This is part two of a post referring to Wired magazine’s recently published article by Felix Salmon in which he discusses the complex formula that is being blamed for spurring the collapse of the financial sector.

Because of Li’s somewhat simple formula, bankers could bundle anything and create a triple A-rated bond – everything from car loans to credit card debt and corporate bonds to mortgage-backed securities.

“The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.”

Warnings against using correlation as a deciding factor for investment or as a tool for risk management (and warnings against using Li’s Gaussian copula function specifically) were voiced by many in the financial arena. But in a time of such moneymaking, Wall Street’s greed was the reigning party and Li’s formula was king.

“Li's copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.”

Common sense tells us that drawing correlation data from a time when real estate only went up is not a sound idea. Basing financial models on only a few years’ worth of data IS, in fact, a recipe for disaster.

But who should really be blamed for this? Li, for inventing such a mathematical model or the bankers for misinterpreting it and failing to act on warnings?

Emily Holbrook
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