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The Math Formula That Lead To the Financial Crash

Soulskill posted more than 2 years ago | from the can-we-blame-fermat-for-this dept.

Math 371

New submitter jools33 writes "The BBC has a fascinating story about how a mathematical formula revolutionized the world of finance — and ultimately could have been responsible for its downfall. The Black-Scholes mathematical model, introduced in the '70s, opened up the world of options, futures, and derivatives trading in a way that nothing before or since has accomplished. Its phenomenal success and widespread adoption lead to Myron Scholes winning a Nobel prize in economics. Yet the widespread adoption of the model may have been responsible for the financial crisis of the past few years. It's interesting to ponder how algorithms and formulas that we work on today could fundamentally influence humanity's future."

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economics ? (5, Insightful)

Anonymous Coward | more than 2 years ago | (#39831685)

Nobel prize in economics.

that's Nobel prize in pseudo-science.

Re:economics ? (5, Informative)

PCM2 (4486) | more than 2 years ago | (#39831771)

It's worth pointing out that the "Nobel Prize in Economics" was not one of the original six prizes founded by Alfred Nobel. It is a separate award, which was invented by the Swedish central bank in 1968. Although it is presented along with the Nobel prizes, it is not technically a Nobel itself.

Re:economics ? (5, Funny)

polar red (215081) | more than 2 years ago | (#39831807)

So that makes it fake-Nobel in pseudo-science.

Re:economics ? (2)

zr (19885) | more than 2 years ago | (#39831959)

why funny? i'd propose insightful if it wasn't obvious (no offense to polar red!)

Re:economics ? (2)

ScentCone (795499) | more than 2 years ago | (#39832065)

it is not technically a Nobel itself

I think it's safe to say that many of the actual Nobel prizes of late should also not be thought of as genuine.

Re:economics ? (0, Insightful)

Anonymous Coward | more than 2 years ago | (#39832179)

How is that pseudo-science? An economy is a highly complex system. An economist makes observations about that system and forms a hypothesis to explain his observations. In other words, he applies the scientific method to the system just like any other scientist would do when studying other systems.

Not economics; theft. (5, Interesting)

Futurepower(R) (558542) | more than 2 years ago | (#39832207)

FRAUD ALERT: It was not a mathematical model that caused the problem. It was fraud. Financial organizations convinced investors that they had a "mathematical model" so that they could steal. The theft was ENTIRELY deliberate, as is described in detail in the 1997 book F.I.A.S.C.O.: Blood in the Water on Wall Street [] , by Frank Partnoy. Somehow the issues were kept quiet for 11 more years until the theft could be completed in the 2008 financial crash. Traders called their work "ripping the client's face off" [] .

There are other editions of the book, such as this one published in 1999, Fiasco: The Inside Story of a Wall Street Trader [] , and a 2009 I-told-you-so edition of the original name.

Nothing has been done to reform the extremely corrupt financial system in the United States. No one in the SEC, U.S. Securities and Exchange Commission, the government organization that is supposed to police financial fraud, was prosecuted, even though the agency knew of the abuses. See the February 17, 2009 show Frontline: Inside the Meltdown. []

Even though the U.S. dollar is experiencing rampant inflation in 2012, U.S. banks give less than 1% interest on savings. Those who would like to invest can't because the system is so corrupt it cannot be trusted. Corporations hold unprecedented amounts of cash. See, for example, the October 7, 2010 Washington Post article, U.S. companies buy back stock in droves as they hold record levels of cash. []

F.I.A.S.C.O. stands for "Fixed Income Annual Sporting Clays Outing" (See page 100 of the 2009 edition.), held at a shooting range called "Sandanona, a club in upstate New York" (Page 97 of the 2009 edition). Traders would go there to shoot guns. The idea was to encourage their taste for violence so that they would be even more financially violent toward the customer.

Perhaps the April 27, 2012 BBC article, Black-Scholes: The maths formula linked to the financial crash [] referenced in this Slashdot story was influenced by public relations agencies trying to get people to believe that the crash was caused by errors in mathematical thinking, and not by fraud, so that the financial industry can continue stealing.

It would be helpful if Slashdot editors signed a statement about each story saying that they know of no conflict of interest, and no one was paid to run the story.

Don't blame math (5, Insightful)

koan (80826) | more than 2 years ago | (#39831695)

It was human stupidity and greed.

Re:Don't blame math (2, Funny)

Anonymous Coward | more than 2 years ago | (#39831741)

Yeah, here I was thinking it was because banks lent lots of money to people and countries who couldn't afford it, then acted surprised when they didn't get it back again. Not it turns out it was Math all along. Damn you, Math!

Re:Don't blame math (3, Insightful)

nickleaton (966500) | more than 2 years ago | (#39831761)

Primarily. However, the real blame doesn't lie with the banks, it lies with governments. It is lending as you say, but its governments borrowing and lying about their borrowing. The main method, and the sums involved are huge, and they are unfunded pensions liabilities. Take the money up front and spend it. Then rely on future taxpayers to pay the bills. Just like in the US and the subprime mortgages, its easy or no payouts up front, but lots of money flowing in. Then it tips. All back end loaded. Now if you hide the debts off the books, like Bernie Maddoff, for the same reason as Bernie, ... In the UK they are 12-13 times geared. Trying getting a mortgage on that basis. Particularly if you have large outgoings. Defense, roads, health, police, legal system, politicians, ...

Re:Don't blame math (5, Interesting)

Anonymous Coward | more than 2 years ago | (#39831845)

The real problem is that the "solution" - bailing out of the banks by the governments that were the source of the problem, is no real solution. It creates a delay. And while a delay was certainly necessary once they let it become as bad as it became, it will just repeat. A lot of Hedge funds are going to become rich - again.

Solving the problem would take a prolonged crash that lasts - well lasts until the system rebalances. That sounds cute in theory but in practice it means that it must last until the baby boomer retirees (a big portion of them) are dead. It also means Obama and the democrats have chosen very close to the worst moment in the nation's history for their national healthcare. It will be a disaster much sooner than even the worst of the republicans projected. It will become a disaster in the next 3 years.

And nobody can really do anything at this point - well I guess baby boomers could commit suicide in large numbers but ... - it's like watching a ship about to crash from the top of it's deck. There's nothing to do but watch. If you're a hedge fund manager you play a few games betting on the ship crashing while the captain assures everyone everything's fine and the ship is unsinkable.

This situation also means the real crash hasn't come yet. It will happen not this year but by the end of next year.

Peter Schiff? (1)

moj0joj0 (1119977) | more than 2 years ago | (#39831889)

Is that you [] ?

