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The Math Formula That Lead To the Financial Crash
New submitter jools33 writes "The BBC has a fascinating story about how a mathematical formula revolutionized the world of finance — and ultimately could have been responsible for its downfall. The Black-Scholes mathematical model, introduced in the '70s, opened up the world of options, futures, and derivatives trading in a way that nothing before or since has accomplished. Its phenomenal success and widespread adoption lead to Myron Scholes winning a Nobel prize in economics. Yet the widespread adoption of the model may have been responsible for the financial crisis of the past few years. It's interesting to ponder how algorithms and formulas that we work on today could fundamentally influence humanity's future."
Nobel prize in economics.
that's Nobel prize in pseudo-science.
It was human stupidity and greed.
"If any question why we died, Tell them because our fathers lied."
A model is a model. The problem was that people who made aggressive (read "stupid") assumptions initially made money and those that were right (read "cautious") made little or lost. This created a bubble. The same kind that happened before option pricing models and computers. http://en.wikipedia.org/wiki/Economic_bubble
The past tense of lead is "led", not "lead". When "lead" is pronounced like "led", it's a metal. This mistake pops up everywhere. Correcting it here won't fix anything, but when someone on the internet is wrong, duty calls.
Disclaimer: It's All Been Said Before.
People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.
Plenty of financial collapses have preceded the current one without the benefit of Black-Scholes. What did they, and the current collapse, all have in common? Excess credit.
The one in 98 (yes there was one there the US gov fixed that one then kept it fairly quiet). Then the one in 2000 and the one in 2003 and the big one in 2008.
Hedge funds are killing us with 'liquidity'. But for a short time they make us boatloads of money!
The way it was explained to me was *IF* the market does not move in one direction or the other much this formula works. If it starts to move in either direction your going to get hit...
Greed was responsible for the financial crash. If this algorithm hadnt even existed, we still would have been in the same mess we're in.
Deregulation, not models, permitted bad behavior. Banks that guarantee loans simply should not be emulsifying them into packaged trades, and then hedging their own equity on the loan derivatives. It's like taking a tulip bulb, selling interest in a tenth of the bulb with 1000:1 equity, and then saying it's more stable. Once it goes the wrong way you are screwed and you know it (but you just don't want to believe it could ever happen).
When the foot seeks the place of the head, the line is crossed. Know your place. Keep your place. Be a shoe.
But people should be clear that it is just a guide and an approximation! Scholes doesn't deserve criticism for what was and is a huge contribution - those who relied on it alone do.
The Black-Scholes formula leads to crash because it misses components which account for: a) looking at the formula, b) using the formula.
Interesting, but really, blaming the seed on Jack looting the giant's castle? I used to write risk analysis software for the traders and market makers at the options exchange in Chicago (CBOE) and am intimately familiar with Black-Scholes algorithm (I've implemented it more than once). In the article, the sub-text to one photo, "Options allow a trader to have a delicious risk-free portfolio", is totally bogus! Options allow a trader to MINIMIZE the risk in their portfolios, and BS (no pun intended) helps traders to do that in a mathematically/statistically rigorous way. Misuse of any tool (using a hammer to kill someone, for example) is not the tool's fault, but the wielder of the tool!
-Rubberman
Amazing how mankind is able to create from A to Z the very rules that eventually lead to its failure.
Slashdot, fix the reply notifications... You won't get away with it...
This was covered by the guardian a whole two months back. Link Partly debunked here
1. Approve $300K mortgages for people earning $35K/yr, falsifying documents as needed
2. Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing, etc, under the direction of math and finance PhD's. Sell these "Triple-A-rated securities" to gullible investors worldwide.
3. ??
4. Profit!
8-figure pay packages for bankers and 7-figure for mortgage brokers, real estate agents, workers in credit rating agencies, etc. until the music stops. But hey, you won't need to defend your resume when you've got enough millions in the bank.
5. Watch housing prices rise by 30-50 percent/yr
6. Goto step 1.
So Einstein and other scientists were responsible for disasters like Chernobyl, etc?
http://www.hawkingthescene.com/.a/6a00e553adf4d5883401053603c4ad970c-800wi
What's the next story, laws of physics to blame for car crash? Excel to blame for embezzlement? I'd expect to hear a story like this in a dive bar. Or a tabloid.
The formula calculates what can be expected based on what is known.... That's all. What's next? Are we gonna start blaming actuarial tables for people dying in car crashes?
Any guest worker system is indistinguishable from indentured servitude.
The Math Formula That Lead To the Financial Crash
No, lending money to illiterate shitkickers who couldn't service the loans caused the crash. (Why does everyone keep ignoring this point?)
The model didn't fail, it was the forecasters that used it. Black-Scholes takes five inputs (strike, underlying price, risk free rate, volatility, and time to expiration) and spits out the price of the option. The problem is that the risk free rate and volatility are both assumed to be known -- but they are two inputs that are completely subjective and only as good as the forecaster. When you put garbage in to the model, you get garbage out. Humans can get lucky at predicting the future sometimes, but will eventually fail at it. I think the better thing isn't for people to stop using Black-Scholes, it's to start remembering the turkey story (see Black Swan) and stop putting every egg you can in to one basket. http://en.wikipedia.org/wiki/The_Black_Swan_(Taleb_book)
Is that you?
I highly recommend the opera at http://www.youtube.com/watch?v=JhEH00rlmz8, from the Ig Nobel prizes a few years ago. It captured the most recent banking crisis rather well, and without the need to blame human greed on misused mathematical formula.
Once Risk became a commodity capable of being bought and sold, it was only a matter of time before market responded by producing more Risk.
just ugh.
drink deep or not from the pyrian spring.
an article that once again demonstrates the inability of mainstream media to grasp even basic technical issues. and because they don't understand, they jump to these sort of sensationalist bullshit conclusions. you know what? the discovery of *numbers* thousands of years ago probably led (not lead) to all major wars. because science.
idiots.
this should not be on /.
Approve $300K mortgages for people earning $35K/yr, falsifying documents as needed
Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel. Slashdot's policy is that "all comments are owned by the poster." I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case.
Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing,
Why do you put "insurance" in quotes? Options do act as insurance. They can be used for speculation, but so can other insurance products (eg: commodity futures).
Sell these "Triple-A-rated securities" to gullible investors worldwide.
As opposed to what? Keeping trash you don't need on your books? Not seeing a single word about rating agencies giving those AAA ratings. Banks didn't even make false statements. The agencies kept giving those ratings because they knew the higher the ratings they gave the more bonds would get issued to be sold. The system of incentives was broken because pension funds had to take the word of the rating agencies on faith (still do by the way). There is plenty of small rating agencies who laughed at the idea of those bonds being rated AAA, but their opinions weren't legally binding.
Now how's the Black Scholes responsible for anything? All it does is calculate a price of an option based on previous history of the underlying. The whole premise of the article is as valid as blaming car crashes on actuarial tables.
Any guest worker system is indistinguishable from indentured servitude.
So I was right all along...math really IS the root of all evil!
the purpose of a tool has a meaning
give everyone a toilet brush, toilets will get cleaned. give everyone a hammer, nails will get pounded. give everyone a gun, people will get shot
the availability and easy access of a tool with an intended purpose and meaning makes certain outcomes easier. it's not complicated
the tool itself, and the presence of the tool, has significance. we all reach the limits of our temper at various points in our lives. we will confuse our teenage son sneaking into the house in the dark with an intruder. we will be drunk and clumsy. and in those situations, whether or not a gun is in easy reach radically changes the outcome of the situation
the purpose and presence of the tool matters
the proper quote is
"guns don't kill people, people with guns do"
if you want guns to be legal, fine. but don't depend upon flimsy easily dismantled logic to justify your beliefs
intellectual property law is philosophically incoherent. it is your moral duty to ignore it or sabotage it
What really happened is this:
#1. Large central banks control the issuing of currency, to governments. This, however, is a loan. Repayable with interest.
