Interesting assertion – a new mathematical concept allowed modeling of complex financial instruments, thus enabling creation and sale of the now infamous mortgage-backed securities.
Interesting article, although by the end it seems to me that the problem wasn’t the formula but the assumptions people (either knowingly or not) had. The formula looks at the credit default swap market’s past performance and projects it onto the future. Of course there’s no guarantee that the future will look like the (in this case fairly recent) past.
From the blog post cited towards the end of the article, it sounds like Li understood this limitation of the formula, but people adopted it anyway. And from the same post it looks like there was a semi-crisis back in May 2005, but it corrected itself so everyone, or at least the big players, assumed it was fine.
So to me it seems like not a failure of the formula per se, but a failure to understand the formula and an overapplication of the formula.
I’m not sure what would prevent this from happening again. It’s easy to say that regulation will solve all our problems, but I don’t buy it. It seems like whenever we regulate one instrument (e.g. mutual funds), the smart guys invent a just-different-enough animal so they can play in an unregulated sandbox. And for a while it generates ridiculous profits, until it doesn’t. Maybe there’s nothing wrong with that, but I think we should go into the next cycle with our eyes open, not pretending that we’re really preventing the types of problems we’ve seen before.
Interesting article, although by the end it seems to me that the problem wasn’t the formula but the assumptions people (either knowingly or not) had. The formula looks at the credit default swap market’s past performance and projects it onto the future. Of course there’s no guarantee that the future will look like the (in this case fairly recent) past.
From the blog post cited towards the end of the article, it sounds like Li understood this limitation of the formula, but people adopted it anyway. And from the same post it looks like there was a semi-crisis back in May 2005, but it corrected itself so everyone, or at least the big players, assumed it was fine.
So to me it seems like not a failure of the formula per se, but a failure to understand the formula and an overapplication of the formula.
I’m not sure what would prevent this from happening again. It’s easy to say that regulation will solve all our problems, but I don’t buy it. It seems like whenever we regulate one instrument (e.g. mutual funds), the smart guys invent a just-different-enough animal so they can play in an unregulated sandbox. And for a while it generates ridiculous profits, until it doesn’t. Maybe there’s nothing wrong with that, but I think we should go into the next cycle with our eyes open, not pretending that we’re really preventing the types of problems we’ve seen before.