula. For example, the formula you cite is also:

  • the formula that built slashdot
  • the formula that sent the explorers to the New World
  • the formula that invented bronze and later iron
  • the formula that started farming in the Fertile Crescent
  • the formula powering most religions

But since you've gotten the ball rolling on the subject of spitting meaningless venom onto the audience, let me join in with one of my own:

the formula that killed wall street: O+U+T+S+O+U+R+C+I+N+G

Re:the formula that killed wall street: (-1, Flamebait)

portscan (140282) | more than 5 years ago | (#27050205)

actually, greed is good. it's the great motivator. really, it's the only motivator. what we need is an incentive structure (marketplace and regulatory framework) where greed does not necessarily compel people to do things that are solely beneficial to themselves, putting others at risk.

Re:the formula that killed wall street: (5, Insightful)

Shakrai (717556) | more than 5 years ago | (#27050245)

actually, greed is good. it's the great motivator. really, it's the only motivator.

It's a good motivator when it's tempered with wisdom. It's a bad motivator when you blinds you to the long term consequences of your actions. I've been saying for years that it seems like our entire economic system has been tailored to next quarters results at the expense of building/investing for the long term. Who cares if this quarter has record profits if you paid for those record profits with the future viability of your enterprise?

Re:the formula that killed wall street: (4, Interesting)

portscan (140282) | more than 5 years ago | (#27050321)

yes, i completely agree with you. the focus on quarterly earnings is representative of "short-termism" everywhere, which is usually detrimental to long term value preservation.

i guess what i should have said is that greed is not going anywhere. harness it when you can and don't be surprised when it causes people to do things that harm others.

Re:the formula that killed wall street: (2, Insightful)

Shakrai (717556) | more than 5 years ago | (#27050385)

i guess what i should have said is that greed is not going anywhere

That's the truth. I would just hope that we can temper our greed with a little bit of wisdom and an outlook on the future. I like your phrase, btw, "short-termism". Seems like short-termism has infected our soceity from the citizen buying a big screen TV they can't afford, all the way up to the Federal Government that tried to wage two wars and expand the social safety net on credit.....

Americans like to have our cake and eat it too apparently.

Re:the formula that killed wall street: (1)

Meneguzzi (935620) | more than 5 years ago | (#27050221)

And we all ended up Copulated [wikipedia.org]

G+A+M+B+L+I+N+G (0)

Anonymous Coward | more than 5 years ago | (#27050231)

Wall Street is supposed to provide the money that Main Street needs to grow and develop. Investors will get returns on their money. Instead, it has become a form of legalized gambling. I think it would be good to bring back capital gains taxes on profits that are made on short term investments. That would dampen the desire to buy and sell so much, and encourage people to make investments in sound companies. That and raise the interest rate. If you do not desire to do research on what is a sound company, you should put your money in the bank and earn interest. With interest rates so low, you would be called stupid for putting your money in the bank and earning interest.

Re:G+A+M+B+L+I+N+G (2, Informative)

BrokenHalo (565198) | more than 5 years ago | (#27050389)

I think it would be good to bring back capital gains taxes on profits that are made on short term investments.

You don't have them? Here in Australia, we pay CGT on any capital gain, but there is a 50% discount on that if you have had the investments for more than 2 years.

Re:G+A+M+B+L+I+N+G (1)

ahmusch (777177) | more than 5 years ago | (#27050555)

I think it would be good to bring back capital gains taxes on profits that are made on short term investments.

Last I checked, short-term (assets held under one year) capital gains are taxed as regular income, whereas long-term capital gains are capped at 28%.

Re:the formula that killed wall street: (3, Interesting)

aurispector (530273) | more than 5 years ago | (#27050267)

Greed is a motivator. Greedy people will work hard to acquire money. Capitalism & free enterprise allow a society to harness greedy people for positive ends like the creation of jobs to produce valuable goods and services. This is a good thing. Unfortunately, greedy people are not necessarily *smart*. And even the smart greedy people are not necessarily *correct* when they do things a particular way.

The story sums it up nicely - this formula oversimplifies a complex market creating a classic bursting bubble. There's an economist named Taleb http://www.fooledbyrandomness.com/ [fooledbyrandomness.com] lecturing about how the market will basically always be more complex than you think.

The best part about his message is in not trusting your data too much. I think of this every time people start talking confidently about geoengineering. We don't know as much as we think we do.

Re:the formula that killed wall street: (0)

Anonymous Coward | more than 5 years ago | (#27050393)

No, it should be CRA. For the uninitiated, that stands for "Community Reinvestment Act": http://en.wikipedia.org/wiki/Community_Reinvestment_Act

Re:the formula that killed wall street: (0)

Anonymous Coward | more than 5 years ago | (#27050447)

Careful examination of Mr. Li's algorithm reveals division by zero on step 42.