#2. The very same large central banks (eg. The Federal Reserve) accept payment only in the currency they themselves issued, or that of another large central bank.
#3. The loan (issue of currency) is therefore impossible to repay, because the interest payments cannot be made without issuing more currency. (Loans with interest)
#4. We have now reached the point where the interest payments outstrip the available currency. Take a look at http://USdebtClock.org (Figures there are sourced from the US Treasury)
#5. The system crashes and burns, because it's an impossible formula. (Happened already, the effects have not been felt yet, not even in Greece. What's yet to come is far, far worse.)
This is why the EU and US are fucked. Who are they actually in debt to? Large central banks, typically of other nations. When two nations are in debt to each other, (as is very often the case, eg. Spain & Italy, which owe each other tens of billions of euros) why is the debt not cancelled out to the extent possible?
Because of the interest payments!
It's really very simple when you look at how the money is created in the first place, to see that the only thing it can possibly end in is debt and the enslavement of entire nations... Exactly as designed.
Oh, also... None of these central banks are using gold reserves any more, that's old hat. No, they've sold those off and now hold reserves of foreign currency instead...
But if none of them have any gold left, and simply have foreign currency issued by banks that also have no gold left... Ultimately, it's all entirely worthless anyway.
The same can be said for pretty much advance in science in the last 50 years. If you're truly interested in what can and cannot be predicted - given correct models, there's a science studying that, complexity theory.
But from finance over climate to even whether the planets will keep turning - all are too complex to be predicted, even though science has advanced to the point where individual events can be predicted short times in advance with near-certainty. However there's obvious things that can't be predicted. If the moon decides to crash into the earth, we will know in advance - but only a few weeks at the most. Yes, really.
In some ways this was inevitable. Science has moved from predicting individual events, like say a car collision, or physical changes happening inside an extremely well-described cloud, a single rational decision taken by someone considering a bank loan - to predicting the global effects of an undefined number of such interactions combined. The answer coming out of all this is rather disappointing : it's not working - and it isn't working any better outside of finance either. The mathematician's answer, chaos theory, is thoroughly disappointing : there is no valid way to make useful long-term predictions of any system more complex than X (btw: you want a nobel prize ? find what X is exactly) which does not require omniscience (which for any real world prediction would effectively be all the information that exists anywhere in the universe)
So the real question changes - if you require proof we can essentially predict nothing. If you even require valid inputs to statistical functions we can essentially predict nothing. Barely any recent science follows from first principles, except perhaps in Mathematics. Physics makes a good-hearted attempt, but it has to violate the first-principles - it's attempting to discover new ones. Every other science never even attempts to work from first principles, it just doesn't work.
Finance - the models only work when you assume decisions don't interact in the short term (ie. nobody decides to either sell a house or forestall selling it because of anything that happens that doesn't directly affect that loan. If this is true, then the financial crisis was impossible (yet also inevitable)). And of course the basic economic assumption - that everyone takes the rational course of action immediately - no matter how complex the logic, and irrespective of any personal convictions.
Climate - energy balance only has to sum up if you assume the entropy of the system is negligible, or if you work on infinite time-scales. Needless to say, infinite time scales are a bit long for practical usage. Entropy within our atmosphere is anything but negligible. The second big assumption made in climate science is that small portions of the atmosphere behave identical to large portions of the atmosphere.
Planets - planet's orbits only behave the way you're taught in school if they followed Newton. But that's not the worst assumption. The other assumption necessary to make Kepler work is that planetary orbits are independent, and no objects with mass can possibly cross into orbits (and obviously that orbits don't cross)
All these assumptions can be proven to be wrong - and rather trivially.
In one case this can be shown. Planetary orbits are extremely, extremely regular in the short term. This was useful for sea-faring when it was discovered as it provided a very accurate source of timing. And we still have the books from those days describing how those measurements worked. We still have books describing how to find a ship's position on earth by measuring the orbits of Jupiter's moons ... only they yield incorrect results. You might chalk that up to bad measurements, but that can't be : if the methods were truly useless, they would never have been written down. Plus we can correct the measurements so they work again. No, the reason is much simpler : Jupiter's moons have shifted so much over the course of 300 years that those me
The equation was not at fault: the output is only as good as the inputs. The real problem was the instruments being traded: credit default swaps. These are of dubious merit and much more complicated than more traditional underlying instruments (the thing on which you hold an option contract). For example, suppose you have an option to be 100 shares of Google at a given price. It's easy to evaluate the value of the underlying instrument because there's an efficient market for it: Google is traded on a public exchange and the value is agreed upon within a penny, generally. Black-Scholes works on Google options just fine and you can minimize your risk reasonable well using it.
The credit default swaps were much more difficult to evaluate because of the lack of an efficient market for them. The essential nature of the underlying instrument were very high risk mortgages, not too different in concept from so-called junk bonds. The potential return was high because the interest rate was high. The potential risk was high because the risk of default was high, making the underlying instrument worth very little, much less than face value. So take these risky mortgages and then buy insurance policies for them, this is standard practice. That hedges the risk of the actual mortgage itself. Bundle the mortgage and the insurance policy up into a quasi-mutual fund like product: you have x number of mortgage/insurance policy bundles with average risk of default at y. Getting more difficult to put a value on, especially since there is no regulated exchange for them and little oversight.
Not done yet. Add in that deregulation rules passed during the Clinton era allowed the banks that issue the mortgages and buy the insurance policies to also use their assets to trade on their own. This group within a group is called "proprietary trading". So, the prop-trading groups within the banks buy and sell the mortgages and insurance policies to each other in order to generate income for the bank. There are also other groups that buy and sell these instruments that don't actually issue mortgages. These are called speculative traders.
Finally, to put the finishing touches on this pile of doo, have a group create a new instrument: a binary option (it does or it doesn't) on a bundle of high-risk mortgages and their insurance policies. A binary option is essentially a gamble: it pays out if something happens, it does not pay out if something doesn't happen. Now you're buying and selling options contracts which predict whether a group of mortgages will fail or not. There's no regulation, no formal exchange (which helps create market efficiency). There's no reliable way to determine the value of the underlying instrument because it depends on knowing how many of the mortgages will fail. And don't forget that the banks were using their investment customers to create demand for a product they wanted to sell ("I think you should invest in such-and-such") without telling the customers that the banks themselves would be profiting by selling questionable instruments to their own customers.
This is the magic of unregulated capitalism (almost - the banks should have been allowed to fail in a purely unregulated capitalism system). Nothing wrong with Black-Scholes here. The real problem at the core is that the banks involved are so driven by short-term success that there is no room for sanity. Wrap it all up with the fact that the banks know they will be bailed out by the Feds if they fail. There is no penalty for risk and no regulatory oversight. Gotta have one or the other or we just plain deserve this insanity.
Except for one thing, the leverage ratio of Wallstreet has gone up and up, meaning that the ratio of borrowed money (created from thin air by the Fed) to real assets went up and up. So everyone in the game knew they were selling magic beans on a Ponzi scheme, but with so much commission being milked from the system nobody cared. After all it was the Fed that created the money and thus the people taking the risk was mostly Americans with dollar assets. The bonuses would be taken out long before these schemes collapsed, and all of that is free money to them. They're not risking their own assets, they're risking Fed magic money.
The Fed recently said "we made a profit on the bailout loans". Let me show you why that's a scam:
Fed lends $1 trillion against magic beans as collateral, at 0.01% interest to Bank. That money is magic money, created in a spreadsheet, as only the Fed can.
