The herd behavior that killed Wall Street (and the rest of us)

Wired has an interesting article explaining some of the mathematical inner workings of The Formula That Killed Wall Street, the "Gaussian cupola function" invented by David X. Li and adopted throughout the financial industry. The article explains why the model used assumptions about mortgage default losses exclusively from a recent ten-year period when default rates were low: The model doesn't input mortgage loss rates at all—it inputs market prices (the wisdom of mobs again) of credit default swaps as surrogates for mortgage loss rates, and CDS trading did not have a long history.

The article discusses who knew what about the limitations and inherent covert risks of the model and who may not have understood but, as Skeptic also reported here, it's clear that the herd instinct overwhelmed reason anyway.

Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up.

"Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."

The only way to keep the herd off dangerous ground, and out of our gardens, is strong regulatory fences.

Thanks to Christine for the heads up.

Comments

[Berkeley Bob]

Just to be clear, it is really more than a "herd instinct:" It is the ineluctable result of the "wisdom of the market." Anyone who relied on a pricing model that was more sensitive to rare but spectacular downturns would have been priced out of the market. Everyone feasted on the short run and no one worried about the long run, perhaps because there was no obvious and immediate payoff there.

Your conclusion is exactly correct. "We" (as a society) need regulation in order to keep an eye out for the interests of us all that are not (and cannot be?) adequately considered by the operation of markets.