Or how David X. Li single-handedly killed the economy
But it’s refreshing to see that some knucklehead with a propeller cap had something to do with it. And the great thing about it: We all knew this.
Ironic? Nope, we’re all just stupid. Read Recipe for Disaster: The Formula That Killed Wall Street for the full, horribly depressing story.
Here’s a recap of how correlation – the heart of the issue, or horrible assumption most everybody made – works:
To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Let’s call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price.
But something important happens when we start looking at two kids rather than one—not just Alice but also the girl she sits next to, Britney. If Britney’s parents get divorced, what are the chances that Alice’s parents will get divorced, too? Still about 5 percent: The correlation there is close to zero. But if Britney gets head lice, the chance that Alice will get head lice is much higher, about 50 percent—which means the correlation is probably up in the 0.5 range. If Britney sees a teacher slip on a banana peel, what is the chance that Alice will see it, too? Very high indeed, since they sit next to each other: It could be as much as 95 percent, which means the correlation is close to 1. And if Britney wins the class spelling bee, the chance of Alice winning it is zero, which means the correlation is negative: -1.
Now, read the story to find out all the rancid, juicy details. Here’s the crux of the matter:
They [bankers] didn’t know, or didn’t ask. 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.
Oh, snap, here comes the the guy letting the single culprit off the hook:
“Li can’t be blamed,” says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the 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.
Dammit, I want my goat, as in scape!
Oh, but let’s rejoice in knowing that Li is doing his “magic” in China now, and we can celebrate our competitor across the Pacific’s demise (I’m being flip here, I don’t want to see this sort of catastrophe again, to anybody. And I like China. So do most Americans, too, judging by their Wal-Mart shopping sprees.):
In fact, he is no longer even in the US. Last year, he moved to Beijing to head up the risk-management department of China International Capital Corporation.
Oh, wait. Li himself said,
The most dangerous part is when people believe everything coming out of it (his model).
I guess he sort of warned us. Read the article. It’s very interesting and it’s written in such a way that even I could understand it.
No, the title is not about another stock market crash – it’s about crashes in the past. This one is a one-pager about the Nikkei Index collapse that began in the early 1990s. I remember being in college at that time, and the Japanese stock market was going absolutely nuts (on the bullish side). I think it got to nearly 40,000!!!
Only to fall to less than 10,000 and stay there for over 15 years!
By the way, the site below has articles on a handful of financial crises that have occurred over time. They’re worth studying because there’s one sure thing:
Humans aren’t very good at learning from our mistakes. In fact, it’s highly likely that we’ll repeat them again and again. Often times, we make the same mistakes over, but bigger and more catastrophic.
The stock market has rebounded quite well since it hit the 6,000 range (Dow). The question is, will the rise continue, or will it stall. OR worse yet, is this the classic “dead cat bounce?”
It all remains to be seen, of course. Too soon to tell. But I’m going on record to say that this, even with today’s announcement by the Fed that it’s officially fueling inflation by printing money, is not a dead cat bounce.
Oh, the market may tumble for a few days. But I think we’ve bottom. Just note that the bottom of the ocean has peaks and valleys, too, and that we might see 6,000 again. We may be here a while. But we’re not gonna go any lower than 6k.
In fact, it is my gut feeling that we’re on the upswing. I believe the end of this decade and the first few years of the next decade will be banner years for stock markets all across the land.
After all, we’re at levels here in the US that we haven’t seen since the mid-90s. The housing, credit, and mortgage messes weren’t even in place then.
So we’ve fallen further than logic would dictate. John Hussman, in his newsletter, says,
As for the stock market as a whole, I continue to view the market as undervalued, but not deeply undervalued. So over the course of a 7-10 year holding period, I do expect passive buy-and-hold investors in the S&P 500 to achieve total returns somewhat above 10% annually.
But he also says,
Shorter-term, however, investors may demand much higher prospective long-term returns in order to accept risk, and that’s a problem, because the only way to price stocks to deliver higher long-term returns is to drive prices lower.
After all, even a dead cat will bounce.
I've seen a lot of stories about what caused the Mortgage Meltdown, the Credit Crunch, and the recession (some are even calling it a depression). On the drive in today, the REAL answer finally came to me.
As in all complex things in life, there wasn't one specific cause. Here's my general thought process on this topic.
People who want to get to the root of any cause always use a root cause analysis to determine the true cause of any issue. One of the practices that process improvement folks use is the fishbone diagram, where if you keep asking "why?" to a question you'll get to the root of it.
But this simple approach often neglects the contributing factors to an issue or a failure. For example, a barn might have caught fire and burned to the ground. The root cause might have been determined to have been a spark from a passing-by freight train.
But the contributing factors were that there was damp hay in the barn, along with kerosene, dry timber, a poorly-maintained exterior, and weeds that had grown rampant over the course of several years.
All of these things led to the fire. Of course, the fire could not have started if not for the spark. But the weeds, hay, timber, etc. allowed the fire to spread at such a rate that the fire crew could not stop it before the entire barn burned down.
Such is the case with the economy. There were many contributing factors: Declining home values, rising bad debt, companies trying to stay afloat cutting staff, phoney financial instruments dreamed up by mathematicians rather than business folks, etc. The list is literally endless.
But what was the root of it all?
As in any mania, it was the madness of crowds. Adam Smith's "invisible hand" and "pursuit of self interest" was the downfall.
Home buyers thought, "If I don't buy this house now, somebody else will."
"Or, if I don't buy this house today, it will cost me $60,000 more to buy this house in 6 months." (By the way, this was the rate of price appreciation for a below-median home price in the Bay Area in California in 2003-2006.)
Lenders said, "If I don't fund this mortgage, somebody else will."
Insurers surmised, "If I don't insure this asset, somebody else will."
If I don't _____ this, somebody else will!
It was all about getting "it" before somebody else got "it." Or, in other words, what I call "relative greed." It wasn't that everybody was greedy, in and of itself. It was more along these lines:
You get a 10 percent pay raise. Your neighbor gets a 15 percent pay raise.
You get a 5 percent pay raise. Your neighbor gets nada.
Do you know which one most people would take? Yeah, #2. It's getting "more" than your neighbor, co-worker, competitor. That's what happened here, in my humble opinion.
It's also "the market" filling in voids. If Bank of America doesn't do this mortgage, Wachovia will. And Wachovia did. And did, and did and did and did.
BofA saw this and said, "We're losing market cap. And we're the biggest and baddest bank around." So, they got into the game, and then some!
People did it, too. If I don't buy a house now, I may never be able to afford one.
"Investors" did it, too. If I don't buy this duplex now and flip it, I may never get another golden opportunity like this.
Do yourself a favor: Read Extraordinary Popular Delusions and the Madness of Crowds.
You only really need to read any one of the stories. They're all the same, really. Market goes up and up, creating self-fulfilling prophecy. Something happens. Market goes down and down, creating self-fulfilling prophecy. What stops it? Who knows?
Money isn't everything. It's the only thing. Wait. That's only for football.
Enjoy life. Spend time with your family.