Bank uses that money to buy a real asset that makes real profit.
Bank borrows against the real asset, and replays the magic bean asset.
The profit from the real asset pays the 0.01% interest.
Fed chief claims to have made a profit on magic bean loans.
The Fed doesn't want the loans repaid, it will keep swapping them for other types of loan each time people notice the scam, because to get the money repaid is deflation and USA cannot allow deflation.
The only fix for these fake assets is to stop leverage loans from the Fed to Wallstreet, directly or indirectly (Fannie May, Freddie Mac, AIG etc.). If Wallstreet was risking its own assets then they wouldn't create fake ones sold with dubious equations.
If you're real world business can't borrow more than 75% of concrete assets, then why would Wallstreet be able to borrow 35 times their assets, where the assets themselves are even known to be junk.
I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case.
Yeah, because there's no evidence whatsoever of any bankers committing such fraud, let alone several state attorneys general engaging in investigations.
Surely you've heard of them?
I don't read a lot in my spare time, but one author I like is William Poundstone. I was going on an international trip and I wanted a book to take with me to read to kill time, so I bought his book _Fortune's Formula_. Essentially the book is about some Bell Labs geniuses who came up with mathematical models that allowed them first to make money at casinos and then to exploit weaknesses in the US stock market to make money. Scholes is featured in the book, but he's not a main character. I offer the following 2 quotes directly from the book which are on this very subject.
"LTCM was simply in the position of a gambler who goes to a casino where the pit boss gives him unlimited credit." (page 283) Note that LTCM was the fund that Scholes helped run. The book further goes on to state that in real life, nobody gets truly "unlimited credit". A casino will not loan more money than they can collect. But LTCM's business model depended on credit never running out to them.
"Warren Buffet marveled at how 'ten or 15 guys with an average IQ of maybe 170' could get themselves 'into a position where they can lose all their money.'" (page 291) It's a big simplification, but basically LTCM got burned by the Russian currency collapse which started a chain of events that killed them.
You forgot:
4.1: get bailout loans, which you use to purchase government securities, profiting off the entity that just saved your ass.
4.2: use said profits to lobby hard against the laws the tried to pass to keep you from bilking the public again.
The mathematical formula is not the problem. All it does is make it possible to get more exact about your guess as to what the future holds (based on your guesses about the actual values of things instead of the expected values). But math cannot predict the future any better than Tarot Cards can.
Falsifying documents in order to ensure loans for people with low income (as was your original claim)? No, I do not know of any such cases. Do you have a link? I would be genuinely curious to see one.
Any guest worker system is indistinguishable from indentured servitude.
Great book about a massive hedge fund crash in the 90's: The Rise and Fall of Long Term Capital Management
try { do() || do_not(); } catch (JediException err) { yoda(err); }
Falsifying documents in order to ensure loans for people with low income (as was your original claim)? No, I do not know of any such cases. Do you have a link? I would be genuinely curious to see one.
Are you retarded? Really? I can dig up about a thousand of these without even trying. http://www.huffingtonpost.com/2012/04/28/chen-guangcheng-blind-chi_n_1461120.html
BS had zero to do with any of the problems which led to the various market meltdowns. What did? Ignorance of liquidity (more precisely, lack of liquidity), counterparty risk, seriously flawed assumptions about various correlations (think gdp, unemployment, geography, subprime mortgages), significant excess leverage financed at exceptionally low interest rates, creation of intstruments which allowed some holders to game the system (credit default swaps) and lastly, ignorance and greed. There are, of course, myriad other contributors but BS is not one of them.
Disclaimer: besides having a masters degree in computational finance I worked in the industry for nearly two decades.
Every model is build upon some hypothesis. If you apply it without be aware of its limits it's your fault.
1. Poorly understood packaging of subprime loans
2. Even more poor regulation and risk assessment of these by Moodys and S&P
3. Poorly understood relationships between prices in housing market and effect on these CDOs
4. Belief that prices for real estate will never go down nationwide and even if they do it will take a massive collapse in prices to cause a financial collapse -- in fact many CDOs failed when prices declined only 6%
5. AIG not understanding what they were insuring and not charging nearly enough for the insurance
6. I-Banks taking the long side on these CDOs that they did not understand and management did not understand
7. Govt policy that was hell bent on pushing home ownership to those that should have been renters -- both parties supported this but the Democrats pushed much harder and when it was clear we had a problem they put their heads in the sand and declared the system perfectly healthy
8. A public that let the i-Bankers off the hook and allowed the US Treasury to pay off the risky bets the I-Banks made 100%
Agreed, if they gambled with their own money, they wouldn't hide behind Black Scholes. It's known not to reflect real world risks (like fraudulant mortgages). The only reason they use Black Scholes is because it lets them claim the asset as solid and thus lets them borrow against it.
But if they gambled their own money instead of Fed money, then you'd suddenly see a revolution in risk analysis which accurately reflects fraud.
More to the point, when these scheme collapse, you'd see proper criminal prosecutions, instead of the whitewash we have now.
At the very least they should be limited to the same sort of multiple any other business is lending money at, 60% of concrete assets or less, not 3500% of garbage pseudo assets.
Superwiz, were you asleep over the past few years, or perhaps while'd it away playing shoot 'em up video games?
It took me about two minutes to find the following. Note these are major news outlets with experienced financial reporters, not bloggers.
Go ahead and forward my post to whichever banks you want.
- OP
http://www.sec.gov/news/press/2010/2010-59.htm
http://www.bloomberg.com/news/2011-01-24/countrywide-sued-by-investors-in-mortgage-backed-securities.html
http://www.forbes.com/2009/04/08/borrower-subprime-mortgage-loan-opinions-contributors-lenders.html
http://www.cbsnews.com/8301-505123_162-57387779/big-banks-could-face-mortgage-fraud-charges/
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ax3yON_uNe7I
FRAUD ALERT: It was not a mathematical model that caused the problem. It was fraud. Financial organizations convinced investors that they had a "mathematical model" so that they could steal. The theft was ENTIRELY deliberate, as is described in detail in the 1997 book F.I.A.S.C.O.: Blood in the Water on Wall Street, by Frank Partnoy. Somehow the issues were kept quiet for 11 more years until the theft could be completed in the 2008 financial crash. Traders called their work "ripping the client's face off" .
There are other editions of the book, such as this one published in 1999, Fiasco: The Inside Story of a Wall Street Trader, and a 2009 I-told-you-so edition of the original name.
Nothing has been done to reform the extremely corrupt financial system in the United States. No one in the SEC, U.S. Securities and Exchange Commission, the government organization that is supposed to police financial fraud, was prosecuted, even though the agency knew of the abuses. See the February 17, 2009 show Frontline: Inside the Meltdown.
Even though the U.S. dollar is experiencing rampant inflation in 2012, U.S. banks give less than 1% interest on savings. Those who would like to invest can't because the system is so corrupt it cannot be trusted. Corporations hold unprecedented amounts of cash. See, for example, the October 7, 2010 Washington Post article, U.S. companies buy back stock in droves as they hold record levels of cash.
F.I.A.S.C.O. stands for "Fixed Income Annual Sporting Clays Outing" (See page 100 of the 2009 edition.), held at a shooting range called "Sandanona, a club in upstate New York" (Page 97 of the 2009 edition). Traders would go there to shoot guns. The idea was to encourage their taste for violence so that they would be even more financially violent toward the customer.
Perhaps the April 27, 2012 BBC article, Black-Scholes: The maths formula linked to the financial crash referenced in this Slashdot story was influenced by public relations agencies trying to get people to believe that the crash was caused by errors in mathematical thinking, and not by fraud, so that the financial industry can continue stealing.