Re:Don't blame math (5, Insightful)

Opportunist (166417) | more than 2 years ago | (#39831947)

Not only that, but it also sends a very, very dangerous message to the banks: Playing risky with high stakes is the way to go. If you win, lots of money for you. If you lose, you get bailed out.

That's NOT a sustainable business model. Impending crash notwithstanding, this idiocy alone would already suffice to send the economy down the drain.

Re:Don't blame math (5, Informative)

swalve (1980968) | more than 2 years ago | (#39831797)

It wasn't even just that, it was that they made the mistake of assuming that the higher interest they were getting from the risky loans was pure profit, instead of a hedge against the higher risk. If my portfolio of loans has a 10% chance of not being paid back, I would have to charge at least 10% interest to break even. They did that, but they booked and distributed the profit before the loans started to fail. It was basically a gross profit versus net profit mistake.

Then there was the failure of the CDS market. Companies made investments, then bought insurance policies to hedge their losses on the loans. But when the loans started to fail, the CDS/hedge couldn't be paid back (cough AIG cough) and they were fucked. I think that will eventually come out as being the ultimate failure- too many layers of reinsurance.

Re:Don't blame math (1)

repapetilto (1219852) | more than 2 years ago | (#39831831)

This is a pretty good anaylsis. All these people saying "its the banks", "it's the governments", "its human greed" are not contributing anything worthwhile. Thanks.

Re:Don't blame math (5, Informative)

Anonymous Coward | more than 2 years ago | (#39831859)

That's half the problem. The other is that poor mortgages were packaged into CDOs [] . This in itself was OK, but the unsaleable bottom tranches of the CDOs were then repackaged into new CDOs. These should have been rated as entirely high risk (being a collection of mortgages that, due to the first CDO, were almost guaranteed to fail) but gullible ratings agencies still gave the top tranche a top rating. So investors worldwide were buying crap believing it to be a low risk investment.

Re:Don't blame math (3, Insightful)

AliasMarlowe (1042386) | more than 2 years ago | (#39831787)

It was human stupidity and greed.

At least the stupidity part is shared with the slashdot headline. It should be "led" (verb, past tense), not "lead" (noun, heavy metal / verb, present tense).

Re:Don't blame math (0)

Anonymous Coward | more than 2 years ago | (#39832117)

I make grammar and spelling mistakes quite frequently, I don't see it as "stupidity" rather I see it as ignorance of English, not the same thing.

In fact I'm sure there is at least one mistake in the above sentence.

Re:Don't blame math (0)

Anonymous Coward | more than 2 years ago | (#39831801)

No, it wasn't human stupidity and greed, since these are judgements about the hind-sight perceptions of "incomplete knowledge" and "profit maximising", the first of which is inevitable and the second of which is only avoidable at the peril of being stuck at hunter-gathering or communism.

They blame Black-Scholes for the downfall, but they don't blame this formula for the growth that came before it. Did anybody ask the question that the growth of the last two decades, with a big portion of it in hardly understandable values like Google, Facebook etc, was even possible without an obsession about risk-management and lending/borrowing money?

Re:Don't blame math (-1, Troll)

superwiz (655733) | more than 2 years ago | (#39831843)

No, don't blame greed. Empathy is 100% responsible for the crash. Greed has always been with us. It's nothing new. It's when those with empathy are given power... that's when feel-good-everyone-can-afford-what-they-can't-afford bubbles happen.

Re:Don't blame math (4, Insightful)

Daniel Dvorkin (106857) | more than 2 years ago | (#39832129)

Empathy is 100% responsible for the crash. ... It's when those with empathy are given power... that's when feel-good-everyone-can-afford-what-they-can't-afford bubbles happen.

Riiight, because Wall Street traders are known for their empathy above all other qualities.

What color is the sky on your planet?

Re:Don't blame math (1)

Anonymous Coward | more than 2 years ago | (#39832143)

Making a statement does not mean it's fact, prove your point.

Re:Don't blame math (3, Insightful)

gutnor (872759) | more than 2 years ago | (#39832153)

If I see that you are hungry and I sell you food for a profit, you call that empathy ? Or is it only when my business failed because I didn't calculate my margin properly, that you blame empathy ?

Bankers thought they could make money off people with no money using their clever formula. They were wrong. Some of them maybe thought they were making the world a better place (empathy), but at the end of the day they were in it to make a profit.

Re:Don't blame math (1)

Auroch (1403671) | more than 2 years ago | (#39831863)

It was human stupidity and greed.

Incorrect. Human stupidity and greed have been around for a long time, and if they were the leading factor, then we'd have a financial crash every few minutes (seconds?).

Human greed may have been the finger that pushed the button(s), but there was an entire system that was set up based on a series of "tools", including some fancy algorithms.

Re:Don't blame math (0)

Anonymous Coward | more than 2 years ago | (#39832093)

That's like saying guns kill people.

Re:Don't blame math (2)

Opportunist (166417) | more than 2 years ago | (#39831925)

But it's proven now that you cannot only count on human being stupid and greedy, you can actually calculate it.

The system works...

Re:Don't blame math (0)

marcello_dl (667940) | more than 2 years ago | (#39832055)

I Completely agree with you. It's like blaming religion.
Well, not really, because you can create a financial crisis and be mathematically correct, it's more difficult to do stuff in the name of a god and adhere completely to religion, most of them have real or perceived contradictions in their teaching.

So I expect the slashdotters who criticize religion based on its implementation (which is discussed here twice a month or more often) to not agree with you and blame Math.

Now choose, -1 troll or flamebait.

No Really (1)

Anonymous Coward | more than 2 years ago | (#39831697)

A model is a model. The problem was that people who made aggressive (read "stupid") assumptions initially made money and those that were right (read "cautious") made little or lost. This created a bubble. The same kind that happened before option pricing models and computers.

Re:No Really (5, Insightful)

chriseyre2000 (603088) | more than 2 years ago | (#39831723)

The Black-Scholes model is an attempt to apply solved heat flow equations to a financial pricing problem. It requires demonstrably invalid assumptions to be made to make it work (such as markets do not trend). Just because a Nobel prize was awarded does not make the model valid.

Complexity theory (5, Interesting)

Anonymous Coward | more than 2 years ago | (#39831995)

The same can be said for pretty much advance in science in the last 50 years. If you're truly interested in what can and cannot be predicted - given correct models, there's a science studying that, complexity theory.

