A couple months ago, there was a PBS documentary on the sub-prime mortgage crisis, describing how those worked, the risks that were involved, and why they failed. I can’t for the life of me find that documentary again, and being a filing-hungry monster, it’s left a bit of a gap in my consciousness. Well, today, my brother pointed out an article to me, from Wired Magazine, called, “Recipe for Disaster: The Formula that Killed Wall Street.” It discusses almost exactly what the PBS documentary had done, but because it’s in writing, it’s ten times better. Because, you can actually go back and read and re-read the stuff that makes no sense. The heart of the problem was this complicated, yet simple, equation into which data was fed, and out pops a magical number rating the risk-factor of a bundle of mortgages:
It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.
The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li’s copula approach meant that ratings agencies like Moody’s—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.
As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function. [emphasis mine]
The man who came up with this formula was no dummy. He is a man armed with 3 master’s degrees and a Ph.D. The potential pitfalls of his formula were not even unforseeable…people did sound alarm bells over it. And yet, the banks and mortgage divisions proceeded to use this beautifully simple and magical formula. Well, as reasonable, rational people, we all know that magic is a dangerous weapon to wield. But the rational and we-answer-to-nobody, you-just-bail-us-out banks deigned to think differently. Why? Because, like the article said:
Bond investors are very comfortable with the concept of probability. If there’s a 1 percent chance of default but they get an extra two percentage points in interest, they’re ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time. [emphasis mine]
Of course, though, the banks never lose. We, the people who are forced to watch them being bailed out with our money–our money which can never be spent on universal health care because it’s too expensive, our money which we might never see again in the form of Social Security because God knows if it’s going to be around forever–are the ones who lose. Every single time. It’s almost better than gambling for the people running the banks. They get their bonuses. They keep their pensions. They can afford the best health care money can buy when they get heart attacks. They never lose. Will they ever lose?