It would be helpful if Slashdot editors signed a statement about each story saying that they know of no conflict of interest, and no one was paid to run the story.
The financial markets used a "formula" without seeing the risks that went beyond what the formula had as INPUTS.
Taleb's book made many points about how the best laid plans of mice and men go awry. Mice make assumptions about the acquisition of grain seed in the field when they don't see or hear the hawks. Unfortunately, the fox also hunts.
Mechanical engineers can say "The beam has a tensile stress safety factor of 10 & it will never break." The formula for tensile stress is satisfied. Unfortunately, creep, crystalization, chemical attack, notch sensitivity, vibration, harmonic vibration temperature and radiation can alter the "strength" of a beam.
Formulas are only as good as the person doing the WHOLE analysis. Naseem Taleb was right, Black Swans will continue to pop up.
Like you say, accusing people of fraud is nasty... and I would add that if we think about it, it's also unnecessary. I don't know how things were over there in the USA, but in the UK during the boom years and until very recently people weren't committing fraud because they didn't even need to:
According to the Financial Services Authority, nearly half of new mortgages between 2007 and the first quarter of 2010 were provided without the customer having to verify his/her income.
Source
So, it's a lot like GP poster said: more credit => higher house prices => more money for those who joined the game earlier.
Don't know of any? Just talk to anyone who got a mortgage between 2000 and 2007 or so. Mortgage brokers were doing all kinds of nonsense. I got three mortgages in that time [including a refinances], and here are the things that happened with one or more of mine:
* mortgage broker changed numbers on forms after I signed them
* mortgage broker suggested I bribe the appraiser to make sure the property value came in at the right number
* mortgage broker included my large signing bonus for my new job in my annual income to make sure my income levels were high enough for the loan
* mortgage broker asked me if I had a parent or uncle who could float me a cash loan to include in my down payment
Three different mortgage brokers, all sleazy. They make money on commission, and were perfectly willing to break law or bank policy to score another loan.
For those who doubt the book F.I.A.S.C.O. is as intense as I said above, here's a quote from page 101:
"As the quick-learning derivatives salesmen began to have more and more violent thoughts, the securities they sold became more violent, as well. In 1986 a typical salesman subscribed to Time or perhaps Playboy, played golf, and sold corporate and government bonds. By 1994 that same salesman read Soldier of Fortune and Guns and Ammo, shot doves, and sold leveraged-indexed-inverse-floating-dual-currency structured notes. This was no coincidence."
There is just too much money and too little demand. The rich and corp have a lot of excess income because of the cuts in their tax rates. The excess money is more than what the poor and middle class can borrow. The result is that real interest rate is almost zero. So all of this excess money goes into speculation, just bidding up the price of some financial commodity. This creates the boom and bust that kills the economy. As long as the excess capital exist the boom and bust will continue and the economy will be grind down.
Umm? Was that a misclick? You posted a story completely unrelated to any your claim that mortgage papers were falsified.
Any guest worker system is indistinguishable from indentured servitude.
Whenever I hear a claim that there are "many" case of something, I get suspicious when the speaker can't provide at least 1 or 2 examples. I am sorry, I am finding it difficult to take the word of an anonymous poster saying "but it happened to me". If this was wide-spread, then I am sure there has to be at least 1 case of it going to trial. That's all I asked for. 1 link to a documented fraud case. It's not that high a bar to set to support such extravagant claims.
Any guest worker system is indistinguishable from indentured servitude.
Step 3 is selling to mortgage to Fannie and Freddie, who were instructed by Congress to buy every mortgage they could, regardless of the safety of the mortgage. Congress wanted their constituents to have houses and reward their Congress members for creating a system that would allow them to have a house. You reelect your Congressman and Congress makes it possible for you to own a house, every body is happy. With Fannie and Freddie buying every piece of crap they could lay their hands on, what would prevent a banker from making horrible mortgages?
Please fix the usage error in both the headline and summary. Please, it hurts.
In the Berkshire Hathaway 2002 Annual Report (PDF file), Warren Buffett said this on page 13:
"Derivatives
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."
From page 14:
"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."
On page 15:
"In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." [my emphasis]
Warren Buffett, the world's most famous investor, published that in 2003. It was widely reported. No one can say the fraud was unknown, or that the present severe economic problems are due to a faulty mathematical formula.
Here's one reference, there are many more. We had one in Ohio where a woman on welfare ended up owning several homes unknown to her. She only found out when the mortgages in her name went bad. No, this was not identity theft, she signed the papers. She just didn't understand what she was signing.
Link to article
If I used a sig over again, would anyone notice?
He's right, though. Stories about fraudulent loan applications are so common that if you haven't read any, you must not read the news.
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aN2DPRuRs93M
Breakfast served all day!
When I took statistics in college my didn't put so much emphasis on whether we knew the formulas our not, he cared more whether we were able to argue our interpretation of the numbers. He told us that computers and calculators will do a better job of crunching the numbers for us, but it will never be able to do what a human does best: interpret that data based on facts, morals and experience. Most important is the moral judgement. I believe that the market failed because of the lack of moral fortitude of enough people in the market sector.
Aside from the greed, fraud, etc. one of the noteworthy things about the crash was the failure of so many "smart" people to pay attention to the real world.
When cafeteria lunch ladies are taking out $500k mortgages with 1% teaser rates to buy 5 bedroom mansions, plainly something is up. Only a few people stepped out from behind the monitors and paid attention.
A lot of us knew it was a bubble and felt trapped. My particular situation involved having my father pass away and inheriting half the house. I felt like I had to buy a smaller house that cost too much. I knew the bubble would burst, but I didn't know when it would burst. I could have been "left in the dust" if prices quadrupled from there. That's how it is with bubbles. You. Just. Don't. Know.
As it turned out, it was the peak of the bubble. The closing to sell my father's house was surreal--a 1% teaser from Countrywide, the closing bilingual Spanish-English. The house sold for $550k, and was eventually foreclosed at $400k. I ended up buying something for $290k and selling it at $260k a few years later. I fared better than many.
Everyone should watch this:
https://www.youtube.com/watch?v=TtJql2aqjkw
The making of the financial mess Wall Street started. Clinton, Bush and Obama sold us out by hiring these criminals to look out for the best interest for Americans.
Category:
News & Politics
Tags:
financial collapse
wall street
white collar crime
"If any question why we died, Tell them because our fathers lied."
Fannie and Freddie purchased mortgages, but this had nothing to do with the financial collapse because these agencies were backstopped by the US Treasury which was capable of withstanding the losses.
It is the purchase of mortgages by private banks who then went insolvent and thus froze up the lending system that led to the financial collapse.
In addition the quality of loans purchased by Freddie and Fannie were considerably better than those bought by private banks with much higher FICO credit scores.
http://www.thedailybeast.com/articles/2011/01/17/wall-street-not-fannie-and-freddie-led-mortgage-meltdown.html
http://www.amazon.com/exec/obidos/ASIN/0805090460/thedaibea-20/
I recently took a class in options theory taught by one of the world's foremost options experts. Basically, his premise was that all models are wrong. That doesn't mean they aren't useful, but you have to understand how they are wrong so you can know what they are telling you.
Essentially, Black-Shoals assumes that the function is continuous. Real world financial markets are by and large continuous, but occasionally there are market shocks. So Black-Shoals tells you what happens in a world where there are no asset bubbles or irrational market swings. It's useful, but there should be other variables included in a pricing model because the world is not a continuous Markov function.