But from finance over climate to even whether the planets will keep turning - all are too complex to be predicted, even though science has advanced to the point where individual events can be predicted short times in advance with near-certainty. However there's obvious things that can't be predicted. If the moon decides to crash into the earth, we will know in advance - but only a few weeks at the most. Yes, really.

In some ways this was inevitable. Science has moved from predicting individual events, like say a car collision, or physical changes happening inside an extremely well-described cloud, a single rational decision taken by someone considering a bank loan - to predicting the global effects of an undefined number of such interactions combined. The answer coming out of all this is rather disappointing : it's not working - and it isn't working any better outside of finance either. The mathematician's answer, chaos theory, is thoroughly disappointing : there is no valid way to make useful long-term predictions of any system more complex than X (btw: you want a nobel prize ? find what X is exactly) which does not require omniscience (which for any real world prediction would effectively be all the information that exists anywhere in the universe)

So the real question changes - if you require proof we can essentially predict nothing. If you even require valid inputs to statistical functions we can essentially predict nothing. Barely any recent science follows from first principles, except perhaps in Mathematics. Physics makes a good-hearted attempt, but it has to violate the first-principles - it's attempting to discover new ones. Every other science never even attempts to work from first principles, it just doesn't work.

Finance - the models only work when you assume decisions don't interact in the short term (ie. nobody decides to either sell a house or forestall selling it because of anything that happens that doesn't directly affect that loan. If this is true, then the financial crisis was impossible (yet also inevitable)). And of course the basic economic assumption - that everyone takes the rational course of action immediately - no matter how complex the logic, and irrespective of any personal convictions.
Climate - energy balance only has to sum up if you assume the entropy of the system is negligible, or if you work on infinite time-scales. Needless to say, infinite time scales are a bit long for practical usage. Entropy within our atmosphere is anything but negligible. The second big assumption made in climate science is that small portions of the atmosphere behave identical to large portions of the atmosphere.
Planets - planet's orbits only behave the way you're taught in school if they followed Newton. But that's not the worst assumption. The other assumption necessary to make Kepler work is that planetary orbits are independent, and no objects with mass can possibly cross into orbits (and obviously that orbits don't cross)

All these assumptions can be proven to be wrong - and rather trivially.

In one case this can be shown. Planetary orbits are extremely, extremely regular in the short term. This was useful for sea-faring when it was discovered as it provided a very accurate source of timing. And we still have the books from those days describing how those measurements worked. We still have books describing how to find a ship's position on earth by measuring the orbits of Jupiter's moons ... only they yield incorrect results. You might chalk that up to bad measurements, but that can't be : if the methods were truly useless, they would never have been written down. Plus we can correct the measurements so they work again. No, the reason is much simpler : Jupiter's moons have shifted so much over the course of 300 years that those measurements became useless, and have to be redone from scratch.

This brings us the real question ... what would you rather have - a -very- inaccurate prediction, very useful in the short term, but you won't realize how inaccurate for several years at least, or would you rather have scientists answer with "we don't know" for almost any large-scale question ? All the predictions suffer from the same problem, surprise "black swan" events that can be explained afterwards but not predicted (and the explanation afterwards brings with it the illusion that we'll be able to predict the next one - but we won't). If we started from first principles, we'd describe everything that was possible, and black swans would be gone, but that's a naive vision : if we started from first principles, we'd hardly predict anything at all, so what use is perfect predictability if we'd essentially lose 99% of all we know ?

Of course the answer is that everyone wants the inaccurate prediction. Often they like to pretend it's not nearly as inaccurate as it is. But whether it's the prediction that the house market will keep rising, the mere thought of a useful climate prediction 100 years out with 95% certainty, or any calculation about the odds of celestial bodies' behavior ... all these predictions are made with less than perfect means, and they will fail.

Re:No Really (0)

Anonymous Coward | more than 2 years ago | (#39832021)

No, you haven't quite understood risk neutrality. Under some not completely realistic circumstances (continuous hedging) then market trend doesn't affect the
option price. That's what the prize was awarded for. Using the risk free interest rate is then correct if non-obvious, it doesn't mean that they don't think that markets trend - it's just that you can hedge it away.

Re:No Really (2)

DoofusOfDeath (636671) | more than 2 years ago | (#39832031)

Most models are invalid in some regard. The trick is to know when you can live with the particular ways in which a given model is invalid.

Re:No Really (0)

Anonymous Coward | more than 2 years ago | (#39832077)

If the market trends, why aren't you rich?

Make a robot that buys when it starts to go up and sell when it starts to fall. Why not?

Re:No Really (5, Insightful)

NonSequor (230139) | more than 2 years ago | (#39831827)

There's more to it than that. The model has developed into a philosophy which has been built out beyond its workable foundation.

It starts with the risk neutral measure. Basically the concept is that you can construct a probability measure (basically a reweighting of probability of events) from market prices. Basically the market prices of a stock, a forward contract (a contract to deliver the stock at a fixed point in the future), a call option (an agreement to offer the option of buying the stock at a given price in the future), a put option (an agreement to offer the option to sell a stock at a given price in the future), and other contracts related to the price of the stock in the future all have to have prices rationally related to each other. If the price of one of these things deviates from the risk neutral measure implied by the others, you can construct arbitrage positions where you can make a profit with negligible risk and executing this arbitrage has the effect of moving the market prices closer toward their theoretical values.

Observably, market prices don't reflect real probabilities. Safe investments such as treasury bonds are disproportionately more expensive than highly rated bonds with a low chance of default based on historical default rates. This is explained due to risk aversion and philosophically, the risk neutral measure is said to reflect the market's assessment of the risk of each investment and also the risk preferences of market participants. This concept is the basis of financial economics, and the school of thought derived from this position has been dominant in economic related disciplines for the past 30 years.

As a means of analyzing for arbitrage opportunities and pricing of marketable securities in a way that avoids offering others arbitrage opportunities, this methodology is largely unassailable. However, where they overextend themselves is that in conjunction with the efficient market hypothesis, they've started to assume that this framework lets you farm out the function of assessing the likelihood of future events to the market and even in some cases they've asserted that it's immoral to use methodologies which imply prices for non-marketable securities which aren't directly comparable to marketable analogues.

It's basically a religion at this point. They honestly believe that the risk neutral measure isn't just a post hoc rationalization imposed on market prices, but a normative guide to upright living and that the market's assessments of the ("risk-adjusted") probability of future events is the best and most rational basis for making all decisions and for framing all policy and regulation.

Re:No Really (1)

repapetilto (1219852) | more than 2 years ago | (#39831861)

Is it that complicated? I thought the models just gave the traders an excuse to underestimate kurtosis risk.

