The Mathematical Risk Assessment Formula at the Root of Current Financial Mess, Literally Translates to “Fuzzy Fucking Formula”

Wall Street has been using a mathematical formula to theoretically avoid any investment risk.  The formula’s name, “Gaussian Copula Function’ has me thinking it was aptly named.  Using the formula made some Wall Street players enormous sums of money in a very short time (in part because, coincidentally, the world’s credit market was flooded with cash that needed somewhere to go, and that could readily be leveraged exponentially).  This  fueled a manic geometrical expansion of the derivatives market.  It sure looks like a big pyramid scheme.  I’d love to have someone tell me how I’m wrong, because a collapsed pyramid scheme cannot be fixed.  If we’re just trying to reinflate the pyramid, we’re doomed to failure–if not sooner, then later.

Do you believe in magic?

You’re feeling it now: the effects of the ‘Gaussian Copula Function’ – a Gaussian blur of ethical and sound financial practice generated on the basis of this mathematical formula.  Securities traders used this formula to assure themselves that bad bets were really good bets.

In the past ten years an enormous market has grown up to manage the risk of people who are making their money gaming the financial market.  Beginning in the 1980s, and sinking deep roots by the late 1990s, the global financial market players became enthralled with the possibility that all the risks and all the gains of playing the financial market could be reduced to mathematical formulas.  We can predict chaos and those pretty fractals, so surely we can predict the shifting interrelationships of the global mind and marketplace.   Risk could be eliminated, or at least reduced to nearly zero, with the right calculations!   Quantify it and profits will come!  The prowess of the quantifiers was highly valued, and the ‘quants’ rose in stature on Wall Street.

The magic tool

In 2000, the financial markets found their magic tool – a formula that they believed would turn every transaction into a guaranteed cash cow.  And, it did for a few years.  The early success generated a chemical feedback loop – risk-rewarded testosterone highs generated higher risk-taking, which generated even higher rewards. Euphoria and manic behavior took over, generating further and more expansive risk taking.  ‘Everybody’ began using this formula without understanding its limitations, and ‘everybody’ assumed it worked without waiting for proof.  And, we all know the first three letters of ‘assumed’ and the maturity level of people who always do what ‘everybody’ is doing. ‘Nobody’ listened to the people expressing caution, which included the formula’s creator.  Wall Street hedge funds were flying higher than kites, pulling a string of securities dealers after them like bows on their kite tail– or wings on their kited options.

An excellent WIRED magazine article describes and explains the formula, which was really and truly named, the “Gaussian Copula Function.” It was developed by mathematical wizard David X. Li, and published in 2000.  The simple formula described in his published paper was adopted by the financial sector as a magical tool for risk management - just know it’s name and the ‘correlation function’ and Rumpelstiltskin would spin endless gold out of corn silk.  And, it worked for about five years.   The big gambler game players, mostly hedge fund managers, walked away with billions in commissions on the sales of these corn silk purses, dressed up as AAA rated derivatives, with little concern for the outcome when the naked guarantees fell due.  The big financial players pocketed so much money it is inconceivable to most of us.  They were able to create an additional steady income in premiums for themselves and their banking partners with little effort, as long as market prices kept going up–and every Pollyanna knows, that is surely all they ever do.

2000-2006 feeding frenzy in the paper jungle

The formula was used to assess the risk of elaborate derivatives – bets placed on just about every aspect of marketplace action.  These bets were sold as insurance against defaults, and labeled SIVs (structured investment vehicles) and CDOs (collateralized debt obligations) and CDSs (credit default swaps).

Deregulation allowed anyone to bet on other people’s business, as well as one’s own; anything could be ‘securitized.’  This meant that I could get a contract to insure that my house would still be standing next year in good repair.  It also meant that Arnie the Arsonist could place a bet with Freddie the Firefighter, on whether my house was going to still be standing.  (Hmmm…homeless next year?)

Holy great geometrically exploding pyramid!

Financial derivatives are essentially bets on the outcome of other financial transactions.  Insurance or guarantee contracts, they come in a variety of forms and are called ‘derivatives’ because they are ‘derived’ from another transaction.  Financial players could write derivatives on bundles of mortgages or slices of bundles (called tranches), on the derivatives guaranteeing the bundled slice of mortgages, on bundles of the derivatives guaranteeing the bundles of mortgages, and on bundles of the bundles of the bundles of the bundles….and the pyramid grew exponentially. With a tip of the hat to Dr. Seuss, derivatives are like the hotch-hotcher watchers watching the hotch-hotchers who are watching the hotch-hotcher bee watchers who are watching the bees … with the watchers watching watchers expanding, ad infinitum.

The market for these derivatives is totally unregulated thanks to the Gramm-Leach-Bliley “Financial Services Modernization Act, Public Law 106-102, enacted in November 1999, and signed into law by President Bill Clinton.   Yee haw! Deregulation attracted Lords of the Flies; the credit derivative market grew like gang-busters with the morals of gang-bangers.

Bets grew from 3% to 101% of global GDP in six years

This derivative “risk management” market of credit default swaps (CDS) and collateralized debt obligations (CDOs) exploded from $1.2 Trillion outstanding in 2001 to more than $67 Trillion by the end of 2007.

To put these numbers in perspective, in 2001, a risk management market of $1.2 trillion represented 3% of the world’s total GDP of $44 trillion.   In 2007, world GDP grew to about $66 trillion, giving this $67 Trillion risk management marketplace a book value of 101% of world GDP – from 3% to 101% of total GDP in six years!  That’s like having a dollar in your pocket and finding you have $67 dollars six days later– by magic!  Wouldn’t you wonder what was going on?

$ 600,000,000,000,000 - that’s $600 TRILLION in ‘assets’

But the pyramid is even bigger and Swiss cheesier.  The $66 trillion worth of derivatives references the value of the bets placed.  When you look at the notional value of the portfolio that the bets are referencing, this value is ten times the bets, or roughly $600 TRILLION (Morris, p.134).  That is about 10 times global GDP.  How could it be?  Where did the $600 Trillion ‘asset portfolio’ come from?

This stunning $600 TRILLION ‘portfolio’ is mostly ‘synthetic,’ meaning it is not directly connected to real things; it is derived from the financial instruments that are claims on real things (stocks, bonds, loans, mortgages, and the like), and derivatives derived from other derivatives, once, twice, removed.  “Not long ago [the early 1980s], the sum of all financial assets–stocks, bonds, loans, mortgages, and the like, which are all claims on real things–were about equal to global GDP.  Now they are approaching four times global GDP.”  (The Trillion Dollar Meltdown, Charles R. Morris, 2008, p.xii).  Four times the global GDP of roughly $66 Trillion means that roughly $264 Trillion of financial instruments, that are claims on real things, have been magically transformed into a portfolio three times that size by players gambling on their outcomes.  Nearly $600 Trillion in ‘value’ created out of thin air!

However ephemeral, some of this notional value is on the balance sheets of ginormous financial institutions that built their own personal pyramids upon and around this synthetic value as if the value were real AND guaranteed.  They were catastrophically wrong, and their portfolios, if marked to market, would show many of them bankrupt.

Think upside down pyramid

This pyramid of financial instruments is standing on its point.  A significant portion of this big financial pyramid rests on real mortgages to real people.   The U.S. mortgage market is about $10 Trillion (with about 15% subprime).  So a substantial and significant portion of the $600 Trillion derivative market grew out of the $10 Trillion U.S. mortgage market.

IF the mortgages had been solid, prudent mortgages that could withstand market fluctuations, the pyramid might have remained upright–maybe.  However, in some markets, for several years, over 40% of the loans made were ‘subprime’ loans – iffy in one way or another: 95-110% of current market value, no verifiable proof of ability to repay, adjustable rate with the potential of jumping several percentage points after three to five years, pay-less-than the interest only, etc.

By 2006, subprime loans accounted for 20% of ALL mortgages issued, and 80% of those were exploding adjustable rate mortgages that reset after three to five year initial low-payment periods.  (With 3 to 5 year detonators, and timers that were set as late as 2007, we’ve got at least several more years of defaults, bankruptcies and foreclosures on the way.  That’s almost guaranteed.  And, don’t go blaming the Big Meltdown on ACORN and the legislation that made it a little easier for previously redlined communities and minority individuals to get mortgages; they represent less than 20% of the total subprime mortgage mess, so 20% of 15% subprime equals about 3% of the total U.S. mortgage market.)