So (1 != 2) still holds. As does (1.0 x 10^5 != 5.0x 10^9).

Sounds about right (1)

raymansean (1115689) | more than 5 years ago | (#27050045)

you mean to say that everyone doing the same thing is bad? 1st post?

Tribute to Huntz Hall... (5, Funny)

Samschnooks (1415697) | more than 5 years ago | (#27050047)

Enter Li, a star mathematician who grew up in rural China in the 1960s. He excelled in school and eventually got a master's degree in economics from Nankai University before leaving the country to get an MBA from Laval University in Quebec. That was followed by two more degrees: a master's in actuarial science and a PhD in statistics, both from Ontario's University of Waterloo.

He has more degrees than a thermometer!

Re:Tribute to Huntz Hall... (1)

NekSnappa (803141) | more than 5 years ago | (#27050173)

I had to look up the term "quant." I thought it might have been a slangy way calling the guy a cunt. But turns out it's somewhat of a regular term in that field.

quant (kwnt) Pronunciation Key n. Slang An expert in the use of mathematics and related subjects, particularly in investment management and stock trading. [Probably short for quantitative.]

Re:Tribute to Huntz Hall... (0, Flamebait)

BrokenHalo (565198) | more than 5 years ago | (#27050405)

Your first surmise was probably correct. :-)

fuck computers (0, Offtopic)

doyoulikegoatseeee (930088) | more than 5 years ago | (#27050049)

computers suck

Citation, please (5, Interesting)

dlcarrol (712729) | more than 5 years ago | (#27050057)

In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

Citation? Booms and busts are caused by, respectively, expansion and contraction of the money supply (usually in the form of bank credit), often accompanied by manipulated interest rates. The formulas used by lots of investing firms could cause clusters of errors, but the extent of types of companies (and governments) affected points to a more Austrian-style, systemic boom/bust rather than a single-(important-)sector miscalculation.

Re:Citation, please (0)

Anonymous Coward | more than 5 years ago | (#27050133)

Booms and busts are caused by, respectively, expansion and contraction of the money supply (usually in the form of bank credit), often accompanied by manipulated interest rates.

Citation, please?

Re:Citation, please (1)

Xabraxas (654195) | more than 5 years ago | (#27050151)

The formulas used by lots of investing firms could cause clusters of errors, but the extent of types of companies (and governments) affected points to a more Austrian-style, systemic boom/bust rather than a single-(important-)sector miscalculation.

It makes sense. When the Glass Steagall Act was repealed bank holding companies began buying into financial companies and these financial companies were all taking bad risks based on this formula. A decade later bad behavior caught up with the financial institutions and banks were left holding the bag. Banks tightend lending considerably which is causing the current contraction. That was the whole point of TARP, to re-infuse the banks with capital so they could start lending again. So far it hasn't worked.

Re:Citation, please (2, Insightful)

El Torico (732160) | more than 5 years ago | (#27050275)

Will there be a reprise of the Glass Steagall Act? It was initially passed for very good reasons, which apparently are still valid.
As for the TARP, the biggest reason the banks aren't lending is that they simply don't trust anyone. They know that they inflated the value of their assets, so they (correctly) assume that everyone else has too. Of course, putting the TARP money on the balance sheet is useful "window dressing".

Re:Citation, please (3, Interesting)

Dunbal (464142) | more than 5 years ago | (#27050171)

Classical economics cannot explain what is happening right now. It's without precedent. There is a little graph I would like to show [msn.com] you...

      It's interesting to note the near exponential shape of the graph pre dot com bust era, and how the exponential part resumes around 2005. Now, imagine the impact on everyone with money to invest, from corporations to banks to retirement and pension funds faced with a choice. You can earn 4% or less, per annum, in bonds or (LAUGH) CD's, etc. OR you can put money on the stock market. That's one hell of an "opportunity cost" if you don't - because everyone else is making out like a bandit. The stock market is unstoppable.

      In fact, the only OTHER "safe" place to put your money is real estate...

        Both of them went bust at roughly the same time. Co incidence? No, they were intertwined from the beginning, because they were the "safest" "surest" bets, and that's where all the wealth was going. So according to supply and demand, if too much money was chasing these "goods", the price moved up accordingly. However these two retracements have wiped out the present AND FUTURE wealth of most of the nation, because everyone was BANKING on the fact that their stocks, 401(k) or home was going to see them through retirement. Welcome to reality - the money is gone (because the demand is gone), and we're not finished yet. The graph still points STRAIGHT down. Something HUGE has to happen to change that. Most people thought it would be a new president, but now we know that's not the case.

Re:Citation, please (4, Informative)

dlcarrol (712729) | more than 5 years ago | (#27050301)

With respect, classical economics and Austrian economics are not quite the same thing, and the Austrian school of economics explains this quite well.

