Bogus Gold

The worldwide financial crisis has prompted me to do a bit of research into the field of finance just to try to make sense of what happened and why. From a layman's perspective, it doesn't seem to make sense that someone defaulting on a mortgage in Minnesota, or Arizona, or Idaho could crash the stock markets around the world. And yet, we have been semi-informed by various news reports that this is exactly what happened.

Okay, so we know something went wrong in the financial sector. My big questions are "What?" and "How?" I've never quite been satisfied with the answers I hear most often. I surely can't trust the spin coming from the politicians, who respectfully blame President Bush (from the Democrats), the Democratic Congress and/or President Clinton(from the Republicans), and corruption (aimed at each other). As the saying goes, fixing the blame isn't the same as fixing the problem. And I've discovered it's not very good at explaining the problem either.

When digging a little deeper on my own, I discovered arcane terms I'd never heard of before deeply embedded into the bloody corpse of our economy... terms like "credit default swaps," "mortgage-backed securities," "LIBOR," and "quants." Making sense of this stuff is quite a challenge to someone who hadn't previously been interested enough in this topic to even know these things existed, let alone how they were supposed to work. And you can't really understand how and why these things failed without knowing that much.

Thankfully there remain a few people out there who do know this stuff, and are able to make sense of it. And that's how I found out that this was all caused by David X. Li, the man who sold the world.

Alright, it's not really fair to say he "sold" the world. But he did something pretty close. He gave others the mechanism by which they thought the world was salable, setting off an explosion of new financial activity as they set about buying and selling it. This activity looked almost like it was making money out of thin air, and that's exactly how you inflate a bubble - with air. But at least now I understand more about what got the air blowing. And that brings us back to Mr. Li.

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. ...

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.

Emphasis mine, and it's just there to justify my characterization. Li was not to blame for the financial bubble, per se. But in a way he invented the air that inflated it. People started buying and selling all sorts of things in ways they simply could not have done without Li's formula.

There's much, much more to this story, and I'm grateful to Felix Salmon for telling it so clearly. I'll encourage everyone to head over and dig into it for yourself. It will be well worth your time, and help you make better sense of the mess we're in. But I will skip ahead to the conclusion to point out an important warning from this story.

In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

Sounds like something I've heard somewhere before.