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.