Notice any similarities here [stlouisfed.org] ? No, it's not a perfect fit, but it's the best I could do on short notice.

No one is saying that these models have nothing to do with malinvestment, but it's likely the inputs to the model are also obfuscated by distorted monetary signals

Re:Citation, please (4, Insightful)

Dunbal (464142) | more than 5 years ago | (#27050557)

With respect, classical economics and Austrian economics are not quite the same thing

      Sorry, I'm not an economist. Therefore if I said something incorrect through ignorance I apologize. I merely wished to emphasize that truly we live in interesting times. I think it's when the world (and especially the consumer intensive US) finds out we've bumped into the limits of our resources on this planet. We can't all have an SUV. We can't all waste electricity. We can't all have a worry free life, and independence, and a nice house, and a big screen tv, and eat in good restaurants, etc. The boom in commodity prices - in part fueled by massive demand from the BRICIT countries that are also expanding their middle classes and trying to adopt an "American" standard of living - has another side to it. Not only was demand increased - but supply is at or near maximum. There IS no more copper, there IS no more gold, platinum WILL run out in 20 years or so, etc.

      Therefore commodities (including petroleum) priced themselves right out of the market. This triggered, and is triggering, financial default from everyone who was living "the dream" on credit. And now the cards keep tumbling. Oh, we will reach a new equilibrium some day - but our population keeps expanding, and those resources keep getting more scarce.

Re:Citation, please (1)

Timothy Brownawell (627747) | more than 5 years ago | (#27050341)

Classical economics cannot explain what is happening right now.

Because if it could, it would also have predicted it, and "they" could have used that knowledge to prevent this mess.

Or maybe it's more a case of "I want to believe", where we had a "new economy" that didn't follow the old well-known rules.

It's without precedent.

[citation needed]

There is a little graph I would like to show [msn.com] you...

Are you seriously trying to claim that the stock markets have never crashed before?

Re:Citation, please (0)

Dunbal (464142) | more than 5 years ago | (#27050467)

It's without precedent.

[citation needed]

You didn't LOOK at the graph, did you? That's my citation.

There is a little graph I would like to show you...

Are you seriously trying to claim that the stock markets have never crashed before?

Not at all - the markets crash all the time. But had you looked at the graph, you would notice that the slope of this curve is unprecedented, and almost completely VERTICAL. Meh, I don't care. Today is a great day to short some more stock. I can buy it back in a few days for a killing.

Re:Citation, please (1)

ZeroExistenZ (721849) | more than 5 years ago | (#27050485)

Classical economics cannot explain what is happening right now.

It's because movements in the market were slower in the classical model, and the stockmarket was less accessible.

I'm working on wealthmanagemnt software, one-click buy and sell transactions wired straight to the stockmarket floor (even automated models which auto sell and buy stocks).
The ease of buying/selling allows more violent fluxuations after media-panic where alot of people take the same, immediate, action on the market bringing it out of balance. New technology, new stockmarketinteraction requires new models or a delay buffer to spread and smooth the interaction. The last one is very unlikely to be desired by clients :)

Re:Citation, please (1)

Logical Zebra (1423045) | more than 5 years ago | (#27050181)

Only partially true. A bubble can also be caused by a lot of a certain commodity being bought up, creating an artificial demand and thus raising prices. This, in turn, leads more people into the market in the hopes of making a quick buck, oftentimes making even more and more of the commodity (like building houses). Whenever the commodity is being built simply to be bought and resold, you have a glut in supply, which sharply drives the prices down and bursts the bubble.

This happened with both the real estate market and crude oil last year.

Re:Citation, please (1)

Timothy Brownawell (627747) | more than 5 years ago | (#27050191)

In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

Citation? Booms and busts are caused by, respectively, expansion and contraction of the money supply (usually in the form of bank credit), often accompanied by manipulated interest rates. The formulas used by lots of investing firms could cause clusters of errors, but the extent of types of companies (and governments) affected points to a more Austrian-style, systemic boom/bust rather than a single-(important-)sector miscalculation.

It could be that, or it could just be mass [wikipedia.org] stupidity [wikipedia.org] ("a million lemmings [wikipedia.org] can't be wrong"). Or probably some combination of both.

Re:Citation, please (1)

Fnkmaster (89084) | more than 5 years ago | (#27050355)

Yes, but the boom in credit and the expansion of the money supply was largely driven by the ease of packaging and re-selling credit through the magic of securitization and tranching (i.e. CMOs and CDOs).

The insurance of debt through credit default swaps helped a lot too.

You combine these two relatively new secondary markets, and banks were able to effectively multiply available capital in the system and cause a massive bubble in asset prices.

Re:Citation, please (0)

Anonymous Coward | more than 5 years ago | (#27050357)

One of the errors of von Mises' work is that he assumes that the aggregate behavior of a group of agents produces something that can essentially be regarded as a certainty. He compares this aggregate behavior to the aggregate behavior of an insurance company's portfolio of policyholders.

He's implicitly invoking the central limit theorem and assuming that a large number of participants means that their aggregate actions will result in a normally distributed variable with small variance.

It's true that if you add up enough random variables (with the exception of certain distributions) you'll get something approximating a normal distribution. However, the rate of convergence is dependent on the means, variances, and amount of correlation between the variables. If you have a handful of highly correlated variables that contribute the lion's share of the mean of the sum, then the distribution of the sum will largely follow the distribution of the correlated variables.

This deeply undermines von Mises' assumption that aggregate behavior can reasonably be modeled as the sum of the actions of idealized rational agents. In reality, the sum can be "captured" by the actions of a handful influential entities, who may or may not follow von Mises' notion of rationality.

Re:Citation, please (1)

Zerth (26112) | more than 5 years ago | (#27050411)

If everyone uses the same formula, it forms a kind of feedback. The formula says buy, so those who use it does so. The price goes up, appearing to validate the formula.

More people use it, more competition for the assets the formula values, more feedback. The system starts spiking as oscilations reinforce until somebody says "WTF?!" and goes against the formula.

Then people start thinking they've been blind, evaluate their positions with a more in-depth look, and then everyone runs. It doesn't mean the formula is wrong, just that in a monoculture of decision-making, certain assets will be overvalued or undervalued solely because everyone is acting identically.

Re:Citation, please (1)

mothlos (832302) | more than 5 years ago | (#27050453)

You could also use a citation because the corrolation of monetary supply to booms and busts is not necessarily causal.

Also, just to look at the obvious a bit, financial institutions such as Leahman Brothers and AIG show how an ineffectively regulated market can foster systemic risk and the government has a central role to play in exposing systemic risk so that it can be incorporated into decisions. Austrian school economics overly emphasizes the ability of the market to self-correct appropriately. While I won't disagree that the federal interest rate policy created pressure on financial institutions to find ways to obscure risk in order to provide financial products for those fleeing treasury bonds, I don't think it is reasonable to say that this policy is to blame for the failure of these institutions to responsibly manage their clients money.

Re:Citation, please (1)

Fractal Dice (696349) | more than 5 years ago | (#27050465)

Citation?

Darwin. Dawkins. Dollars reproduce dollars, genes reproduce genes. It's the same math at a different time scale.

One word (5, Insightful)

DigiShaman (671371) | more than 5 years ago | (#27050071)

Diversity.

Or there's my financial formulae (5, Insightful)

Rosco P. Coltrane (209368) | more than 5 years ago | (#27050121)

- Don't spend the money you don't have
- Don't do credit unless you absolutely have to

I know I know, Wall Street are these big finance hotshots who do complicated things that have nothing to do with personal finances, but what is it they do apart from speculating and playing with money they don't have, or other people's money? They just hide that simple fact under abconce financial constructs, but that's all they do in the end.

Bring back some morals sanity in the credit business and there won't be anymore crisis of this magnitude. No need for math here...

Re:Or there's my financial formulae (2, Insightful)

internerdj (1319281) | more than 5 years ago | (#27050365)

While I agree with you on a personal finance level and that a lack of moral sanity is a problem on the larger scale, the personal goals at a larger level would constrict the economy. In fact it is what is happening right now: the banks unsure of what their holdings are really valued at are unwilling to loan money. Due to that unwillingness to loan, many businesses are struggling to obtain the money they don't have yet, but businesses rely on credit to at the very least even out the financial bumps in the road so they can pay their workers a steady paycheck.

Not Wall Street. Us. (5, Insightful)

computersareevil (244846) | more than 5 years ago | (#27050123)

It isn't killing Wall Street. Those jokers are getting $billions$ in free money.

It's killing us, the people who work for a living and have to provide all those $billions$ or suffer the inflationary consequences when the Feds just print it.

Re:Not Wall Street. Us. (5, Insightful)

Notquitecajun (1073646) | more than 5 years ago | (#27050201)

A BIG part of the problem is Washington's tendency to reward economic losers at the expense of the people who know what they're doing, and I'm NOT just talking about the poor. There are plenty of the high-salary types who have some sort of governmental loophole or backing that saves them when they screw a big company up.

It's one reason we don't need to be bailing out bad companies, and instead rewarding or backing up the good ones with incentives and tax cuts so that they can really succeed and push forward.

Re:Economic Stimulus (2, Interesting)

conureman (748753) | more than 5 years ago | (#27050435)

In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?

