The Formula that Killed Wall Street.
 

Very interesting read in Wired Magazine by Felix Salmon: "Recipe for Disaster: The Formula That Killed Wall Street". It is as good an explanation of "what went wrong" as I've seen, and an excellent example of what goes wrong in lots of places (Engineering, too often): A computer program produced the numbers so they must be accurate; except for the little detail -- Garbage in, garbage out.

:rolleyes:

Sure, blame it on mathematics, education, politicians, union workers, etc. Anything to avoid blaming it on the people in charge: Wall Street CEOs. Let's face facts here: Wall Street has been around for much longer than David Li has been alive. His theory could not have been tested well enough or long enough to be relied on. The blame goes to those who allowed that to happen.

I think you miss the whole point of the article, CWT. Of course Wall Street and its risk managers are to blame -- that's undisputed. The point of the article is to point out how on earth rational managers (greedy though they might be) could have persuaded themselves that they were not on a path to disaster of their own devising; ignoring all sorts of signals and analysis in the firm belief that their risk assessment programs would defend them.

I could give dozens of examples from engineering where designers were completely off the mark because they believed their flawed computer programs and didn't listen to their instincts and physical sense of what was going on.

But can you give one example where the entire engineering community abandoned well established and proven engineering principles based on one guy's formula?

Of course not; but that's not the point. Engineering principals have evolved over time and are generally backed by confirming experiments. When they are sufficiently solid and tested, they are often reduced to public standards (like the ASME Boiler & Pressure Vessel code) and these, in turn, become the "guts" of computer software for simplifying their application. Where did that progression come from? A whole series of steam boiler explosions that killed hundreds of people.

Trouble arises, however, when engineers who don't understand the hard physics underlying these programs attempt to extrapolate their results. This has, on occasion, led to "entire engineering communities", i.e. the folks who used a particular program, to produce bad designs. The examples I can think of are simply too complex to include in a forum.

Li's formula was a first in its field, a field that was starving for methods of evaluating that fuzzy concept called risk and they bought it hook, line, and sinker without appropriate testing, largely because they aren't scientists or engineers -- they don't think about experimental verifications, they think about results. They blew it and used a tool that is, in fact, fatally flawed because they wanted it to work -- it was making them rich.

But it is the point! Neither a single engineer nor a large group of engineers is analogous to what's happened here. Any comparable mistake would require virtually all engineers to accept as fact an untested formula proposed by some one not an engineer, and without testing it before applying it in the real world!

This is not about a bad design. It's about a bad design being embraced and used without review.
That is no excuse.

The people who bought it are/were highly paid "professionals" whose job it was to protect the investments of their clients. They failed, and failed miserably. Even worse, they defrauded those clients (and now the American tax payers) by taking bonuses for their failures.

My biggest problem with that article and others like it is that it gives people who are not scientifically trained the idea that it somehow wasn't management's fault because they relied on an "expert" who had developed this complex mathematical model. It implies that they were doing their jobs. They were NOT.

I give up. You're bound and determined to affix blame; I'm interested in the background flaws that got us there.

The bridge fell down because a bunch of corner-cutting, profiteering engineers produced flawed plans, say. I'm interested in how it actually failed; where did the plans actually go wrong?

Years ago, an Agena (as I recall) lost an engine shortly after launch and as the remaining pair tried to correct, the rocket remained vertical and slewed sideways at a fairly high speed. The controllers blew it up. After the fact, however, it was pointed out that the thin-walled shell of the main tank should have buckled at that horizontal speed. In the next version, they increased the payload substantially by thinning the wall of that tank. They learned something from the failure that had nothing to do with the proximate cause.

I'm interested in keeping blame from being deflected. I see articles like this as thinly veiled attempts at using technical arguments to do just that.*

While there may be some merit to them for MBA candidates, they don't contribute anything to the public's knowledge: they detract from it.

* Just look at the title of this thread: CEOs aren't to blame, this guy's formula did it!

Aha! We've moved to rocket science... something we can all understand more easily than economics or philosophy.

Watched a few of the Atlas (and Thor) Agena launches and a couple of the high altitude destructs. Spent 20 years working with Titan II, including 10 at the Air Force Western Test range at Vandenberg AFB, Ca. Worked with some engineers from Martin Marietta, Boeing and others on a couple accident investigation.... incredibly smart bunch of guys. Also incredible is the number of things that can go wrong with a two (or more) stage launch vehicle.... almost as many things as can go wrong with the economy.

@AEH;

Now that sounds like it must have been an interesting career! My only direct contact with rocketry was in 1961 (Canada doesn't have an independent space program); I was part of a group that re-designed the propellant/nozzle geometry of a sounding rocket called the Black Brandt so it would reach a little higher altitude to sample the gases in the Aurora Borealis from Northern Canada.