This is not the fault of the function. It is the fault of the bankers and mathematicians who wrote the pricing algorithms not understanding the limitations of the math they were using. Black-Shoals is a model -- that's all it is. The banks were over leveraged and didn't have the capital to cover the losses they were seeing in the short term. Over the long term, Black-Shoals will likely be very close to correct once it has been recentered after the market shocks. But it's just a model, and you need the liquidity to cover events that are not modeled by the model.
myron scholes or any of the other tools that enabled the 2008 crash, including CDOs, securitization, etc.
Edwrd Chancellor has a much, much more accurate , and scientific approach to crises - and that is to catalog and record them and their details, going back to Tulipmania and before. His book "Devil take the hindmost" came out before the 2008 crash, but basically what he is doing is proving that History is much more of a 'science' than economics --- at least in History, they try to gather actual data before making theories, and throw out the theories when the facts dont match.
the various attempts to 'blame math' for the crash of 2008 are little more than attempts to cover up the massive fraud that was perpetrated on the taxpayers of the planet. you make a huge amount of horrible loans to people you know cannot pay them back, resell the loans to people and lie about it, then get the government to bail you out when the whole system is about to collapse. you dont need a formula to do that, it is the basic feature of every economic bubble and its bursting. Fraud.
the difference here is that the fraudsters have completely made an end run around all the rules implemented after the 1929 crash to prevent this sort of thing, they practically own the politicians that are supposed to regulate them, and they insinuate themselves into positions of power in the political class. thats the difference - that we are actually regressing backwards in our civilization, and having the free market run less well than it did previously, and watching entrepenurial capitalism die a nasty death by its own supposed proponents.
http://www.pbs.org/wgbh/nova/stockmarket/
Unfortunately you can't stream it anywhere.
But the BBC adapted it with re-recorded narration, and it's right over here.
http://www.youtube.com/watch?v=4auzn4bK1bM
Remember, this was all stuff we knew about in the late 90's.
The only interesting question is, did we fail to learn the lessons from LTCM, or did we learn the wrong ones?
I will lead someone to the water - present tense. I led him to the water - past tense. Lead is also a metal but it is NOT pronounced the same as in the context mentioned earlier. So the headline should read "The Math Formula That Led To the Financial Crash" - as in past tense. And the sentence in the article should read "...and widespread adoption led to Myron Scholes..." - again past tense of lead.
investment bank after investment bank, hedge fund after hedge fund, saw that this whole thing was a risky load of shit, and they actively moved to profit from the collapse, even at the expense of their own institutions. CEOs like Dick Fuld actively demoted and ignored internal critics, and walked away with millions after their companies disappeared into a puff of smoke.
The guys on the CDO desks at these places, not one or two, not a handful, not a dozen. Dozens. Dozens of them, made billions of dollars. Why should they care if it blew up? They were making bonuses based on 'future profits' calculated back to the present based on these shitty loans. They colluded with the ratings agencies to lie about the quality of the loans.
Then they made the taxpayers fix it all.
Where is the 'black swan'? Fraud is not a black swan, fraud is endemic to human nature and to financial bubbles.
Taleb is fine but here are some other books about the actual mechanics of the fraud
Colossal Failure of Common Sense, Lawrence McDonald
Sellout, Charles Gasparino
Trillion Dollar Meltdown, Charles R Morris
Fool's Gold, Gillian Tett
All the Devils are Here, Bethany McLean and Joe Nocera
Structure Finance and CDOs, Janet Tavakoli
House of Cards, William Cohan
Greatest Trade Ever, Zuckerman
The Big Short, Michael Lewis.
EConned, Yves Smith
your list is full of 'didnt understands'.
but there were a huge number of people who understood it perfectly well.
they get fat bonuses quarter after quarter for delivering 'results' that they knew were BS. they dont care. they keep on doing it.
the ratings agencies purposely colluded with the investment banks to lie about the ratings of CDOs. it wasnt 'they didnt understand', it was that they understood and were making too much money to care. their profit margins in these years came from CDO ratings. they actively stopped people inside their organizations who were pointing out the obvious flaws in the models.
AIG itself stopped the game a year before the thing began to crash. And yet, the Monoline insurance companies picked up where AIG left off. the idea that everyone 'didnt understand' does not make sense. Plenty of people understood. They just didnt care. its called fraud.
to use the word "Fraud", "Theft", "Corruption", or any of the other nasty things that 'greed' is a euphemism for.
I guess you don't know Slashdot well. Here are comments on other articles that raise suspicion. Judge for yourself from these 3:
Nuclear Energy Now More Expensive Than Solar
Brains Work Best At Age of 39
The Painkiller That Saves Money But Costs Lives
Mr. Mandelbrot
DR MANDELBROT
the thing about the LTCM is that the guys that ran it got jobs in the industry, again, and they proceeded to destroy even more money, and then they did it again and again and again.
people say that capitalism 'weeds out the non performers' but when you look at the history of places like LTCM, its bullshit. its a big old boy network where people like Dick Fuld do not get busted down to street sweeper - they get to sit on millions of dollars of other peoples money, forever, with no prosecution of any kind. guys fail and fail and fail, over and over, and they keep getting jobs in the industry.
there are people who commit blatant frauds who keep getting spots in the industry too, over and over and over. The SEC and the other federal agencies then are supposed to regulate, but their top officers routinely get hired away by these companies they are supposed to be regulating at huge salaries as 'consultants' and lobbyists.
this is one of the few posts to get it right. it was a fucking ponzi scheme, not some 'oh woops sorry' miscalculation by math guys.
as for the Fed bailout, it wasnt just a bunch of loans. there are an alphabet soup of programs the Fed set up to 'shore up' the banking system in 2008. there are literally at least a dozen programs they set up, each working in a different fashion and targeted at a different piece of the industry that was failing.
but the other side of this argument is its just more BS to lie to people about. they can claim that they 'payed the TARP money back', but that doesnt mention ANY of the other programs and the massive, huge losses the taxpayers took in bailing out these banks.
the AIG Credit Default swap deal being a prime example - you, the taxpayer, payed Goldman Sachs 100% of the 'face value' of the CDS that AIG wrote against a bunch of crappy CDOs. Those CDS were not woth but maybe a few pennies, like 1-10% of their face value. but we taxpayers were forced to pay 100%. Thats a 90% rip off. And the guys who did this running Treasury and the Fed were former Goldman people, like Hank Paulson. if its not conflict of interest i dont know what is. And, by the way, it has come out recently that he TOLD his hedge fund buddies what was going on, 'outside of the loop' of his normal job as Tres Sec. He put his banker friends before the American people.
I have a hard time believing it was math. Why? because nobody was doing math. You cannot gamble on a massive market built on giving people loans who cannot pay for those loans and not have a crash; the math doesnt work.
It is greed that was responsible for this, greed and selfishness; mainly the banks, but some home owners as well. While its great to try and point the blame at some mathematical abstract theory, it doesnt help bring light to the true problem and that is a culture of greed that always finds a way to skirt around the rules. They are like a kid figuring a way to get daddys gun, but when they shoot themselves in the foot, they blame it on the gun, the bullet, the firing chamber, or the trigger, not once do they look at the dumb idea of playing with the gun in the first place.
All the revisionistic bullcrap changes nothing....
very nice people, who are very well spoken and have very nice suits, and give huge, huge amounts of money to political campaigns.
you dont talk bad about the nice people in the nice suits.
they stole a trillion dollars from the taxpayer. they are stealing more as we speak. but do not say this out loud. your journalism career will be rather short.
It's ridiculous to blame the Black-Scholes model, the Black-Scholes equation, or the Black-Scholes formulas. There are two groups of individuals responsible for the crash, even if the corporate press refuses to acknowledge it: bank executives who knowingly did ridiculously risky things and the ratings agencies that gave them the cover to do it. It's also ridiculous to refer to the crash as the "subprime crisis," because the problem most definitely was not subprime mortgages. The sum total of all the subprime mortgages was on the order of a few hundred million dollars, but the damage done by the crash was in the tens of trillions of dollars. The bailout of 2008 amounted to over one-and-a-half trrillion dollars, which was enough to pay off all the subprime mortgages several times over, and yet it didn't solve the problem.