Re:Economic Stimulus (4, Interesting)

Hemogoblin (982564) | more than 5 years ago | (#27050517)

In China, they're using this slack time to upgrade the infrastructure, closing down old inefficient factories and building new ones with government CASH. Who's winning this round?

Not the millions of migrant chinese workers who have lost their jobs, which will probably also cause civil unrest. Also, the Chinese holding trillions of dollars in U.S. treasuries will also be slightly annoyed when the U.S. government inflates away their debts.

Finally, the vast majority of China's stimulus package was already announced before this major recession. You have the order backwards.

Re:Not Wall Street. Us. (1)

dreamchaser (49529) | more than 5 years ago | (#27050415)

Most people ARE Wall Street whether they know it or not. At least, anyone with a 401K, pension, or other retirement fund. The fat cats at the top are getting bailed out but THEY are not Wall Street. America is Wall Street these days.

Uhm, no... (1)

WheelDweller (108946) | more than 5 years ago | (#27050139)

On Wall Street a lot of decisions are made by people who ACTUALLY READ THE NEWS...who have ACTUALLY TAKEN CIVICS AND BUSINESS CLASSES. Sure there's a time or two they get strayed by panic, but when a man makes it to president without any vetting, then says he wants to bankrupt the coal industry (which makes 60% of the electrcity we use) and then talks about taxing each and every company based on CO2, as well as taking 12 TRILLION DOLLARS from the taxpayers, they tend to freak.

This entire mess is of Democrat-party origin. Recall it started when Fanny-n-Freddy were made to make loans to anyone based on skin color, not business-sense. (The CPA, under Clinton.) Surprise! Banks can't work by throwing money away, so the Congress comes in to pretend to "oversight" while nationalizing banks.

WERE IN A TAKEOVER OF THE COUNTRY. And Wall Street knows it.

tinfoil (0)

Anonymous Coward | more than 5 years ago | (#27050145)

if you look really close you will see that
it all started with the swiss banks moving to
the USA, namly UBS and credit suisse.
they bought american "investment banks" in the
94-96 and have probably engineered this
gaussian curve with the beginning around 96, high
2006 and end around 2016.
this whole "recession" is hedged with options.

Re:tinfoil (3, Insightful)

morgan_greywolf (835522) | more than 5 years ago | (#27050511)

Well, maybe. If we use the Dow Jones Industrial Average [google.com] (zoom out to Max for this discussion) as a measure of the economy (you could definitely do worse), the interesting thing is if we draw the trendline "flat" from about 1995 to today, and base that on the more or less steady trendline from 1985 to 1995, you'll notice that we're actually right where we should be right about now. The DJIA grew wayyyy too fast from about 1996 to 2007 (where the real peak is).

I attribute this skyrocketing economy to a couple of different phenomena: a) The dotcom boom and b) some external factors that I'm uncertain of, but I'm guessing there is some manipulation somewhere. You could be right. I also think it is interesting that current busted economy occurred shortly after the retiring of Alan Greenspan in 2006, who was Fed chairman from 1987 on.

Look at the violent and volatile growth between 1995 and 2000, and again from 2005 to 2007. We were due for crash, for sure.

It's very interesting, because from the 1970s to about 1995, the DJIA grew very steadily. After 1995, it was wild ride.

Picking up pennies in front of bulldozers (5, Interesting)

ahodgkinson (662233) | more than 5 years ago | (#27050149)

Engineers are taught: Your model is only a model, and does not necessarily capture the complete behavior of the thing being modeled. You must understand the limitations of the model.

That Gaussian curves are a poor model for unlikely events has been known for quite some time. This is best explained by Nassim Taleb in the following books:

  • Fooled by Randomness
  • The Black Swan

His main thesis is that the markets are essentially random and are basically impossible to predict in any meaningful way. Further there are unlikely unknown unknowns can cannot be predicted until the they occur, usually with disastrous consequences.

Re:Picking up pennies in front of bulldozers (1)

I confirm I'm not a (720413) | more than 5 years ago | (#27050281)

I'm tempted to suggest that training for bankers is at fault here. However, in this fortnight's Private Eye [wikipedia.org] they list several senior UK bankers, regulators and ministers - and a radio presenter. The only one with any kind of banking qualification was Terry Wogan - the radio presenter. And Sir Terry doesn't present money programmes - he does light 60s/70s chart hits. He used to host the Eurovision Song Contest. And he's better qualified than the muppets who got Britain into this mess. I'd love to know what kind of qualifications senior people have on Wall Street - I suspect it'll be much like Britain.

Re:Picking up pennies in front of bulldozers (3, Insightful)

nedlohs (1335013) | more than 5 years ago | (#27050369)

Except that the current economic woes don't fit into Taleb's "Black Swan" category. It was obvious that his was going to happen to anyone with one brain cell 5 years ago, and to anyone with two brain cells a decade ago.

