how did a housing crisis become a financial crisis, ending up as an economic crisis?
how come highly trained professionals didn't see it coming?
a nice simple summary visualizing all the subprime mortgage, CDO, CDS, leverage, tranching, rating, AAA, default, frozen credit market stuff:
at the barebones level, wired magazine gives insight into the core mechanism in their article Recipe for Disaster: The Formula That Killed Wall Street.
the culprit:
the gaussian copula function
basically a quantity measuring the correlation (preciser: the dependence structure) of two random variables.
"the corporate CDO world relied almost exclusively on this copula-based correlation model."
"everyone was pinning their hopes on house prices continuing to rise."
the idea, published in 2000, quickly became a metric quants ubiquitously used to evaluate risk and a cornerstone of financial engineering allowing simple modeling of vastly complex risks. particularly default risks of CDO tranches. until august 2007...
the ideas:
- tame the nasty nature of real-world dynamical, complex and latent variables by substituting them with a clean and simple number summing up everything
- convey an image of what is happening: correlation is more like a constant than a fluctuating variable and all you need to know and compute
- let the method be adopted by investors, banks, rating agencies and regulators
- ignore any warning signs (for instance d. sornette in 2006: "this recurrent use [of gaussian copulas] has been ratified by the recommendations of the BIS concerning credit risk modelling. however, there are many indicators suggesting that this [...] approach may be grossly inadequate to account for large credit risks [...]." pg. 138)
- let everyone make a lot of money
- let quants forget about the concrete reality behind the math and crank up the models
- let managers, lacking formal math skills, execute transactions worth trillions of dollars based on the models
- forget about the underlying magic that makes it all work: a decade of soaring housing prices
- lend money to people without jobs and income
- be surprised when everything blows up in your face
cartoon from cagle.com
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update 28th of june 2010:
