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gaussian copula - the formula that crashed the world economy?

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Tyco

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A few months ago I read this article on a mathematical formula used by financiers to assess the risk of investments. The authors argued this formula was so widely used, so prevalent, that its flaws/limitations were the cause of the economic bubble. 'The Formula that Killed Wall Street'

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant

(summary: the formula looks at insurance quotes, rather than 'real' data, to gauge the value of disparate elements in diverse collectivized debt obligations, producing a correlation figure for risk that anyone (ie. CEOs) can understand and act upon, even if the finer details are far beyond their level of understanding and should be left to experts)

This differs from the reasoning I've encountered on this forum - ie. government meddling with interest rates and homeownership. I am far from knowledgeable on any of these subjects, but I wondered if anyone would care to comment on the above article.

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All sectors in the economy have cycles. Due to some faulty assumptions, by itself, that may have caused the home-related industries to slow down for a while as capital reallocated to other industries. This is a normal market "correction" and, in less regulated times, happened fairly regularly and was seen as a good thing.

What turned what, by itself, would probably have been a normal market 'correction' into a worldwide crash was, indeed, the government meddling. When governments give breaks in specific areas (home ownership, house building, "subprime" loans, etc.,) it artificially inflates the expected return from those activities. Since there are incentives to do x, such as big tax breaks, more and more people tie themselves into that activity. Government intervention, in effect, masks risks and artificially inflates rates of return, causing a dramatic imbalance in the economy as people rush to where they can get the greatest return for their money. Combine this with the bogus bailouts of banks "too big to fail" and you have a recipie for an extended recession and crash.

Economies are complex things, so it really is difficult to track down the "cause" of any particular thing - like the exact source of what tossed this one over the edge. But it can be concluded fairly uncontroversially among learned company that the government exaserbated the problem at best and continues to do so.

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I am also no expert but this formula sounds like a continuation of the kind of unconsciousness that led to Madoff being able to scam so many people for so long.

"We don't need to do due diligence on this... Bernie Madoff is running the show..."

"We don't need to examine this any further, we have the formula!"

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Even within the context of those who took on what turned out -- in retrospect -- to be too much risk, blaming a single formula is too concrete-bound. Yes, there is a degree of rationalism among some professors in financial education. This can manifest itself in some (ex-students) relying too much on a mechanical approach. This is mixed in with a second problem: certain false assumptions about market rationality. It is no surprise that some people get overly enthusiastic or overly pessimistic about some type of investment. Markets will correct. If one has a significant segment of people who have been taught the wrong type of "markets are efficient" lesson, it might exacerbate things. If one has government incentives pushing in the same direction, that can make things worse.

When it comes to banks, the government has removed the most important check/balance: the bank customer. The government has enacted laws so that the typical bank-customer does not have to care what his bank is doing. They could be using his cash to light cigars, for all he cares -- he still knows he'll get it back. For example, when Countrywide was close to bankruptcy, it offered slightly higher CD rates and money poured in, because folk knew the government would cover them.

In the end, markets are efficient, but not in the sense that "they're always right" as is often implied by modern financial theory. Markets are efficient because the guys who were wrong lose and the guys who were right win. Some people may also win or lose from a degree of luck; so, the process is more like biological evolution, where each "generation" sees slightly more money in the hands of winners (those who have the right "survival trait", etc. Unfortunately, this is where the government comes in once more and short-circuits the process again, by propping up many of the losers. This means that elements of incorrect theory (see paragraph #1) do not get weeded out as efficiently as they normally would. Apart from slowing the culling of the losers, this also promotes a second type of person: the person with the right connections. The government help suppresses the propagation of the free-market "survival trait", and also encourages the propagation of the statist "survival trait" of being politically savvy.

To focus on a single formula really misses the true picture. I doubt even the author of that article really believed his own hype.

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