I'm pretty sure I heard an interview with Taleb in which he mentioned this. Of course his strategy of investing to break even in the expected conditions and make out like a bandit when a black swan appears would have done very well as risk was repriced.

Re:Picking up pennies in front of bulldozers (4, Interesting)

Wite_Noiz (887188) | more than 5 years ago | (#27050397)

As someone who works with traders, I'd say that the randomness/unpredictability of the markets is part of the reason *why* traders are so reliant on their models.
Otherwise, it's all just blind gambling (which it isn't far off, anyway).
The advent of full on algo trading means that random events in the market have the ability to wipe out tons of capital because the models predict (e.g.) a global crash when it's just a blip. (Extreme example)

The other part of the problem is that traders are nowadays just glorified clerks in that all (well, 90%+) of the actual calculation and predictive work is done by complex platforms (or Excel), so they don't really care or have exposure to the real risks behind their trading.
Coupled with the huge bonuses they used to get (I'm in London where bonuses are being denied; is it the same elsewhere?) as long as they showed *quantity* of trades, it was always a recipe for disaster.

Re:Picking up pennies in front of bulldozers (1, Insightful)

Dunbal (464142) | more than 5 years ago | (#27050413)

His main thesis is that the markets are essentially random and are basically impossible to predict in any meaningful way.

      If they are random then why do they predict economic change with 100% accuracy? Or do you imply that major economic changes are CAUSED by the markets, and thus our entire economies move completely randomly? Should we do away with markets, then, and solve all our economic woes?

      One can argue that the Brownian motion of water molecules is almost completely random, however that doesn't stop them from flowing downstream in the river. Speaking as someone who makes his living on the stock market, if you look at individual price movements over a short period of time then it does seem as if there's absolutely no sense to them. That's why most people lose money - prices don't move the way you expect them to. However if you're able to get a "feel" for the general flow of prices across a sector of the market - not any individual price - then you can be right more often than you are wrong. This must exclude randomness, especially when it remains true over the long term.

      If the markets move randomly, then today (or any day) the markets can start heading up again towards the sky. And although I am willing to bet money that today and tomorrow we will probably go up (because we fell so much yesterday - 4%), over the medium term we are more likely to continue to head down. Because it's NOT random - there is no longer a demand for stock. In fact, there are a great deal of people who still want to get RID of their stock. Now if I can predict the general direction of the market through the next weeks (the same or lower than today) - how can you say it's random?

Re:Picking up pennies in front of bulldozers (0)

Anonymous Coward | more than 5 years ago | (#27050455)

someone somewhere knows a hell alot more then
us mere mortal.
it's like that guy in a major NOC, that can
see on a big screen that a major story has broke
somewhere, because there's alot of traffic going
that way-website (or virus/worm outbreak).
same thing in finance. we just look at a nice
facade of some bank and maybe even dare to go inside and checkout the tellers.
but somewhere in this building people, can SEE the
money flowing. they are and will always be a step
ahead of the sheep folk. bless you!

Re:Picking up pennies in front of bulldozers (2, Interesting)

bfrpsw (1327025) | more than 5 years ago | (#27050475)

"All models are wrong, but some are useful" - George Box http://en.wikiquote.org/wiki/George_E._P._Box [wikiquote.org]

Re:Picking up pennies in front of bulldozers (1, Insightful)

Anonymous Coward | more than 5 years ago | (#27050507)

Saw a show on this back in 97-98 (after that bust followed by the 2001 version). They showed traders on the floor using handhelds that did this for them on the floor.

It was like a magic money machine. Put numbers in buy here sell here, or sell here buy here. It works 'decently'. So long as the market is on a 'trend'. Get something out of 'trend' though and the models are useless. These dudes have NO clue what the model does or WHY. The guy they were following around did not know why he was not making tons of money. He did not understand what he was doing. He did not actually understand the models he was playing with. He just knew on average he was doing 'ok'. He is common.

The only indicator that I have found for an ending trend is when EVERY talking head on TV starts talking about the 'new economy' and 'how all the rules have changed since time X'. The last few I have told people 'sell'. This time it will be 'buy'.

Ironic (2, Insightful)

kauttapiste (633236) | more than 5 years ago | (#27050167)

In a way ironic that a guy from rural china comes to play, lives the american dream of wealth and glory, and (partly) causes the most massive failure of free market economics in the history.

Re:Ironic (0)

Anonymous Coward | more than 5 years ago | (#27050419)

Yeah, it's all a freakin' conspiracy man!

