The Blame Game

I believe everyone impacted by the current economic situation is eager to know what caused this event. I am no different and still searching to find out the reasons what made the most stable economies of the world kneel down on their knees? What factors triggered this collapse? There is a plethora of information on the web, hundreds of books and articles are published on this sensitive subject. Different people have different views. Some are knowledgeable enough to predict what is going to happen next while others are a mere charlatan. In a sense they all are busy playing the game which the situation demands. Confuse the people on the main street, bring new theories and discard the old ones, and most importantly never keep the ball in your court. In short and popular term – The Blame Game.

I read one such article (sometime last year) which is interesting enough to be mentioned on this blog. Let me start with a brief description and we will see how one class of professionals are held responsible and getting most of the blame for triggering one of the worst financial crisis ever known. Quants or quantitative analysts are the professionals who are pretty good with mathematics and related fields, like physics and statistics. Nearly about 2 decades back these quants were invited by the wall street to make sophisticated and efficient financial models based on their ostentatious knowledge of mathematics, probability, statistics, physics and computer science. Various investment banks, insurance agencies and other financial institutions hired these so called geniuses. Things were going pretty good, markets were booming, banks were making tons of profit, Wall Street executives were making millions. All in all the financial models which most of the people were not able to understand, including some of the smart Wall Street managers & CEOs were mesmerizing the world. We all finally found some really good and profitable use of mathematics and physics.

David X Li was one such quantitative analyst who entered Walls Street with the hope of making things even better. Chinese by origin and academician by record, Li achieved double masters, one in business and another one in actuarial science. Actuarial science is the field of mathematics & stats which is used to assess risk in insurance and finance sectors. Li obtained his PhD (Stats) as well. He earned all the 3 degrees from one of the famous Canadian universities. While working on the Wall Street Li came up with this amazing mathematical formula – Gaussian Copula function which makes use of the mathematical copula. Li derived this formula while working on one of the problems of actuarial science known as “the broken hearts” – which states that life expectancy of an individual decreases after the death of their spouse. What a interesting theory? The formula initially used on Wall Street to assess risk of various security derivatives, CDS (credit default swaps) and creeping from all those financial intricacies reached the final destination to assess the risk and set the price for mortgage based CDOs (Collateralized debt obligations is a kind of asset based security). CDOs played an important part in the current financial crisis and most of the damage done was somewhat related to CDOs. According to many, Li’s formula served as one of the primary reasons why the CDO market was not able to calculate the risk properly and hence failed. Li’s formula was one of the very hot topics as now people got this one name this one person and this one formula to blame. Did Li’s formula jumpstart the financial crisis? I will not comment on that. What I know is that there are many smart people who are sitting in those financial institutions who just used this formula without even validating its impact. What they loved about the formula till it got broke is the simplicity associated with it and its capability to earn trillions of dollars. CDO market grew from $275 billion in 2000 to the staggering $4.7 trillion till 2006. Amazing, isn’t it? Tax payers & home owners are you listening?

If Mr. Li’s formula is responsible for killing the wall street, our stocks, our home values, our 401ks and our dreams, then I guess Mr. Alfred Noble is responsible for all the modern wars as Noble was the inventor of dynamite and somewhat today’s weaponry is the derivative of that. We cannot point fingers and held the inventors responsible for things they came up with. Us being the end user, it is our job to validate what he/she has introduced and depending on that we need to make a decision to use that stuff or not (keeping our greed out of the equation). We all need to put greed in the backseat or throw it out of our lives (even better) and start thinking about the human value. This has happened in the past and as the things are proceeding, it will again happen in the future. There are many more Gaussian copulas or similar formulas making rounds in the world and other places of significant importance. How many of them has actually been validated, how many of them are something else apart from being the gas for the greed machine? If things did not fall into place I am pretty sure we will have this conversation again. God Bless the mankind, at least we all can hope for that.