Where were the adults in the room?

A bit of common sense says that the chance of default when a mortgage payment increases by 50-100% is extremely high– no matter what your income bracket.   No one in the industry should be surprised that people began to default when the three and five year free-skate period of their mortgage was over and the mortgage payments reset at higher interest rates and included principle payment on top of the dramatic increases in interest.

Apparently without thinking much, from 2000-2007 banks continued to make these loans, and securities firms continued to bundle and slice and sell them, and to write derivative contracts guaranteeing the bundles and slices.  Even when the early wave of three to five year planned explosions hit and the rising tide of defaults began, securities firms continued to guarantee the guarantees that guaranteed the mortgages. In October 2006, CEO Jamie Dimon of J.P. Morgan was one of the first to see danger signs and lead his team out of the subprime business before the bubble burst. Most players hung onto the illusion of magic and an ever expanding pyramid of assets until their companies were bankrupt.  Are we collectively doing the same?

Are the adults in the room now?

This debacle is a stunning reflection on human beings’ willingness to be part of a herd mind instead of paying attention to what their own capable mind is telling them.

The derivative market has collapsed like a popped balloon, dragging down most of the big security firms with it.  AIG, the giant, too-big-to fail insurance company in which the U.S. taxpayer has purchased an 80% stake, was a major player in this game.  WE the taxpayer have been doling out tens of billions to this company(and others) so that they can cover the bets that they made with other banks, governments and businesses.  Our leaders seem to be hoping that if they can just dribble out payments until everyone gets back on board with CONfidence in the pyramid, that it will all right itself, and we can just get back to business.

I’d sure like to understand why paying off these bad bets is the right way to go.  Anyone?

A system that rewards fiction and fraud

Our financial system appears to be a pyramid scheme with a Gaussian blur– put on your happy-I-am-confident glasses and the blur crisps up and looks like the real deal.  Get your confidence back, and everything will be just fine.    More CONfidence may be a short term solution, but it seems likely that deep and structural fault lines in the system will sooner or later take us down. We must change from an ever-expanding pyramid system that guarantees ultimate failure, to a sustainable system that supports a healthy and prosperous world community.  Do or die.

Systemic change must confront and neutralize the power of uber rich game players who will do everything in their power to keep the game going in their favor for as long as they can.  Imagine the commissions they made: one tenth of one percent of $600 Trillion is $600 Billion, and their commissions may have been much higher.  $600 billion can buy you a lot of inattention from Congress or law enforcement; and it is human nature to just want to be nice to people who are so brash and beautiful and rich.

It is foolish to expect the financial sector to right itself; they have demonstrated weak, groupthink, greed driven, manic, immoral behavior.  Moral and cognitive development are complimentary, so we know that people who will do anything and hurt others to make a buck, cannot grasp that they are ultimately pissing poison into their own drinking water.  The grownups have to take back control.

The Jenga Challenge

Right now are we are playing Jenga? Pull out a block of assets from taxpayers and put it…in the right place?… or put the billions back in the wrong place, and the entire towering pyramid can fall?

March 19, 2009, Federal Reserve Chairman, Ben Bernanke announced that the FED is going to create another $1 Trillion out of thin air to buy up Treasury Bonds and more of these Swiss cheese toxic crap bets (called assets), so that the financial institutions that made the bad bets can avoid the consequences and get back to profit-taking business.  This will bring the total FED exposure to nearly $3 Trillion.    This is in addition to the trillion in taxpayer money that went into TARP and into the Emergency Economic Stabilizaton Act.  We are all hoping that the right placement of these Jenga blocks of cash will keep the pyramid standing.  It is not a sure bet.

And, it leaves unanswered whether we really want to keep a pyramid standing on its point.

Recommended:
The Ascent of Money; a Financial History of the World by Niall Ferguson (2008)
The Trillion Dollar Meltdown; Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris (2008)
$700 Billion Bailout; the Emergency Economic Stabilization Act and What It Means to You, Your Money, Your Mortgage, and Your Taxes by Paul Muolo (2009)