Re:No Really (1)

NonSequor (230139) | more than 2 years ago | (#39832013)

Yes it actually is that complicated, although the majority of people working in finance and related disciplines don't understand the model and at best just know how to plug prices into Black-Scholes.

Re:No Really (0)

Anonymous Coward | more than 2 years ago | (#39831973)

now my brain hurts

typo in headline (4, Informative)

mrgil (126184) | more than 2 years ago | (#39831705)

The past tense of lead is "led", not "lead". When "lead" is pronounced like "led", it's a metal. This mistake pops up everywhere. Correcting it here won't fix anything, but when someone on the internet is wrong, duty calls.

Guns are don't kill people (4, Insightful)

gmuslera (3436) | more than 2 years ago | (#39831707)

People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.

Re:Guns are don't kill people (4, Insightful)

Guppy (12314) | more than 2 years ago | (#39831755)

People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.

Quite so. A risk evaluation that says "95% of the time you will lose less than X" implies "5% of the time you will lose a more than X".
With the stinger being that it says nothing of the range and distribution of values of "more than X".

Re:Guns are don't kill people (5, Insightful)

timeOday (582209) | more than 2 years ago | (#39831767)

You're so sure they didn't understand what they were doing? Maybe they didn't care. None of them returned their commissions on all the trades and phony "profits" they took out of the system, and practically nobody went to jail. They won. Furthermore nothing much has changed. It will happen again.

Re:Guns are don't kill people (2)

O('_')O_Bush (1162487) | more than 2 years ago | (#39831965)

Well who really is to blame? The banks for taking advantage of vehicles that were seen as revolutionary and safe, hedge funds for generating extreme demand for said vehicles despite their safety going beyond common sense once the market grew, the credit reporting companies that kept the insurers credit ratings despite being undercapitalized to fulfill the insured debt obligations, or the government administration that saw the rise of the derivatives market amd subsequent housing bubble but chose to not interfere with something so obviously and radically different until they were almost out of office and simply announced impending doom of the collapse?

The real tradgedy is that the banks were bailed out at all, and instead of propping them up to save the economy, they were given loans at rates so low they could screw the economy over even more by killing credit and investing in treasury bonds.

Re:Guns are don't kill people (4, Informative)

tunapez (1161697) | more than 2 years ago | (#39832067)

You are both right. The fund managers and their pet quants did not understand the whole process and the effects of their actions, all they knew was they were 'printing money' out of thin air every day. Cannot say they were not warned by many, including the father of quantitative analysis; the late, great Mr. Mandelbrot [] . Yeah, the fractal guy. Taleb [] was also an ardent 'wet blanket'. Both predicted this mess years before it happened. Nothing has changed, toxic assets are STILL accumulating in many funds' portfolios. Who cares? The Guv will bail them out after they're done raping the markets.

this quote is so lame (4, Interesting)

circletimessquare (444983) | more than 2 years ago | (#39831937)

the purpose of a tool has a meaning

give everyone a toilet brush, toilets will get cleaned. give everyone a hammer, nails will get pounded. give everyone a gun, people will get shot

the availability and easy access of a tool with an intended purpose and meaning makes certain outcomes easier. it's not complicated

the tool itself, and the presence of the tool, has significance. we all reach the limits of our temper at various points in our lives. we will confuse our teenage son sneaking into the house in the dark with an intruder. we will be drunk and clumsy. and in those situations, whether or not a gun is in easy reach radically changes the outcome of the situation

the purpose and presence of the tool matters

the proper quote is

"guns don't kill people, people with guns do"

if you want guns to be legal, fine. but don't depend upon flimsy easily dismantled logic to justify your beliefs

Re:this quote is so lame (1)

ScentCone (795499) | more than 2 years ago | (#39832131)

we will be drunk and clumsy. and in those situations, whether or not a gun is in easy reach radically changes the outcome of the situation

Yeah, just like with kitchen knives and car keys, right?

Meat cleavers don't kill people, people with meat cleavers do. Right? The presence and purpose of a kitchen knife clearly has moral weight, don't you think? The knife is meant to render things apart. To cut holes in things, to chop things, to remove meat from bones, and such. What moral value are you assigning to that destructive device, while being so capricious about guns? I've never shot anybody, though I've used guns thousands of times. I have, though, ended a very violent situation by brandishing a gun, and thus saving myself and another from certain damage and quite possible death. I've used guns to kill a venomous snake likely to injure or kill a domestic animal. I've used guns untold times to put dinner on the table.

flimsy easily dismantled logic

You're operating on completely muddled premises, plenty of ignorance, and a heaping dose of disingenous cherry picking.

the purpose and presence of the tool matters

No, what you do with it matters. If you think you're the type who can't trust yourself around a shotgun, a chain saw, large kitchen knives, a gallon of gasoline, or behind someone standing at the edge of a train station platform, then you should remove those temptations and tools from your own weak presence. Simple as that. If you know you can't stop yourself from hurting someone with a tool when you get drunk, then your sober awareness that you have the item around is again you acting. Deliberately. The tool doesn't cause you to use it, ever.

No need for Black-Scholes to account for things (5, Insightful)

ehynes (617617) | more than 2 years ago | (#39831715)

Plenty of financial collapses have preceded the current one without the benefit of Black-Scholes. What did they, and the current collapse, all have in common? Excess credit.

Re:No need for Black-Scholes to account for things (3, Insightful)

Anonymous Coward | more than 2 years ago | (#39831731)

In this case, Black-Scholes led to the excess credit by creating too much investor confidence in the loans being given. Because it models risk as a thin-tailed distribution, its use systemically encourages risk taking.

Re:No need for Black-Scholes to account for things (2)

polar red (215081) | more than 2 years ago | (#39831777)

Don't forget the fake financial psuedo-products.

Re:No need for Black-Scholes to account for things (0)

Anonymous Coward | more than 2 years ago | (#39831905)

Hyperbole. Those products were simply natural extentions of the same thin-tailed distribution.

Re:No need for Black-Scholes to account for things (0)

Anonymous Coward | more than 2 years ago | (#39831915)

In this case, Black-Scholes led to the excess credit by creating too much investor confidence in the loans being given.

No, no, no! What lead to excess credit was the failure of those responsible for regulating mortgage lenders. It didn't take a genius to see what was happening with the housing market, that daily price increases outpacing the average wage was absolute fucking nonsense.

It was a computer model, it was complex financial instruments, borrowers were partly to blame... BULLSHIT!

