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Felix Salmon's Recipe for Disaster: The Formula That Killed Wall Street takes a complex subject and seems to make it understandable. The problem I'm having is with his conclusion: that David X Li's Guassian copula formula's use by the financial markets killed your 401(k) .
I'll use his analogy to illustrate my problem with his position, that oversimplifying the correlation parameter skewed the risk assessment process. Did I get that right? Close enough? Okay.
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To
understand the mathematics of correlation better, consider something
simple, like a kid in an elementary school: Let's call her Alice. The
probability that her parents will get divorced this year is about 5
percent, the risk of her getting head lice is about 5 percent, the
chance of her seeing a teacher slip on a banana peel is about 5
percent, and the likelihood of her winning the class spelling bee is
about 5 percent. If investors were trading securities based on the
chances of those things happening only to Alice, they would all trade
at more or less the same price. But, the boy sitting next to
Alice has head lice, and his mother hides the fact to spare him a
shunning. The school's principal is soon assessed of the now
school-wide epidemic of head lice by the school nurse. He
pays her to keep quiet about it so parents won't be upset.
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Are you scratching your head? Wait. Change "head lice" to "worthless Fannie Mae mortgages."
School nurse becomes Congressional Democrats like Chris Dodd, Barack
Obama, and Barney Frank. "Principal" of course is Fannie Mae's board,
made rich by selling air. It wasn't until everyone in the city had head
lice that the problem so rudely manifested itself. No compound
formula was needed to rate risk assessment by that time. It's
100%.
What am I missing? Must be something, because these guys are PhDs.
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