THE EQUATION THAT LED TO A LOT OF TOXIC ASSETS.

THE EQUATION THAT LED TO A LOT OF TOXIC ASSETS. I have posted previously that a lot of the financial crisis seems to come from intellectual mistakes by brilliant people. Felix Salmon has an article in Wired which prints a formula which was, according to the title of the article, “The Formula That Killed Wall Street.” It’s a wonderfully complicated formula–based on a copula function. I don’t have the fonts to reproduce it. Scroll down at the link if you want to see what it looks like. The article also has a very good description of how the toxic assets were created. The formula makes a very strong assumption: “the model used price [prices of risks in the markets] 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).” The result is that, to quote the 2005 Wall Street Journal article cited in the Wired article, “The model runs the data through the copula function and spits out a default correlation for the pool — the likelihood of all of its companies defaulting on their debt at once.” Notice that rather than thinking about the probability of an event which would lead a pool of mortgages to all default at once—say, a large decline in housing prices—the probability depends on data from years when no such decline had happened to arrive at a very low probability of it ever happening. A paper about the formula was published in The Journal of Fixed Income in 2000. By 2005 trillions of dollars of the new securities were traded.