Re:Ironic (0)

Anonymous Coward | more than 5 years ago | (#27050509)

Almost right - he was living out the Chinese dream of undermining the capitalist pigdogs by accelerating their naturally self-destructive greed.

yeah...not so good (4, Informative)

portscan (140282) | more than 5 years ago | (#27050169)

An interesting article, for sure. The issue with the Gaussian Copula model for pools of mortgages in CDOs is how sensitive they are to the assumptions of the model. If, for example, the annual growth rate of home prices is 2% instead of 10%, things look tremendously different. If correlations between housing prices in different cities is 50% instead of 10% -- disaster. The lack of stress testing of these models (checking what the results are for different inputs into the model) was a huge issue. Even if a model is decent (which in principle, copula models are), if they are too sensitive to inputs, then the prices it produces are not trustworthy. If the proper uncertainty was taken into consideration, then perhaps everyone would have been a little less gung-ho about CDOs.

Like the (worthless) Value-at-Risk figure, the (also pretty worthless in the end) Gaussian Copula was "easy" to understand. Given that the dynamics of financial markets are not simple and easy to understand, reliance on simple models that are easy to explain to the MBAs is probably not the best idea.

Re:yeah...not so good (1)

sammyo (166904) | more than 5 years ago | (#27050477)

Many models are effective for a sufficiently small segment of a curve. (In this case while the market is going up).

Similar to a hedge fund? (3, Interesting)

ProfM (91314) | more than 5 years ago | (#27050185)

This story reminds me of "Long-Term Capital Management" story back in the late 1990's.

http://en.wikipedia.org/wiki/Long-Term_Capital_Management [wikipedia.org]

These guys did the EXACT same thing using computer models to predict what funds they should be investing in so that they never have a loss ...

Unfortunately, they were bailed out, but folded in 2000.

http://www.geocities.com/eureka/concourse/8751/jurus/hf100203.htm [geocities.com]

There was a PBS special about these guys and the computer models they used.

http://www.pbs.org/wgbh/nova/transcripts/2704stockmarket.html [pbs.org]

Makes sense (0)

Anonymous Coward | more than 5 years ago | (#27050189)

If everybody's a winner in a win/lose game then everybody's a loser too.

Felix Salmon (1)

quarrel (194077) | more than 5 years ago | (#27050227)

The author of TFA Felix Salmon is a good read. If you're into finance or economic happenings check out his blog Market Movers [portfolio.com] at portfolio.com

I've had him on my feed list for a few years through various sites he's been at.

--Q

brilliant spark of mathematical legerdemain (2, Interesting)

conureman (748753) | more than 5 years ago | (#27050247)

My grandfather woulda thought this guy was a Red infiltrator. Good job if he was.

Thou shall not calculate behaviour (5, Insightful)

Anonymous Coward | more than 5 years ago | (#27050269)

This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.
It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

Hayek. Nobel Prize Lecture, 1974.

And who discovered that formula ? (0)

Anonymous Coward | more than 5 years ago | (#27050293)

Gaius Baltar.

Don't Blame the Equation (4, Insightful)

mothlos (832302) | more than 5 years ago | (#27050303)

This seems to be a popular story for the past few weeks, but it is a mistake to blame the statistical method used. The problem wasn't that they were all using the equaton, it is that they were all mis-using the equation. All statistical tools can fail to be sensitive to certain aspects which may be critical to an application.

People in finance applied these statistical tools believing that they would be able to master risk with them. Unfortunately, they made assumptions that certain things would continue to be the same in the future, plugged the information into the equation, and now science was telling them that everything would be alright. If everybody on Wall Street was making decisions based on the Magic 8 Ball would we blame the ball or the foolishness of those misapplying it?

slightly inaccurate (2, Informative)

operand (15312) | more than 5 years ago | (#27050311)

FTA: "The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time."

The problem wasn't that the Triple A accounts were defaulting rather Moody's and other companies were stamping these ratings while they were combined with Triple B and other more riskier loans. All it took is several loans to fail while rotting the entire bushel and therefore the Investor is stuck with securities that have no value.

No. (0)

Anonymous Coward | more than 5 years ago | (#27050327)

The problem started when wall street (and the rest of the financial system) stopped being a facilitator for investors and entrepreneurs to meet and became an incestuous self-perpetuating system.

Yeah right. (3, Insightful)

msormune (808119) | more than 5 years ago | (#27050353)

Complete BS. The Wall Street knew all along the bubble would burst, and cashed in all the time while knowing it. In essence, they kept milking while perfectly well knowing it would come to a disaster.

There's a crisis every 10-15 years. Huge crisis in every 30 years. How can some one be that gullible as to believe the economics would NOT see this coming? Of course they did, but saying and doing something about it would be bad business. It would scare off the suckers... who end up paying the bill.

Hmm.. (2)

OneSmartFellow (716217) | more than 5 years ago | (#27050363)


1.) Encourage Joe the delivery man to re-mortgage up to %125 of his property value
2.) Transfer the mortgage to the in-house hedge fund.
3.) Encourgae Joe the delivery man to use his funds (from the re-mortgage) to purchase shares in the hedge fund
4.) ???
5.) Profit



Sorry, I'm new to this meme.