I see them as the foundation of a reasoned set of regulations concerning investments risks and the SEC rating systems for speculative investments. If that formula had been thoroughly tested and vetted it's flaws and sensitivity to its assumptions would have led the SEC to be a lot tighter with its AAA ratings on tranched real estate bundles and damped the enthusiasm for their unreasonable spread.

Ha. Seems we used some of the same targets for R & D.... Kwajelein Atoll, Marshall Islands. The good old days.

And in that context, they're fine. It's when they get into the public arena that things go horribly wrong. It starts off innocently enough with a title that's intended to grab attention, but implies that everything would have been fine if only those poor CEOs hadn't been duped by this mathemagician's evil formula. From there it's a few easy steps to rewriting history. Heck, even the article makes no mention of the fact that this formula could at most have played a small part in the massive wrong doings that went on in Wall Street firms!

Soon, we will always have been at war with Eurasia.

As I said above, CWT, blame seems to be much more important to you than understanding what went on. So be it.

The article's focus is on diverting blame! First it diverts it to Li and his formula, then it diverts it away from him. I think it's actually very clever how it uses a veil of academia as a pretense while gradually moving the idea of blaming anyone out of the realm of possibilities.

Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

Aha, the H(am)E(gg) function! "If we had some ham, we could have ham and eggs, if we had some eggs."

Exactly, Woodsman; Exactly.

Here's Warren Buffet's take (in his annual newletter):

Right on. Note that he wasn't stung by the mortgage meltdown at all.

.
Interesting thread! I like the way Wired’s article analyses what went wrong -- without diverting blame. There is no contradiction between focusing on the how, and pointing at the who. Thanks!

Paul Krugman, in today's NYTimes, has an interesting analysis he titles "Revenge of the Glut". He points out that after the Asian financial crisis of 97-98, the Pacific Rim economies began to amass huge war chests of western capital financed by their exports. This huge flow of money from Asia to North America and Europe resulted in their economies being "awash in cheap money looking for somewhere to go", and most of it went to the US. He then goes on to say:

Interesting read.

So, what countries were the conservative think-tanks trashing three years ago? Maybe we should move there. :)

You probably are there. Scandinavia doesn't make the disaster news much.

Hmm... Interesting.
You mean they don’t consider our well-function social democratic (that’s probably a pinko European euphemism for Socialist) economy a disaster?

Just out of curiosity, let’s make a list of Norwegian and Canadian banks that have failed during this particular financial crisis.

Let’s see, uhm... zero! :cool:

True, Stones;

In bubble economies, it pays to be stodgy and stick to the old standards of bank behavior.

Yeah, but you have a good job market too. That's probably more important.

You would do well to read Newsweek Editor Fareed Zakaria’s excellent article on what the Canadians are doing right -- and have been doing right for a good many years. In fact, I’ll see if I can dig up a link. However, in my opinion that deserves a separate thread. :)

Our current unemployment rate in Canada is 6.6%, about double Norway's, but that is largely due to the huge job losses in the automotive industry and the huge decline in crude oil prices which has brought tar sands production to a near halt.

Zakaria's article is here

Oh, I'm sure that American banks are completely out of whack, but I think employment is more important because leverage works when everyone has a job.

I think the US has had things backwards for so long now that we think it's normal! We think that by making the business profitable, jobs will come, but in reality businesses don't invest in new employees if they're already profitable. Instead, they look for cheaper labor elsewhere so they can increase their profits.

We need to focus on creating good jobs and let profitability come from them.

I'm not sure how that could be arranged. Companies don't exist to create jobs except when they're small family-run businesses.

Think Henry Ford.

Seed money and morality, seizures and summits...
 

Well, some types of businesses are more capital intensive than others -- for instance the defense industry. In many sectors, small businesses are a far better way to go.

Also I think there is a lot to be said for seed money, even from the government. In fact that was the helping hand that enabled me to establish my company 14 years ago; since then I have paid that money back dozens of times over in the form of payroll tax, personal tax and VAT. In other words, it proved a sound investment for the government.

If I had my druthers, bureaucracy and current paperwork burdens would be greatly simplified for small businesses. Certainly that could be done with advantage in Norway; I suspect that’s also the case in the USA and many other countries.

Morality and the social contract
Another point is this: strengthening of social contracts and the moral aspects of corporate leadership and ownership. And, no, I am not kidding. I do not think corporations by definition are immoral or amoral. There are lots of exceptions!