Re:No need for Black-Scholes to account for things (1)

hey! (33014) | more than 2 years ago | (#39831895)

The difference here is how the existence of that excess credit was justified. The model says you can create riskless investment positions, in which case, why not extend more credit? You've got the risk of default covered. As long as not too many people are doing that, you're actually in pretty good shape. When enough people are doing it, you end up with people shoring each other's absolutely safe investments up, a situation ripe for a chain reaction.

Re:No need for Black-Scholes to account for things (2)

pitchpipe (708843) | more than 2 years ago | (#39832073)

The previous financial collapses were caused by using the Black-Holes mathematical model. Black-Scholes just spruced that one up a bit.

Re:No need for Black-Scholes to account for things (0)

Anonymous Coward | more than 2 years ago | (#39832119)

Excess credit coupled with greedy people who have no problem screwing others over for personal gain.

Re:No need for Black-Scholes to account for things (0)

Anonymous Coward | more than 2 years ago | (#39832183)

Plenty of financial collapses have preceded the current one without the benefit of Black-Scholes. What did they, and the current collapse, all have in common? Excess credit.

Exactly. The Black-Scholes model is not really applicable to credit markets anyway - it is aimed at things such as equity, FX, commodity options. None of these markets caused the collapse of a bank in 2008. In fact, FX traders had their most profitable year ever in 2008 due to the high volatility.

All these "Black-Scholes is evil" stories also miss something else. They are making a hypothesis about the behaviour of real world traders, but make no effort to gather evidence about whether real-world traders actually behave this way. In fact, if you look at any option market, whether that be Chicago, New York, London, Paris, Tokyo etc, the prices of the range of different options on a particular asset cannot be made consistent with any simplistic Black-Scholes model (or the Black model for futures options), whatever parameters you choose. This is called the volatility smile and it is a permanent, large and significant feature of all option markets for the past few decades. It is proof that the models actually used by traders cannot be Black-Scholes.

Footnote: The Black-Scholes-equivalent volatility is sometimes used as a way to express the price of options, in the same way that bond prices are sometimes expressed as yields. That doesn't mean that the traders seriously think that all options or all bonds from a given company should have the same value.

Gamble with their own money (0)

Anonymous Coward | more than 2 years ago | (#39832195)

Agreed, if they gambled with their own money, they wouldn't hide behind Black Scholes. It's known not to reflect real world risks (like fraudulant mortgages). The only reason they use Black Scholes is because it lets them claim the asset as solid and thus lets them borrow against it.

But if they gambled their own money instead of Fed money, then you'd suddenly see a revolution in risk analysis which accurately reflects fraud.

More to the point, when these scheme collapse, you'd see proper criminal prosecutions, instead of the whitewash we have now.

At the very least they should be limited to the same sort of multiple any other business is lending money at, 60% of concrete assets or less, not 3500% of garbage pseudo assets.

well known in econ circles... (2, Insightful)

Anonymous Coward | more than 2 years ago | (#39831717)

The one in 98 (yes there was one there the US gov fixed that one then kept it fairly quiet). Then the one in 2000 and the one in 2003 and the big one in 2008.

Hedge funds are killing us with 'liquidity'. But for a short time they make us boatloads of money!

The way it was explained to me was *IF* the market does not move in one direction or the other much this formula works. If it starts to move in either direction your going to get hit...

Greed (1)

GeneralTurgidson (2464452) | more than 2 years ago | (#39831727)

Greed was responsible for the financial crash. If this algorithm hadnt even existed, we still would have been in the same mess we're in.

Re:Greed (2)

SaroDarksbane (1784314) | more than 2 years ago | (#39831779)

Saying greed causes financial collapses is like saying gravity causes plane crashes; while trivially true, it doesn't give us much insight into the nature of the problem.

Theory and Application (3, Informative)

alphatel (1450715) | more than 2 years ago | (#39831733)

Deregulation, not models, permitted bad behavior. Banks that guarantee loans simply should not be emulsifying them into packaged trades, and then hedging their own equity on the loan derivatives. It's like taking a tulip bulb, selling interest in a tenth of the bulb with 1000:1 equity, and then saying it's more stable. Once it goes the wrong way you are screwed and you know it (but you just don't want to believe it could ever happen).

Re:Theory and Application (5, Informative)

swalve (1980968) | more than 2 years ago | (#39831871)

The emulsifying you are talking about wasn't the problem so much as was the leverage and the short information horizon. An investor could buy one mortgage and take on binary risk- it pays off, or it fails. That's a lot of risk. So he can pool his money with a bunch of other people and buy 1% of 100 loans. The risk of any loan failing is spread across all the investors. That, in itself, is a good idea, it is just basic diversification.

The leverage problem was that they didn't just split the loans equally like that, they split the loans into tranches, or classes, of investor. The risk averse investor bought the high quality tranche, and for that got a higher guarantee of payment in exchange for a higher price (lower yield). The lower tranches were sold to suckers with the promise of potentially high rates of return. But as the individual loans started failing, the way the package was levered, the higher investors ended up getting paid, and the lower investors got nothing.

A quick example of the information problem was the practice of the 80-15-5 mortgage loans. Conventional wisdom says that when someone takes out a mortgage with zero down, that mortgage is more likely to fail. So again, conventional wisdom says that in order to hedge for that increased potential failure, you need to charge a higher interest rate. For some reason, and I agree it was probably lack of regulation, someone figured out that you could split the mortgage into three portions- standard risk (the 80%), higher risk (the 15%) and highest risk (the 5%). In the documents for the 80% loan, you could then say that this loan had 20% down, and you'd get the good rate. Then you do the same with the 15% loan- "hey, this loan has 5% down, give us the OK rate". Then you would only end up paying the super high risk rate on 5% of the balance of the mortgage instead of the whole thing. The problem there was that the whole loan had the high risk, but the investors in the 80% and the 15% didn't know it.

Re:Theory and Application (1)

repapetilto (1219852) | more than 2 years ago | (#39831885)

Well, you could argue that any bank doing that would just eventually fail due to their policy of underestimating risks. The problem is that the bank gets to take down everyone around them as well. Why are banks so huge and powerful?

Perhaps if banks were treated like normal businesses it wouldn't be such a big deal when they fail. Then again there is a 200 year history of special treatment (bank holidays, etc) so it would be a shock to the system to do that now.

Re:Theory and Application (4, Interesting)

TubeSteak (669689) | more than 2 years ago | (#39831963)

Deregulation, not models, permitted bad behavior.

Banks were faking/changing loan documents, lying to customers, and pushing customers into bad (but profitable) loans.
All the regulation in the world won't help if there's no one enforcing the rules.