Let's start with the ratings agencies. With winks and nudges to their friends running the banks, the people at the ratings agencies gave ratings of AAA, which means "as close to risk-free as you can get," to packages of mortgages in which they knew many were "subprime" and many, many more had been given by unethical lenders (who later sold them off in packages) who did not check the ability of their customers to pay. In some cases, the AAA rating was even extended to complex derivatives based on the mortgage packages, despite the fact that the people at the ratings agencies didn't understand those derivatives well enough to give a rating at all. It's worth mentioning that among those customers were many middle-class and wealthy individuals counting on the obviously unsustainable growth of real estate prices in the US market so they could take out mortgages to buy properties, hold on to them for 6-18 months, and then "flip" them for a huge profit. Also among them were many companies. So don't go blaming the lower-middle-class and poor holders of "subprime" mortgages, who only represented a small fraction of the number of bad mortgages. Anyway, a rating like AAA should only be given to things that are as risk-free as a government bond. Since wealthy people and economists love to talk about there being "no such thing as a free lunch," it's worth pointing out that that idea is a basic principle used in things like pricing assets. In that context, it's called the "no-arbitrage principle." Arbitrage basically means "risk-free profit." The idea behind the no-arbitrage principle is that if there were an opportunity for risk-free profit, somebody would have already taken advantage of it and driven prices to the point where the opportunity no longer existed. In today's world of high-frequency trading, the no-arbitrage principle actually works pretty well. A classic example of arbitrage would be a stock that's sold in two different exchanges. If the price is lower in one and you can buy it quickly enough, then sell it quickly enough in the other exchange, where it's worth more, then you can make a profit with basically no risk. The thing is that if anyone notices and tries to do that, it drives up the price (buy increasing demand) in the exchange where the price was lower and brings the price down (by increasing supply) in the exchange where the price was higher. The prices are thus driven rapidly toward equilibrium. And in fact a crucial step in the derivation of the Black-Scholes equation is an application of the no-arbitrage principle, equating a risk-free return to the rate paid by government bonds.
Additionally, when heads had to roll at the banks for, y'know, breaking the world economy, you know the execs wanted to protect themselves and their own and put all the blame on their quantitative analysts, but they couldn't because the quants had done a good job of covering their own asses by sending e-mails to their superiors warning that there were all kinds of risks not being controlled or managed, and that there were even new risks introduced by modeling that could lead to problems. So the execs were fully aware that they were trading in assets tha
"It is nice to know that the computer understands the problem. But I would like to understand it too." --Eugene Wigner
"Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel. Slashdot's policy is that "all comments are owned by the poster." I do hope you got something to back up the "falsifying" claim. Otherwise, some "bankster" or such just might get annoyed enough to go after you.... cause you know... he might have a case."
There are numerous documented cases of fraud. The robo-signing scandal is just a huge, massive fraud. Read any of the crisis books, they are full of pictures of fraudulent documents being created.
Your bit about 'insurance' is hilarious. The industry itself pushed to make Credit Default Swaps not be considered 'insurance', even though tons of journalists will later describe them as 'insurance' because the only other way to describe them is to call them 'gambling bets'. But they are not regulated like insurance, specifically because the industry pushed the NY state insurance commission to exclude them from such regulations.
Please just stop lying. We are not stupid, and we can read books. just stop lying.
Fraud is a big problem, but not the worst problem. I've grown concerned that we're all engaged in mass delusion. We think the world works a particular way, but we may be wrong. We can produce what seems to be supporting evidence. I am referring to a much more fundamental idea of finance: the formulas for rates. They're neat and simple, and wrong. Implicit in compound interest is exponential growth. The universe doesn't support exponential growth.
Historically, depending on who you talk to, the stock market has averaged an annual rate of return of 7% or 10% or even more. But that record is only about 100 years long. Can the stock market keep up 7% growth for another 100 years? If it can, how about 1000 years?
Intellectual Property is a monopolistic, selfish, and defective concept. It is "tyranny over the mind of man"
This one drives me nuts. When "lead" rhymes with "bread" - it means element 82. If you want the past tense of "lead" (rhymes with "seed") then it's "led".
Not my original claim, the OP and the grandparent (myself) are not the same.
But you could find it in the reports released by the attorneys general of New York, Nevda, California, and others.
However, if you want a proven example
http://www.justice.gov/opa/pr/2012/April/12-crm-488.html
Pardon me for not bothering with more, your ignorance is so apparent that more effort is wasted.
Black-Scholes a rehash of a formula derived from physics, as derived from differential equations as derived from Newton and Leibniz (1675)
AccountKiller
The investor is responsible for choosing what to invest and not invest in. Warren Buffet is a smart investor, and has wisely chosen to avoid many things that he can not comprehend. Many investors do not.
To ban something because the average investor does not understand it does not make for a good financial system.
Black-Scholes is sound in a statistical/mathematical sense. Unfortunately it makes implicit assumptions about how the market operates that simply aren't true, so it was bound to fail. Financial engineers -- and I use the word "engineers" loosely here! -- accepted the assumptions as gospel because their jobs/bonuses depended on it.
I used to work in that industry. It will be a cold day in Hell before I go back.
The only way to prevent another train wreck is to remove the incentives for "too big to fail" banks to take unreasonable risks with other peoples' money, based on the assumption that the government will bail them out if things go badly.
Soulskill: at the very least, when you're writing for a large readership, you should set a good example and take the time to proof your writing. Otherwise your errors are magnified. I'm begging you.
I understand that English is a living language, but I object to changes arising merely from repeated errors.
Actually reading through the BBC story, I feel it's yet another example of the BBC's declining grasp of anything technical. Long term capital management called into question Black-Scholes and demonstrated extreme events in markets, sure. But the elements of the recent crash were also to do with greed, arrogance, mis-selling [of mortgages that were then securitised in un-auditable and therefore un-priceable mixtures] bad-fatih [banks selling both complex derivatives AND insurance for the failure of these complex derivatives] and a general credit-bubble that distorted asset pricing. Michael Lewis' the Big Short: http://www.amazon.com/The-Big-Short-Doomsday-Machine/dp/0393072231 is very good on the detail of this.
Then, because the firewalls between speculation and retail banking had been removed, there was a great deal of general contagion and bank to bank movements froze.
However, one can't conclude that all mathematical pricing is wrong from these two separate events. One can reach conclusions regulation, capital adequacy, firewalls etc/ Above all, if the public is well protected and genuine industry is well protected, these idiots [of which I was one once] can do what they like and then suffer the consequences.
On y va, qui mal y pense!
When unpredictable things hit a prediction model, weird things happen. Instead of dampening risk, it looks like it created a feedback loop.
1) This formula only works if few people use it.
2) Math formulae don't bankrupt people. Only people bankrupt people.
Sorry, but gray text on gray background is making my eyes bleed.
In other news, the number of editors who know that the past tense of "lead" is "led" creeps ever closer to zero...
The US Treasury and the Fed bailed out both of them. Your distinction is driven by political ideology.
Freddie/Fannie got their share of shitty loans, just like everyone, and their funding higher loans after the conforming rates were bumped (in a futile attempt to stop the fail) will only make shit way worse in the long run.
It certainly wasn't Black Scholes that created the recent financial meltdown. But there was the Gaussian Copula formula that absolutely DID contribute to the meltdown. All stemming from greedy Wall Streeters who were using the copula to determine the risk of a large percentage of sub-prime mortgage holders defaulting at the same time. This is old news. Black Scholes had nothing to do with it.
