The Smoking Gun on the Financial Crisis?

Felix Salmon, writing in Wired, offers the equation above as the “smoking gun” for the current financial crisis:

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li’s work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li’s formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

and

In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years’ worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

I’ve mentioned it before but in the mists of the distant past I made a few bucks tutoring social sciences graduate students in statistics and using a computer-based statistical package. I was appalled at how little they knew about the underlying mathematics. And how little they cared.

Rather than blaming it all on Dr. Li, I think I’d chalk it up to human nature. There’s no substitute for research, investigation, and insight. And anything that looks too good to be true probably is. However, research, investigation, and insight takes time and money and when your competitors are willing to skip over the middle steps and the profits to be made are beyond the dreams of avarice, you’ll probably grasp at a get-rich-quick equation, too.

I suspect that when the dust has settle and the history has been written, computerization of the financial system more generally, by which they operated largely by the same rules and in lockstep, will also be found to be a prime culprit.