Math whiz proposed applying this statistical formula to credit risk, and financial meltdown ensued Mar 18, 2009 04:30 AM Comments on this story (102) Cathal Kelly STAFF REPORTER
Note: This article has been edited to correct a previously published version.
Former University of Waterloo statistician David X. Li didn't burn down the American economy. He just supplied the matches.
As economists and market watchers cast about for people to blame for the U.S. market meltdown, Li has surfaced as a scapegoat. Recently, Wired magazine ran an article on Li's work subtitled, "The Formula That Killed Wall Street."
The formula in question is the so-called Gaussian copula function. On the most basic level, the formula allows statisticians to model the behaviour of several correlated risks at once.
In a scholarly paper published in 2000, Li proposed the theorem be applied to credit risks, encompassing everything from bonds to mortgages. This particular copula was not new, but the financial application Li proposed for it was.
Disastrously, it was just simple enough for untrained financial analysts to use, but too complex for them to properly understand. It appeared to allow them to definitively determine risk, effectively eliminating it. The result was an orgy of misspending that sent the U.S. banking system over a cliff.
"To say David brought down the market is like blaming Einstein for Hiroshima," says Prof. Harry Panjer, Li's mentor at the University of Waterloo. "He wasn't in charge of the financial world. He just wrote an article."
When David X. Li first arrived from China in 1987, he was known as Xiang Lin Li. He already held a masters in economics from Tianjin's Nankai University. He was one of a group of the faculty there who won a scholarship to study business in Canada through CIDA. In order to claim his prize at Quebec City's Laval University, Li was given four months to master French.
"We were all highly motivated," says Jie Dai, who was in the program with Li. "He was from a small town in the south of China. A small family, very ordinary, not poor or rich. There wasn't anything distinguished about his personality."
Li graduated with an MBA in 1991. Most of his Chinese classmates were bound for academia. Li saw a more worldly future. Says Dai: "I clearly remember him mention that if you are an actuarial guy, you can earn a lot more money."
Li had recently married a colleague from Nankai when he decided to study at Waterloo's department of statistics and actuarial sciences. He was drawn by the work of Panjer, a world leader in the study of loss modelling, especially as it applies to the world of insurance.
"He had the ability to take ideas from different fields and synthesize them," Panjer says.
In Waterloo, Li lived the hand-to-mouth life of a grad student. He anglicized his name. He and Panjer became close, and still correspond. Over six years, he earned his third masters and a PhD.
After graduation in 1997, Li taught briefly. He worked for CIBC World Markets. But his ambition quickly drove him to New York. He tore up the corporate ladder. By 2000, he was a partner in J.P. Morgan's RiskMetrics unit, trying to find ways to leverage a new generation of risk-based financial assets.
His breakthrough was an article published that year entitled, "On Default Correlation: A Copula Function Approach."
Many of the ideas contained within it were drawn from statistics research Li had observed firsthand at Waterloo. His insight was to transfer the work to financial models.
Li's model sidestepped the problem of trying to correlate all the variables that determine risk. Instead, it based its assumptions on the historical dips and swells of the market itself. In essence, Li used the past to map the future.
"It was a very simple mathematical answer almost anyone could use," Panjer says "And when you've got a hammer, everything suddenly looks like a nail. They jumped on it."
Through the lens of Li's theorem, even the shakiest investments suddenly looked viable. The Gaussian cupola created the sort of financial alchemy that made high-risk mortgages and credit card debt look like triple-A rated gold.
Money poured into CDSs (credit default swaps), a financial device that acts as an insurance policy against defaults. By the end of 2007, the total investment in credit default swaps had swelled to $62 trillion (U.S.), a 6,700 per cent increase in only six years.
Li didn't make money directly off the idea, but it made him famous.
Maybe he sensed the danger inherent in the system he'd help establish. By 2005, Li was among those warning about the limitations of his model. "The most dangerous part is when people believe everything coming out of (the model)," he told The Wall Street Journal.
What Li's theorem could not do was predict what might happen in extreme economic environments, what experts call "tail dependency." And one was arriving.
The 2008 collapse of the U.S. housing bubble rendered Li's model useless. Defaults that the model had not predicted piled up, rippling through U.S. banks and wiping out trillions of dollars in investment.
But Li's colleagues say he's not to blame. "We have a saying in statistics, `All models are wrong, but some are useful,'" says Panjer. "He supplied something, a tool kit, for financial analysts. They took one small part of it and used it in ways he had never intended."
Li since moved to Beijing, where he heads the risk management department for the China International Capital Corp., a major investment bank. He has not commented on the meltdown or his role in it.
Kinda scary when you think about it. Most of these bankers are still in charge.
Posts: 105 | From: Toronto | Registered: Nov 2005
| IP: Logged |
and even if you bkrpt them all and make them start over from scratch? who do you think will be in charge again? same people.
gotta have rules, they gotta be enforced with jail, not fines that merely make the scams LESS profitable, jail and NO profits at all... force some of these peple into personal bankrutpcy and strip away the corporate insulation they enjoy.
they don't mind seeing the middle class go to bankruptcy court.
-------------------- Don't envy the happiness of those who live in a fool's paradise. Posts: 36378 | From: USA | Registered: Sep 2003
| IP: Logged |
posted
We have agreed on this before. It is too big to let it fail. We both know, on a smaller scale, that would be for the best.
Not only did these guys spend the reserve float but they created and sold CDS "scam" all over the world.
It is not hard to see that when the bank branch down at the end of the street was under performing head office decided to share its high risk paper and blend it in with profitable paper at other banks. They created an investment out something that should have remained internal to the bank and not for the public. They spun it so fast no one could reed the fine print but they bought it anyway. They bought it everywhere because it had a Big Bank name on it, and out of greed and so on...
