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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."
It's worth pointing out that the "Nobel Prize in Economics" was not one of the original six prizes founded by Alfred Nobel. It is a separate award, which was invented by the Swedish central bank in 1968. Although it is presented along with the Nobel prizes, it is not technically a Nobel itself.
Breakfast served all day!
It wasn't even just that, it was that they made the mistake of assuming that the higher interest they were getting from the risky loans was pure profit, instead of a hedge against the higher risk. If my portfolio of loans has a 10% chance of not being paid back, I would have to charge at least 10% interest to break even. They did that, but they booked and distributed the profit before the loans started to fail. It was basically a gross profit versus net profit mistake.
Then there was the failure of the CDS market. Companies made investments, then bought insurance policies to hedge their losses on the loans. But when the loans started to fail, the CDS/hedge couldn't be paid back (cough AIG cough) and they were fucked. I think that will eventually come out as being the ultimate failure- too many layers of reinsurance.
That's half the problem. The other is that poor mortgages were packaged into CDOs. This in itself was OK, but the unsaleable bottom tranches of the CDOs were then repackaged into new CDOs. These should have been rated as entirely high risk (being a collection of mortgages that, due to the first CDO, were almost guaranteed to fail) but gullible ratings agencies still gave the top tranche a top rating. So investors worldwide were buying crap believing it to be a low risk investment.
The emulsifying you are talking about wasn't the problem so much as was the leverage and the short information horizon. An investor could buy one mortgage and take on binary risk- it pays off, or it fails. That's a lot of risk. So he can pool his money with a bunch of other people and buy 1% of 100 loans. The risk of any loan failing is spread across all the investors. That, in itself, is a good idea, it is just basic diversification.
The leverage problem was that they didn't just split the loans equally like that, they split the loans into tranches, or classes, of investor. The risk averse investor bought the high quality tranche, and for that got a higher guarantee of payment in exchange for a higher price (lower yield). The lower tranches were sold to suckers with the promise of potentially high rates of return. But as the individual loans started failing, the way the package was levered, the higher investors ended up getting paid, and the lower investors got nothing.
A quick example of the information problem was the practice of the 80-15-5 mortgage loans. Conventional wisdom says that when someone takes out a mortgage with zero down, that mortgage is more likely to fail. So again, conventional wisdom says that in order to hedge for that increased potential failure, you need to charge a higher interest rate. For some reason, and I agree it was probably lack of regulation, someone figured out that you could split the mortgage into three portions- standard risk (the 80%), higher risk (the 15%) and highest risk (the 5%). In the documents for the 80% loan, you could then say that this loan had 20% down, and you'd get the good rate. Then you do the same with the 15% loan- "hey, this loan has 5% down, give us the OK rate". Then you would only end up paying the super high risk rate on 5% of the balance of the mortgage instead of the whole thing. The problem there was that the whole loan had the high risk, but the investors in the 80% and the 15% didn't know it.
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.