Re:Hmm.. (1)

Celvin (601177) | more than 5 years ago | (#27050445)

Hey. Pay attention! It's Joe The Plumber.

I just hate people who don't pay attention to politics...

Happy square root day! (4, Insightful)

mcgrew (92797) | more than 5 years ago | (#27050391)

The love of money is the square root of all evil.

This formula may have and probably did help crash the world's stock markets (yesterday's Dow Jones was HALF of its worth at its high last June), but the reality is that high energy prices drained everyone's wallets.

When Bush took office, gasoiline here in Springfield was $1 per gallon. At Wall Street's high last summer it was nearly $4.50, over four times as high. We talk about elders living on a "fixed income" but the fact is almost all wage earners' incomes are fixed. We can't demand raises or overtime and have to live within our means. But when that $20 per week gasoline budget quadruples to $80 per week, with heating and electric costs going up as well, that takes money out of other aspects of the economy. Sooner or later people are over their heads and behind on bills, and things spiral out of control.

The result of that and other factors is what you see now.

Happy square root day, everyone.

we have been warned... (1)

mutemutt (1341901) | more than 5 years ago | (#27050401)

Mandelbrot and Nassim Taleb have been writing for the last few years about the misapplication of models in financial markers... things were understood but people like Chuck Prince preferred to keep dancing... what makes some sense as it was the fun that shareholders were paying for and that politicians were in need of, right?

Diversity is good, 'mmkaay? (3, Interesting)

Max Romantschuk (132276) | more than 5 years ago | (#27050417)

Any sufficiently complex system should be heterogeneous, so that not all parts of the system can fail due to the same flaw.

Any homogeneous system will inevitably be at greater risk of failure due to a flaw in the common "gene pool" so to speak.

Biology, computers, economics, politics... I could go on.

Consumer Credit Report (3, Insightful)

chelsel (1140907) | more than 5 years ago | (#27050421)

"produced a single number to characterize risk" isn't this what Equifax, TransUnion, Experian and others have been doing for decades?

Correlation's revenge (2, Funny)

UnixUnix (1149659) | more than 5 years ago | (#27050457)

As if it weren't bad enough to be using skewed or insufficient inputs, we also had everybody doing the exact same thing -- seeking a talisman to exorcise danger and legitimize universal greed.

And then it came. Correlation's revenge!

gaussian copula fraud .. (1)

viralMeme (1461143) | more than 5 years ago | (#27050471)

A massive shell game foisted on the public by the traders to disguise the fact that these financial 'instruments' were worthless. A glorified ponzi scheme + some magic numbers .. :)

Where have we heard this before? (1)

paiute (550198) | more than 5 years ago | (#27050519)

My old friend Dr. Godel would like to have a word with you about the recklessness of going about smugly thinking your little model has captured every possibility.

When I think of Wall Street... (2, Insightful)

Ronald Dumsfeld (723277) | more than 5 years ago | (#27050523)

When I think of Wall Street, one of the first things that springs to mind is a photo I saw sometime late last year. In it, a protester is holding a home-made sign with the text, "Jump you bastards".

They didn't jump, and I have only seen one or two articles mentioning trader or banker suicides.

I can only conclude that those working on Wall Street are so utterly detached from the riskier-than-roulette gambling they were engaged in, that the losses are meaningless to them. It wasn't their money, they had no real stake in any investment being viable in the long-term, and - what's worse - is I see zero effort to move away from the "must profit in the next quarter" philosophy.

I really don't care about any 'magic formula', and I doubt you can squarely lay the blame for the current problems at the foot of any. The issue is the drive to profit right now.

What is perhaps more worrying for the average person is that governments have been sucked into this mindset too - but perhaps not surprising when the only people who can get elected are those who have made the money to campaign from their own short-term investments, or by accepting backing from others who did so in exchange for perpetuating the system.

Two sides to every trade (2, Interesting)

Lawrence_Bird (67278) | more than 5 years ago | (#27050527)

So if the Street were all one way (hypothetically) then the
counterparts are the otherway.

The genesis of this debacle lies as much with the buy side
- pension funds, mutual funds, etc who were willing to buy
anything so long as they got a pickup of 15-25bp over the
comparable treasuries. In effect, they asked for this
stuff and they got it.

As to VaR - its a great way to model relatively stable
markets and to quantify short term risks of a large move
based on recent historical returns, volatility and asset
correlations. It's not meant to predict trends nor to
quantify 'what if the market for X tanks every day for Y
months'. Thats what managers and traders are for - to
realize there has been some change, perhaps fundamental,
which will have a long term negative effect on their
positions and to take what action is necessary to reduce
that risk. Instead, they froze.

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