Re:Theory and Application (-1)

Anonymous Coward | more than 2 years ago | (#39832015)

Who are you selling the tulip bulb to? Is it the Federal National Tulipbulb Mortgage Agency, who bought roughly two-thirds of the crises' crazy tulip bulbs? The agency you were required to sell tulip bulbs to in order to meet quotas for minority tulipbulb ownership? "Deregulation" my foot.

It still had a hugely positive effect... (0)

Anonymous Coward | more than 2 years ago | (#39831737)

But people should be clear that it is just a guide and an approximation! Scholes doesn't deserve criticism for what was and is a huge contribution - those who relied on it alone do.

It led to crash because... (1)

drobety (2429764) | more than 2 years ago | (#39831747)

The Black-Scholes formula leads to crash because it misses components which account for: a) looking at the formula, b) using the formula.

Re:It led to crash because... (2)

Attila Dimedici (1036002) | more than 2 years ago | (#39831829)

Exactly. The Black-Scholes formula (and most other formulas which attempt to predict market behavior) are structured on the theory that people make decisions regarding buying and selling based on factors primarily concerned with the value of the financial instrument being traded vs the value of other financial instruments that are available to the buyer and seller. The problem with the formula happens when people start to make decisions regarding the market on the basis of the formula rather than their perception of the value of various financial instruments available to them. As soon as the number of traders relying on the formula exceeds some percentage (I do not know what that percentage is) the formula stops accurately predicting the market. It will continue to appear to be predicting the market for a short period of time after this happens, but it will be inflating a bubble that will inevitably burst when someone notices that the pricing of certain financial instruments is out of sync with their relative value to other financial instruments.

Interesting, but really... (5, Interesting)

Anonymous Coward | more than 2 years ago | (#39831757)

Interesting, but really, blaming the seed on Jack looting the giant's castle? I used to write risk analysis software for the traders and market makers at the options exchange in Chicago (CBOE) and am intimately familiar with Black-Scholes algorithm (I've implemented it more than once). In the article, the sub-text to one photo, "Options allow a trader to have a delicious risk-free portfolio", is totally bogus! Options allow a trader to MINIMIZE the risk in their portfolios, and BS (no pun intended) helps traders to do that in a mathematically/statistically rigorous way. Misuse of any tool (using a hammer to kill someone, for example) is not the tool's fault, but the wielder of the tool!


The Economy, a genuine creation (1)

hcs_$reboot (1536101) | more than 2 years ago | (#39831765)

Amazing how mankind is able to create from A to Z the very rules that eventually lead to its failure.

old news (3, Interesting)

Anonymous Coward | more than 2 years ago | (#39831773)

This was covered by the guardian a whole two months back. Link [] Partly debunked here []

A math model? That must be a fancy name for (5, Insightful)

Anonymous Coward | more than 2 years ago | (#39831775)

1. Approve $300K mortgages for people earning $35K/yr, falsifying documents as needed

2. Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing, etc, under the direction of math and finance PhD's [] . Sell these "Triple-A-rated securities" to gullible investors worldwide.

3. ??

4. Profit!

8-figure pay packages for bankers and 7-figure for mortgage brokers, real estate agents, workers in credit rating agencies, etc. until the music stops. But hey, you won't need to defend your resume when you've got enough millions in the bank.

5. Watch housing prices rise by 30-50 percent/yr

6. Goto step 1.

Re:A math model? That must be a fancy name for (0)

superwiz (655733) | more than 2 years ago | (#39831931)

Approve $300K mortgages for people earning $35K/yr, falsifying documents as needed

Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel. Slashdot's policy is that "all comments are owned by the poster." I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case.

Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing,

Why do you put "insurance" in quotes? Options do act as insurance. They can be used for speculation, but so can other insurance products (eg: commodity futures).

Sell these "Triple-A-rated securities" to gullible investors worldwide.

As opposed to what? Keeping trash you don't need on your books? Not seeing a single word about rating agencies giving those AAA ratings. Banks didn't even make false statements. The agencies kept giving those ratings because they knew the higher the ratings they gave the more bonds would get issued to be sold. The system of incentives was broken because pension funds had to take the word of the rating agencies on faith (still do by the way). There is plenty of small rating agencies who laughed at the idea of those bonds being rated AAA, but their opinions weren't legally binding.

Now how's the Black Scholes responsible for anything? All it does is calculate a price of an option based on previous history of the underlying. The whole premise of the article is as valid as blaming car crashes on actuarial tables.

Re:A math model? That must be a fancy name for (0)

Anonymous Coward | more than 2 years ago | (#39832023)

I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case.

Yeah, because there's no evidence whatsoever of any bankers committing such fraud, let alone several state attorneys general engaging in investigations.

Surely you've heard of them?

Re:A math model? That must be a fancy name for (1)

superwiz (655733) | more than 2 years ago | (#39832081)

Falsifying documents in order to ensure loans for people with low income (as was your original claim)? No, I do not know of any such cases. Do you have a link? I would be genuinely curious to see one.

Re:A math model? That must be a fancy name for (0)

Anonymous Coward | more than 2 years ago | (#39832141)

Falsifying documents in order to ensure loans for people with low income (as was your original claim)? No, I do not know of any such cases. Do you have a link? I would be genuinely curious to see one.

Are you retarded? Really? I can dig up about a thousand of these without even trying.

Re:A math model? That must be a fancy name for (2, Informative)

Anonymous Coward | more than 2 years ago | (#39832205)

Superwiz, were you asleep over the past few years, or perhaps while'd it away playing shoot 'em up video games?

It took me about two minutes to find the following. Note these are major news outlets with experienced financial reporters, not bloggers.

Go ahead and forward my post to whichever banks you want.

- OP

Re:A math model? That must be a fancy name for (0)

Anonymous Coward | more than 2 years ago | (#39832049)

You forgot:

4.1: get bailout loans, which you use to purchase government securities, profiting off the entity that just saved your ass.

4.2: use said profits to lobby hard against the laws the tried to pass to keep you from bilking the public again.

Right (0)

Anonymous Coward | more than 2 years ago | (#39831795)

So Einstein and other scientists were responsible for disasters like Chernobyl, etc?

The textbook that lead to correct grammar (0)

Anonymous Coward | more than 2 years ago | (#39831809)

really slashdot? (0)

Anonymous Coward | more than 2 years ago | (#39831837)

What's the next story, laws of physics to blame for car crash? Excel to blame for embezzlement? I'd expect to hear a story like this in a dive bar. Or a tabloid.

nonsense...pure nonsense (2)

superwiz (655733) | more than 2 years ago | (#39831851)

The formula calculates what can be expected based on what is known.... That's all. What's next? Are we gonna start blaming actuarial tables for people dying in car crashes?