See the Wired Article
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
> The US Treasury and the Fed bailed out both of them. Your distinction is driven by political ideology.
Nonsense. The idea that the economic crash is due to Freddie and Fanny has been debunked many times including in the links I posted plus many more. Many conservative economists know that it is a wrong idea. Even the Republican members of the congressional commission that investigated it know it to be false.
http://www.bloomberg.com/news/2011-12-21/romney-gingrich-bid-to-pin-crisis-on-government-ignores-culprits.html
Tell me - what did Freddie and Fanny have to do with the collapse of Lehman, the event everyone points to as the beginning of the collapse?
And what culpability do the banks have for selling flat out fraudulent mortgages to F&F?
http://www.crainsnewyork.com/article/20120222/REAL_ESTATE/120229979
Black-Scholes might be correct, but widespread fraudulent initial conditions to this PDE most likely, led to crash.
As a PhD in statistics I should be commenting on the merits (or lack thereof) of the mathematical model, but noooo, it's the misuse of the English language that gets _my_ attention. I can't believe that otherwise intelligent people don't know the difference between lead (a notorious metal, rhymes with dead), led (past tense) and lead (present tense, rhymes with weed). Pitiful.
Mortgages were approved because the federal government imposed a quota on low-income borrowers. Banks didn't want to make loans to those borrowers, so they were given the option of sharing the huge risk via derivatives. Of course it all came crashing down, but the root problem was the Community Reinvestment Act that was pushed through by Carter and made worse by Clinton.
I don't think you need to point to a particular book. This will happen any time you base a financial system on fiction and detach it completely from the resources it is trying to represent, then systematically pay those who add value (workers) bottom dollar through techniques such as outsourcing the jobs to poor barely qualified or totally unqualified desperate people who'll do it for peanuts....all so you and your buddies can have an endless extravagant party life full of hookers and hash.
And leave the actual news to others. Black-Scholes is fine. The current breed of quants use models that are orders of magnitude more complex than black-Scholes. In fact one need only go back to ENRON to understand that a big part of the problem was caused by tertiary and quaternary derivatives that no one not even their creators understood.
Another rarely discussed problem is HFT - high frequency trading, which is where 75-80% of the market churn is. That's a trading universe that exists below the 650 millisecond threshold. Those are trades that beneath the limit of human interaction or notice. A couple of years ago there was something called the Flash Crash where the market for no explicable reason, dropped 500+ points in a matter of seconds. Research after the fact tells us that HFT models behaved entirely the way they were supposed to. But what they were designed to do was wrong. The nature of HFT means that a whole ecology of trading exists w/o people knowing what it's doing.
B-S is a tiny tiny tiny piece of the puzzle.
I didn't say he was wrong. I simply asked to see a report of a documented claim. Your link definitely did that. Thanks. It made for an interesting read. Certainly such fraud does hurt both borrowers, the creditors and the homeowners at large. I hope whoever committed this fraud does serve time. Doing due diligence is pretty much the S&L bankers' main job. If they not only dropped the ball on it, but actually falsified the numbers, that's no different from just plainly stealing money out of your employer's cash register.
Any guest worker system is indistinguishable from indentured servitude.
1. The time remaining until the contract expires
2. The current price of the undelying asset
3. The strike price (the contract gives its buyer the right or "option" to buy the asset at the strike price)
4. The risk-free rate of return on cash (return that could be earned by putting your money into, say, treasuries rather than stock)
5. The volatility of the underlying asset.
At the time the contract is written, the first four of these values are known (assuming of course that the risk-free rate stays constant, which is pretty close to a sure bet). The LAST value is the problem. It says how much the stock will fluctuate, between the present time and the time of expiry. This is unknown, because, after all, it requires knowledge of the future. Usually, PAST volatility is used in its place, going with the assumption that the stock will behave in the future the same way it behaved in the recent past.
If the stock suddenly becomes very quiet, and stops fluctuating, the buyer payed too much for the contract, on average. If the stock gets very wild, the buyer got a bargain, on average. In either case, the contract buyer and seller guessed wrong. They should have used a different volatility to price the option.
Of course, stock fluctuations do NOT follow a normal curve, after all. And option traders do NOT follow Black-Scholes exactly either (see "volatility smile"). But the much bigger flaw, I think, is lack of clairvoyance. The formula requires knowledge of the future.
Was it not a divide by zero issue?
Whoever wrote the parent comment apparently expects to make money in the stock market, or other investments, and want people to ignore the well-documented fraud.
Rampant inflation.Where are you reading that. What I could find on Google says 2.4 to 3%. When is that Rampant?
Step 3 is selling to mortgage to Fannie and Freddie, who were instructed by Congress to buy every mortgage they could, regardless of the safety of the mortgage. Congress wanted their constituents to have houses and reward their Congress members for creating a system that would allow them to have a house. You reelect your Congressman and Congress makes it possible for you to own a house, every body is happy. With Fannie and Freddie buying every piece of crap they could lay their hands on, what would prevent a banker from making horrible mortgages?
Fannie and Freddie were an insignificant fraction of the subprime market. They have specific lending standards that forbid them from investing in the sorts of mortgages that went bad.
I have an ideological problem with many things the government does, including the existence of Fanny and Freddy. However, I draw the line at making shit up to make my case. Economists Peter Wallison and Edward Pinto wrote the paper that seems to be the source of this lie. A short summery of the issue is here:
http://www.nytimes.com/2011/12/20/opinion/nocera-an-inconvenient-truth.html
Google can show you both sides of this debate if you search for their names. You can also see the original numbers, and they clearly show that Fanny and Freddy only got into the market for loans that went bad many years after the rest of the (private) market, and did not have time to accumulate a significant amount before the crash.
Whoah, cowboy! "falsifying documents" is fraud. Fraud is a crime. Making a false accusation a crime in writing is libel.
I know several people in the compliance area of the Mortgage industry that document everything they do to cover their asses because they seriously suspect that the way the companies they work for are doing things is fraudulent. Of primary concern is having unlicensed loan origination AND processing illegally outsourced to India. The compliance managers tell their higher ups that what they're doing is probably wrong, but they don't care; They're yes men. The bosses are business men making deals trying to make things happen and they don't ACTUALLY know what's legally required. In fact, one of their bosses is a here on a visa, from India, and doesn't care if they get shut down -- He's working another more lucrative project for their parent company -- If it all goes south, he doesn't care, he still has his cushy job back in his homeland's main offices.
I'm seriously not trying to diss Indians: Nationality has nothing to do with it at all. This may not be representative of the whole industry, but I can't prove that -- I'm just telling you like I hear it is for the people that I know -- And letting you know that fraud IS STILL HAPPENING, and the accusations are not libel unless you name names and it happens to be a false accusation (in my case it's certainly NOT libel).
My friend's bosses won't take the advice to seek attorneys' legal opinions before making the crazy deals or restructuring agreements because that would likely prove they knew full well they were wrong (and it also costs money). They believe they're cunning business men who can find a way to cut corners and beat a system which the government has done its best to remove corners from. The larger companies that buy and sell and do business contracts with such smaller companies are some of the biggest international banks in the world. In the past five years, one of my friend's companies has been bought four times. The regulations require that the new corporate owners disclose their identities, so they instead play games with their corporate structures instead of doing things the right way -- The investment group doesn't want to be fingerprinted and have their names associated with the mortgage companies under their actual control -- That should tell you something right there...