In some cases the social contract should be made very explicit. I still cannot fathom how banks can receive billions in taxpayers’ money and not provide the lifelines many businesses need. There are vast numbers of viable projects being cancelled because businesses cannot get loans. (That applies to Norway, too.)

Sensible seizures
Prosecuting (and seizing the assets of!) people who are guilty of tax evasion and illegally salting away money in bank accounts in Switzerland, Liechtenstein, the Bahamas and the like is a good start in that respect. Penalties should be financial in nature and immediate -- say a fine of 10x-50x the taxes evaded. That would pay for a lot of stimulus programs (and jobs)!

Another kind of summit
Let me throw out another idea. I would like to see Geithner and Obama call an Economic Summit Meeting of, say, the 100 richest people in America and ask one simple question: What constructive efforts can you contribute and how? Come to think of it, that might be a good thing to try in other countries as well.

Well, those are a few ideas.

-- ArcticStones

That seems odd that a decline in oil prices should impact on production when according to the oil bubble thread the price was artificially inflated. I'd have thought that a price crash would simply unmuddy the waters for a return to normal production. Still my grasp of anything to do with money is sketchy at best.

@fazstp: The decline in oil prices has made some oil recovery less viable. A number of oil companies, at least here, have shelved plans for further expansion and cut back on production. Those things produce jobs. Similarly, even with the price decrease, people are driving less so fuel consumption is down -- equals loss of jobs in the industries that refine, distribute, and sell oil and gasoline. Etc.

@Stones: Here in Canada, employment in small business exceeds employment by huge corps. In Nova Scotia, it's well over half.

Even better: round up the cokehead bankers, put them in a prison camp and hold an auction. Highest bidder -- as contributor to earmarked social programmes -- gets out first. Lather, rinse, repeat. Group solidarity? I don't think so.:D

I thought of another take on this during my morning constitutional in the woods. The model prices risk on the basis of the market's pricing of risk without using the model. Therefore, if the model is so great, the market's pricing of risk, which does not use the model, cannot be very good. Ergo, the model is using a sub-mechanism that cannot be very good. Ergo, if the model is great it cannot be very good.

There has been a lot of focus on the bankers -- but they are just tools. The financial system that has stopped working is "the bank behind the banks", i.e. the one run by individuals who truly have resources.

In my opinion, there is far too little focus on them and what they can contribute.

Not sure 18:1 or 26:1 makes a lot of difference if the underlying assets (as in outstanding mortgages) are all bad.

@Woodsman
That would be all of them that didn't have enough regulation to prevent wide spread corruption.

Might raise more money if you put the trophy wives in jail and auctioned them off to the highest bidder...... every rich banker has a strong wife standing behind him saying, "It's not enough... make more!" :D

@AEH: Only one Canadian bank had any exposure to toxic mortgage paper and they wrote it down as a loss, took the stock price hit last year. The investors holding that paper got screwed, of course, their investments frozen, and that's still unwinding.

The investors should take the big hit, along with the individuals who bought the homes and cannot make the payments. Not sure it's going to go down that way here.

Lest we all forget... at the height of the housing bubble, a full 40 percent of all homes sold went to the rich as a vacation home or an investment in rental property (spending their new found wealth courtesy of major tax cuts). When the housing market went South, many just walked away and turned the house back to the bank. They could do that because the loan was secured by the house.

Most could make the payments. Of course, now lots of people can't make payments because they've lost jobs, which is the real problem. The banking crisis wouldn't have happened if people (not large corporations) were making money. The irony is of course that if people were making money, so would corporations!

We'll get out of this mess when the MBAs finally learn what Henry Ford knew a century ago: pay the workers well and everyone benefits. Cut their wages (those darned union workers!) and everyone suffers.

So why should anyone bid folding money for such baneful creatures? You probably couldn't give them away with a tank of petrol now. Lady MacBeth is a toxic asset all right.

Er.... NovaScotian was saying that the conservatives were cheering three years ago for the countries that have melted down completely now, like Iceland. I don't think excessive regulation was the problem there, nor have I heard of any conservatives lately who go round trashing countries for insufficient regulation, as you suggest.

If the conservatives were cheering the countries that were getting rich on funny money, this might imply that they were trashing the countries that were banking prudently, with good regulation. It would be interesting to know if that was the case. If so, for the rest of the century, whatever such soi-disant conservatives say we should do, let us go and do the opposite.

Confucius he say, "Good housewife not get fulsome editorials from spiders."

@Woodsman
My fingers/mind got tangled up there for a minute from lack of sleep. Yes, I meant praising those without enough regulation to prevent corruption and condemning those with strong reserve requirements that restrict the expansion of the money banks can create. :o

Leverage is a two way street.