Who comes up with this shit? (1)

Anonymous Coward | more than 2 years ago | (#39831853)

The Math Formula That Lead To the Financial Crash

No, lending money to illiterate shitkickers who couldn't service the loans caused the crash. (Why does everyone keep ignoring this point?)

Re:Who comes up with this shit? (1)

Anonymous Coward | more than 2 years ago | (#39832071)

Because more often than not the "illiterate shitkickers" we're lied to and told they could services the loans? Why do people keep ignoring that people were commiting fraud for profit?

Always trying to pass blame... (0)

Anonymous Coward | more than 2 years ago | (#39831879)

The model didn't fail, it was the forecasters that used it. Black-Scholes takes five inputs (strike, underlying price, risk free rate, volatility, and time to expiration) and spits out the price of the option. The problem is that the risk free rate and volatility are both assumed to be known -- but they are two inputs that are completely subjective and only as good as the forecaster. When you put garbage in to the model, you get garbage out. Humans can get lucky at predicting the future sometimes, but will eventually fail at it. I think the better thing isn't for people to stop using Black-Scholes, it's to start remembering the turkey story (see Black Swan) and stop putting every egg you can in to one basket.

Not too complex for a musical (3, Funny)

Antique Geekmeister (740220) | more than 2 years ago | (#39831901)

I highly recommend the opera at [] , from the Ig Nobel prizes a few years ago. It captured the most recent banking crisis rather well, and without the need to blame human greed on misused mathematical formula.

Supply and Demand (4, Funny)

Guppy (12314) | more than 2 years ago | (#39831913)

Once Risk became a commodity capable of being bought and sold, it was only a matter of time before market responded by producing more Risk.

Re:Supply and Demand (1)

Nimey (114278) | more than 2 years ago | (#39831981)

Should have used the Australian Gambit.

ugh (0)

Anonymous Coward | more than 2 years ago | (#39831923)

just ugh.

drink deep or not from the pyrian spring.

  an article that once again demonstrates the inability of mainstream media to grasp even basic technical issues. and because they don't understand, they jump to these sort of sensationalist bullshit conclusions. you know what? the discovery of *numbers* thousands of years ago probably led (not lead) to all major wars. because science.


this should not be on /.

Math IS the root of all evil... (0)

Anonymous Coward | more than 2 years ago | (#39831933)

So I was right all along...math really IS the root of all evil!

What really happened... (2, Informative)

Anonymous Coward | more than 2 years ago | (#39831983)

What really happened is this:

#1. Large central banks control the issuing of currency, to governments. This, however, is a loan. Repayable with interest.

#2. The very same large central banks (eg. The Federal Reserve) accept payment only in the currency they themselves issued, or that of another large central bank.

#3. The loan (issue of currency) is therefore impossible to repay, because the interest payments cannot be made without issuing more currency. (Loans with interest)

#4. We have now reached the point where the interest payments outstrip the available currency. Take a look at (Figures there are sourced from the US Treasury)

#5. The system crashes and burns, because it's an impossible formula. (Happened already, the effects have not been felt yet, not even in Greece. What's yet to come is far, far worse.)

This is why the EU and US are fucked. Who are they actually in debt to? Large central banks, typically of other nations. When two nations are in debt to each other, (as is very often the case, eg. Spain & Italy, which owe each other tens of billions of euros) why is the debt not cancelled out to the extent possible?

Because of the interest payments!

It's really very simple when you look at how the money is created in the first place, to see that the only thing it can possibly end in is debt and the enslavement of entire nations... Exactly as designed.

Oh, also... None of these central banks are using gold reserves any more, that's old hat. No, they've sold those off and now hold reserves of foreign currency instead...

But if none of them have any gold left, and simply have foreign currency issued by banks that also have no gold left... Ultimately, it's all entirely worthless anyway.

Nothing Wrong With the Math (5, Insightful)

dupup (784652) | more than 2 years ago | (#39832007)

The equation was not at fault: the output is only as good as the inputs. The real problem was the instruments being traded: credit default swaps. These are of dubious merit and much more complicated than more traditional underlying instruments (the thing on which you hold an option contract). For example, suppose you have an option to be 100 shares of Google at a given price. It's easy to evaluate the value of the underlying instrument because there's an efficient market for it: Google is traded on a public exchange and the value is agreed upon within a penny, generally. Black-Scholes works on Google options just fine and you can minimize your risk reasonable well using it.

The credit default swaps were much more difficult to evaluate because of the lack of an efficient market for them. The essential nature of the underlying instrument were very high risk mortgages, not too different in concept from so-called junk bonds. The potential return was high because the interest rate was high. The potential risk was high because the risk of default was high, making the underlying instrument worth very little, much less than face value. So take these risky mortgages and then buy insurance policies for them, this is standard practice. That hedges the risk of the actual mortgage itself. Bundle the mortgage and the insurance policy up into a quasi-mutual fund like product: you have x number of mortgage/insurance policy bundles with average risk of default at y. Getting more difficult to put a value on, especially since there is no regulated exchange for them and little oversight.

Not done yet. Add in that deregulation rules passed during the Clinton era allowed the banks that issue the mortgages and buy the insurance policies to also use their assets to trade on their own. This group within a group is called "proprietary trading". So, the prop-trading groups within the banks buy and sell the mortgages and insurance policies to each other in order to generate income for the bank. There are also other groups that buy and sell these instruments that don't actually issue mortgages. These are called speculative traders.

Finally, to put the finishing touches on this pile of doo, have a group create a new instrument: a binary option (it does or it doesn't) on a bundle of high-risk mortgages and their insurance policies. A binary option is essentially a gamble: it pays out if something happens, it does not pay out if something doesn't happen. Now you're buying and selling options contracts which predict whether a group of mortgages will fail or not. There's no regulation, no formal exchange (which helps create market efficiency). There's no reliable way to determine the value of the underlying instrument because it depends on knowing how many of the mortgages will fail. And don't forget that the banks were using their investment customers to create demand for a product they wanted to sell ("I think you should invest in such-and-such") without telling the customers that the banks themselves would be profiting by selling questionable instruments to their own customers.

This is the magic of unregulated capitalism (almost - the banks should have been allowed to fail in a purely unregulated capitalism system). Nothing wrong with Black-Scholes here. The real problem at the core is that the banks involved are so driven by short-term success that there is no room for sanity. Wrap it all up with the fact that the banks know they will be bailed out by the Feds if they fail. There is no penalty for risk and no regulatory oversight. Gotta have one or the other or we just plain deserve this insanity.