It would be great to see most of the upper management face trial. The bad guys should be barred for life. We need more jails anyway. Hey that would crate jobs too.
Posts: 105 | From: Toronto | Registered: Nov 2005
| IP: Logged |
posted
the problam that i see is how to convince the lawmakers to go ahead and do the right thing..
the traders on CNBC (right now) are starting to say we've bottomed. i am not convinved, but let's say they are corrrect and this recession is about to bottom. (the markets are ahead of main st) so, assuming we will now proceed to improve? people will get over it and nothing will change. "they" 'll do it again as soon a the "sponge" is full enough to squeeze out again...
with the way the economy works today? that could be as soon as 7 years...
it took less than a decade to collpase after they began to implement the real deregulation in the late 90's.
i don't LIKE th eidea of big govt, but i dislike monopolies just as much. we have to find a balance.
the wealthy have to have motivated employees with at least a chance to work their way to join the ranks of the wealthy, take away real opportunity and you end up with angry people carrying torches
-------------------- Don't envy the happiness of those who live in a fool's paradise. Posts: 36378 | From: USA | Registered: Sep 2003
| IP: Logged |
posted
I agree that at this point we have to use the resouces of the government to unfold all this handy work.
I just hope that at some point they realize we have systems in place that handle this. We are probably going to have to use the tools from the credit union mess of Bush 41's time.
The government will have to take control of the banks that are insolvent, clean them out and set them up as a business with no debt.
Right now it looks like the keystone cops.
Congress has turned this into a circus and that's to bad because a lot of this could have been done quietly with out all the grandstanding.
I feel for Obama because he's got to answer for a lot of crap that's beyond his control.
-------------------- Let's Go METS!!! Posts: 3317 | From: CT | Registered: Dec 2006
| IP: Logged |
quote:Originally posted by glassman: Chris Dodd just admitted that he is the one who allowed the bonus provisions to go thru on the AIG bailout..
he said he did it at the request of treasury people.. i assume that's Bush's treasury people from the way it was reported.. it just broke on CNN.
He was saying earlier he had no idea how it got in there. This guy is a master of denial. Someone must have shown him undisputable evidence of his handy work for him to come clean.
And of course in Chris Dodd style it wasn't his fault.
-------------------- Let's Go METS!!! Posts: 3317 | From: CT | Registered: Dec 2006
| IP: Logged |
quote:Originally posted by glassman: Chris Dodd just admitted that he is the one who allowed the bonus provisions to go thru on the AIG bailout..
he said he did it at the request of treasury people.. i assume that's Bush's treasury people from the way it was reported.. it just broke on CNN.
He was saying earlier he had no idea how it got in there. This guy is a master of denial. Someone must have shown him undisputable evidence of his handy work for him to come clean.
And of course in Chris Dodd style it wasn't his fault.
We'll if he's from the Bush era... are you surprised he is?
-------------------- Let the world change you... And you can change the world.
Ernesto "Che" Guevara de la Serna Posts: 4669 | Registered: Mar 2004
| IP: Logged |
quote:Originally posted by glassman: Chris Dodd just admitted that he is the one who allowed the bonus provisions to go thru on the AIG bailout..
he said he did it at the request of treasury people.. i assume that's Bush's treasury people from the way it was reported.. it just broke on CNN.
He was saying earlier he had no idea how it got in there. This guy is a master of denial. Someone must have shown him undisputable evidence of his handy work for him to come clean.
And of course in Chris Dodd style it wasn't his fault.
We'll if he's from the Bush era... are you surprised he is?
Apparently this little piece of legislation was congered up in late February. Snow from Maine had put a restriction clause about bonuses in, and it was removed at the last minute in a committee meeting. Dodd then stuck in this little change that blocked any attempts to deny bonuses. He had a memory lapes yesterday and over the past weekend, but today darn if he didn't remember it. This was on Gietners watch if that means anything.
-------------------- Let's Go METS!!! Posts: 3317 | From: CT | Registered: Dec 2006
| IP: Logged |
quote:Originally posted by glassman: well, in this case? we can say bipartisanship was practiced. maybe not such a good thing...
somebody said the bonuses should be paid in stock instead of cash that sounded apropriate to me.
Then what, the big boyz will sell the stock asap, in mass quantities, to get the cash and AIG will tank because of the sell off. Then what, another bailout and more money to keep the comp. running. It's how the market works and it's ow the government works.p****, let em go broke.. survival of the fittest as it were.
-------------------- A million unemployed comedians and you are trying to be funny, have you no shame? Posts: 128 | From: Here | Registered: Apr 2006
| IP: Logged |
quote:Originally posted by glassman: pparently this little piece of legislation was congered up in late February.
got a link or is this just TV talking heads?
cuz Meryl gave bonuses too at the end of last year just before they closed the buyout.... apparently it got overlooked in that deal.
Go to CNBC website it's on front page.
Wow it looks like Dodd might throw Obama officals under the bus. Everyone running for cover I wonder who the fall guy is gonna be.
OK, i have a problem with Dodd claiming thathe was told lawsuits would be problem. Very few lawyers are interested in suing the federal govrnment. I suppose lawsuits could be filed against AIG, but in the end it would have been the same as suing the govt....
as for the stock bonuses? you make the shares restricted, that way they can only trade option on them, and i doubt there's much market being made in AIG options... i could be wrong tho... options are not one of the areas i have spent much time studying (yet).
-------------------- Don't envy the happiness of those who live in a fool's paradise. Posts: 36378 | From: USA | Registered: Sep 2003
| IP: Logged |
UBBFriend: Email this page to someone!
Printer-friendly view of this topic
![[Wink]](wink.gif)
![[Big Grin]](biggrin.gif)
that sounded apropriate to me.