Furthermore, when a state orders an exam, their document repositories hardly ever have all the correct info because the over seas people completing the loans and filing the forms try to manipulate closing dates and so they can get bigger bonuses in a given window -- Except they're sloppy and don't go back and update the info in the Calyx point system they use. As a programmer I've offered many times that the computer system should prevent them from closing the loans unless all the pertinent details are in the system -- But a large part of the industry still relies heavily on Faxes! Electronic signatures would be preferable, but even those are frequently used incorrectly.
One of my friends said that frequently, Upon pulling a set of docs for a loan, the lender's name won't even be on the form! It's not that it never was, or that the loan has no lender -- Just that someone (in India) didn't care enough about their job to go back and scan in the form and add it to the file before closing it. My friend has been complaining to me about incomplete forms for over three years -- Apparently the manager can't get their employees to do the job correctly -- They do all sorts of other document processing as well since it's a sister company that operates primarily as an outsourcing business, and what's a few incorrect forms here and there?
Each of my friends has worked for several other companies, and their past businesses have all eventually gone under due to regulatory fines for non compliance and inability to create new loans for want of valid state licenses as their only legal loan origi
U.S. dollar inflation, some examples:
Food, +4.8% -- Food Price Outlook, 2012
Quote: "The food-at-home Consumer Price Index (CPI), in turn, increased more than expectedâ"4.8 percent in 2011â"which means that food price inflation was not as strong as in 2008 when it increased 6.4 percent over 2007."
Medical treatment, +8.5% -- Medical cost trends for 2012
"This year's report from PwC's Health Research Institute finds that the medical cost trend is expected to increase from 8% in 2011 to 8.5% in 2012."
University tuition, +8.3% -- College costs climb, yet again.
"Tuition at the average public university jumped 8.3% to $8,244."
Gas, +208% -- Historical Price Charts
>>> ... the U.S. dollar is experiencing rampant inflation in 2012...
There must be a US Dollar on some other planet but which one?
One was the claim that the sellers understood what they were selling and its risks.
Another was that they were selling something they thought was in their client's best interests (often the opposite is the case.)
Another was that they sold things they were actively betting against, and trying to create a climate in which these failures would result in windfall profits to them.
Read Gretchen Morgenson, and others. The fix was and is in.
If you are going to lay the blame on a model rather than greedy people the use of Gaussian copula for collateralized debt obligations is a better choice than Black & Scholes.
That's pure journalistic BS from BBC. Options were not even the reason for the crash, liquidity crunch caused by Structured Financial Instruments like MBSs, CDSs etc. was more of the reason, in addition to netting problems when banks like Lehman went down! And the issue with the structured instruments was that the probabilities of default were co-related and had fatter tails than what the models had assumed. But the real problem was a problem of confidence where al structured products became toxic - causing severe liquidity issues.
What's this got to do with Black-Scholes or options? Traders have know for the longest time that BSC doesn't work - heck that's why we use implied volatility as a plug!
Those are increases driven by fundamentals; principally, the fact that the oil is running out. Apart from college tuition: now that's a scam.
[FUCK BETA]
Did Black-Scholes formula create new jobs in the economy?
Casteism
He says the collateralized debt tranches were computed assuming bad debt was independent and infrequent events. You then AND (multiply) risk probabilities together, getting a small number. But if events are correlated, then you OR probabilities, i.e take the largest value. During a significant economic downtown, bad debt events are correlated, i.e many people have the problem for the same reason. So during the downtown "high grade" tranches were really overrated, and "junk grade" were underrated, assuming there was someone bailing the debt out. Goldman Sachs and Paulson Funds bought a lot of junk grade at the peak of the boom and made a killing.
One word to say all : Blythe Masters.
Sure, blame the mathematicians now!
I've read a lot of interesting comments here about phenomena that contributed to the GFC, but I don't think anyone has really nailed down the set of necessary conditions (if they have and I'm repeating someone elses post I apologize). Clearly, the articles assertion that Black-Scholes caused the GFC is rubbish - many commenters have already clearly explained why this is so. But there seems to be a trend to place all the blame squarely on the shoulders of complex derivatives such as credit default swaps. IMHO this is only a third of the story. I think the three necessary conditions are: 1) the existence of complex derivatives, especially credit default swaps, 2) the repeal of the Glass-Steagall act, and 3) the privatization of Freddie Mac and Fannie Mae. 3) essentially created a private institution with monopoly power whose profit was linked the quantity of mortgages it created. The incentive structure of Freddie Mac and Fannie Mae virtually guaranteed that a large number of loans of dubious quality would be made (similarities to the current incentive structure for the US patent office anyone?). Combine 3) with 1) and the inherent risk in these mortgages was able to be disguised from the vast majority of investors. Throw 2) into the mix and all of the sudden the institutions that hold the deposits of mum and dad investors (ie the ones that should be taking as few risks as possible) are taking enormous positions in incredibly risky assets. Finally, when the shit hits the fan, none of the banks know how exposed the other banks are to the bad loans, and so they all get very shy about lending to each other. Anyone who knows a bit of economics will understand that when banks stop lending to each other in the overnight market, the system will collapse. So, my position is that without all 3 conditions - complex derivatives, repeal of Glass-Steagall, privatization of Fannie Mae and Freddie Mac - the GFC could not have happened. This is not to say that there would have been no financial turmoil at all, but the scale of the problems would have (IMO) been orders of magnitude smaller. By the way, slashdot, how about adding a FAQ page for how to format comments? How do I indicate a new line for example? Standard LaTeX or reddit type formats don't appear to work, nor does a newline indicator like /n???
give everyone a toilet brush, toilets will get cleaned. give everyone a hammer, nails will get pounded. give everyone a gun, people will get shot
Are you, by any chance, straight out of kindergarden?
The Guardian did this same story on February 12th.
The problem was with mathematical formulae that let the user "customize" some of the variables, to predict the value of derivatives. Unfortunately, when everyone plugged in values that increased the risk and reward, the outcome was predictable -- everyone was taking even more risk than they imagined. Black-Scholes was just an early prototype of the kinds of formulae that were widely used.
Gas, +208% -- Historical Price Charts
Doubling in price over eight years isn't 200% inflation. First of all, it's only 100%. Secondly, normally inflation is listed per year. Properly compounded, your plot shows and annual inflation rate of 9.5% for gas. Of course, that's still cheating, because you picked the starting point. If we start four years ago, gas prices are unchanged. No matter what, your 208% if totally wrong.
It's people stupidty (and greed) that led to the financial crash, not a math formula.
Thanks, I made a mistake.
My comment below, Price increases are far more than interest rates, had some errors. I'm posting a corrected version again here. I don't have the time to do more research.
Inflation is around 2% only if the reduction in house prices is considered, I'm guessing. The fact is that prices for everything are being raised rapidly.
U.S. dollar inflation, some examples:
Food, +4.8% -- Food Price Outlook, 2012
Quote: "The food-at-home Consumer Price Index (CPI), in turn, increased more than expected '4.8 percent in 2011' which means that food price inflation was not as strong as in 2008 when it increased 6.4 percent over 2007."
Medical treatment, +8.5% -- Medical cost trends for 2012
"This year's report from PwC's Health Research Institute finds that the medical cost trend is expected to increase from 8% in 2011 to 8.5% in 2012."
University tuition, +8.3% -- College costs climb, yet again.
"Tuition at the average public university jumped 8.3% to $8,244."
Gas, +108% in 8 years -- Historical Price Charts
They were, at first, not-so-innocent semi-bystanders and, eventually, too-willing accomplices who followed Wall Street as it led the nation’s economy off a cliff.
Which is why selling to Fannie and Freddy is step 3 in a plan, not the entire evil scheme.
PBS had made a movie about this some time ago... The Trillion Dollar Bet. Watch it here on YouTube: http://www.youtube.com/watch?v=dsrOXJwGwtk