Fake assets, meaningless equations (1)

Anonymous Coward | more than 2 years ago | (#39832011)

Except for one thing, the leverage ratio of Wallstreet has gone up and up, meaning that the ratio of borrowed money (created from thin air by the Fed) to real assets went up and up. So everyone in the game knew they were selling magic beans on a Ponzi scheme, but with so much commission being milked from the system nobody cared. After all it was the Fed that created the money and thus the people taking the risk was mostly Americans with dollar assets. The bonuses would be taken out long before these schemes collapsed, and all of that is free money to them. They're not risking their own assets, they're risking Fed magic money.

The Fed recently said "we made a profit on the bailout loans". Let me show you why that's a scam:

Fed lends $1 trillion against magic beans as collateral, at 0.01% interest to Bank. That money is magic money, created in a spreadsheet, as only the Fed can.
Bank uses that money to buy a real asset that makes real profit.
Bank borrows against the real asset, and replays the magic bean asset.
The profit from the real asset pays the 0.01% interest.
Fed chief claims to have made a profit on magic bean loans.

The Fed doesn't want the loans repaid, it will keep swapping them for other types of loan each time people notice the scam, because to get the money repaid is deflation and USA cannot allow deflation.

The only fix for these fake assets is to stop leverage loans from the Fed to Wallstreet, directly or indirectly (Fannie May, Freddie Mac, AIG etc.). If Wallstreet was risking its own assets then they wouldn't create fake ones sold with dubious equations.

If you're real world business can't borrow more than 75% of concrete assets, then why would Wallstreet be able to borrow 35 times their assets, where the assets themselves are even known to be junk.

Author William Poundstone pointed this out in 2005 (2)

Zontar_Thing_From_Ve (949321) | more than 2 years ago | (#39832027)

I don't read a lot in my spare time, but one author I like is William Poundstone. I was going on an international trip and I wanted a book to take with me to read to kill time, so I bought his book _Fortune's Formula_. Essentially the book is about some Bell Labs geniuses who came up with mathematical models that allowed them first to make money at casinos and then to exploit weaknesses in the US stock market to make money. Scholes is featured in the book, but he's not a main character. I offer the following 2 quotes directly from the book which are on this very subject.

"LTCM was simply in the position of a gambler who goes to a casino where the pit boss gives him unlimited credit." (page 283) Note that LTCM was the fund that Scholes helped run. The book further goes on to state that in real life, nobody gets truly "unlimited credit". A casino will not loan more money than they can collect. But LTCM's business model depended on credit never running out to them.

"Warren Buffet marveled at how 'ten or 15 guys with an average IQ of maybe 170' could get themselves 'into a position where they can lose all their money.'" (page 291) It's a big simplification, but basically LTCM got burned by the Russian currency collapse which started a chain of events that killed them.

Guessing is the problem (1)

minstrelmike (1602771) | more than 2 years ago | (#39832069)

The mathematical formula is not the problem. All it does is make it possible to get more exact about your guess as to what the future holds (based on your guesses about the actual values of things instead of the expected values). But math cannot predict the future any better than Tarot Cards can.

Re:Guessing is the problem (1)

Lawrence_Bird (67278) | more than 2 years ago | (#39832227)

BS is not about predicting the future. BS, binomial,etc models enable you to establish a 'fair value' for an asset such as an option, based on various input parameters. Along with the fair value come various metrics which allow you to predict how that price may change for small moves in each of those parameters and to attempt to hedge, if desired, against said small moves.

And just as in the housing market, 'fair value' does not necessarily equate to 'market value'.

when genius failed (1)

ch-chuck (9622) | more than 2 years ago | (#39832135)

Great book about a massive hedge fund crash in the 90's: The Rise and Fall of Long Term Capital Management []

Re:when genius failed (2)

andy1307 (656570) | more than 2 years ago | (#39832209)

Scholes was one of the co-founders of LTCM.

Bollocks (3, Informative)

Lawrence_Bird (67278) | more than 2 years ago | (#39832157)

BS had zero to do with any of the problems which led to the various market meltdowns. What did? Ignorance of liquidity (more precisely, lack of liquidity), counterparty risk, seriously flawed assumptions about various correlations (think gdp, unemployment, geography, subprime mortgages), significant excess leverage financed at exceptionally low interest rates, creation of intstruments which allowed some holders to game the system (credit default swaps) and lastly, ignorance and greed. There are, of course, myriad other contributors but BS is not one of them.

Disclaimer: besides having a masters degree in computational finance I worked in the industry for nearly two decades.

We are taking about nothing ... (1)

pumapunku (2627607) | more than 2 years ago | (#39832169)

Every model is build upon some hypothesis. If you apply it without be aware of its limits it's your fault.

Causes of the Financial Crisis (0)

Anonymous Coward | more than 2 years ago | (#39832171)

1. Poorly understood packaging of subprime loans
2. Even more poor regulation and risk assessment of these by Moodys and S&P
3. Poorly understood relationships between prices in housing market and effect on these CDOs
4. Belief that prices for real estate will never go down nationwide and even if they do it will take a massive collapse in prices to cause a financial collapse -- in fact many CDOs failed when prices declined only 6%
5. AIG not understanding what they were insuring and not charging nearly enough for the insurance
6. I-Banks taking the long side on these CDOs that they did not understand and management did not understand
7. Govt policy that was hell bent on pushing home ownership to those that should have been renters -- both parties supported this but the Democrats pushed much harder and when it was clear we had a problem they put their heads in the sand and declared the system perfectly healthy
8. A public that let the i-Bankers off the hook and allowed the US Treasury to pay off the risky bets the I-Banks made 100%

Black Swans...Break Things (0)

Anonymous Coward | more than 2 years ago | (#39832219)

The financial markets used a "formula" without seeing the risks that went beyond what the formula had as INPUTS.

Taleb's book made many points about how the best laid plans of mice and men go awry. Mice make assumptions about the acquisition of grain seed in the field when they don't see or hear the hawks. Unfortunately, the fox also hunts.

Mechanical engineers can say "The beam has a tensile stress safety factor of 10 & it will never break." The formula for tensile stress is satisfied. Unfortunately, creep, crystalization, chemical attack, notch sensitivity, vibration, harmonic vibration temperature and radiation can alter the "strength" of a beam.

Formulas are only as good as the person doing the WHOLE analysis. Naseem Taleb was right, Black Swans will continue to pop up.

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