[Infowarrior] - The Formula That Killed Wall Street

[Richard Forno]

Recipe for Disaster: The Formula That Killed Wall Street
By Felix Salmon Email 02.23.09
In the mid-'80s, Wall Street turned to the quants—brainy financial  
engineers—to invent new ways to boost profits. Their methods for  
minting money worked brilliantly... until one of them devastated the  
global economy.


A year ago, it was hardly unthinkable that a math wizard like David X.  
Li might someday earn a Nobel Prize. After all, financial economists— 
even Wall Street quants—have received the Nobel in economics before,  
and Li's work on measuring risk has had more impact, more quickly,  
than previous Nobel Prize-winning contributions to the field. Today,  
though, as dazed bankers, politicians, regulators, and investors  
survey the wreckage of the biggest financial meltdown since the Great  
Depression, Li is probably thankful he still has a job in finance at  
all. Not that his achievement should be dismissed. He took a  
notoriously tough nut—determining correlation, or how seemingly  
disparate events are related—and cracked it wide open with a simple  
and elegant mathematical formula, one that would become ubiquitous in  
finance worldwide.

For five years, Li's formula, known as a Gaussian copula function,  
looked like an unambiguously positive breakthrough, a piece of  
financial technology that allowed hugely complex risks to be modeled  
with more ease and accuracy than ever before. With his brilliant spark  
of mathematical legerdemain, Li made it possible for traders to sell  
vast quantities of new securities, expanding financial markets to  
unimaginable levels.

His method was adopted by everybody from bond investors and Wall  
Street banks to ratings agencies and regulators. And it became so  
deeply entrenched—and was making people so much money—that warnings  
about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when  
financial markets began behaving in ways that users of Li's formula  
hadn't expected. The cracks became full-fledged canyons in 2008—when  
ruptures in the financial system's foundation swallowed up trillions  
of dollars and put the survival of the global banking system in  
serious peril.

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http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all