You may have heard of CDSs and CDOs and how they ended up as worthless junk clogging bank balance sheets everywhere with trillions of dollars worth of "toxic loans" . You may even have some idea of what they are. But if you want to know WHY they...were ('cause they aren't, anymore)...then read on.
(H/T @bernardchickey via Twitter) Wired magazine explains how the "Gaussian copula function", developed as a finance tool by David X. Li, played a key role in the finance market crash.
The key idea here is that this mathematical model allowed risk to be reduced to a single number denoting the correlation between past and present pricing for something.....anything. Nice and simple, right? No so fast. It's key flaw was this correlation had no real connection to the actual underlying risk of the mortgages or risk represented by the CDOs and CDSs. It depended on the price, but the price itself depended not on real risk, but instead the single number this tool produced to represent risk.
In other words, bankers stopped looking directly at the real risk and instead used a seriously flawed tool to assess risk. Like driving a car blindfolded. You're fine until you hit something big you didn't see. The warnings of the tool's limitatons by David X. Li and others were ignored.
As the Wired article explains, there was too much money to be made.
Read the whole story. It's mundanely typical of what happens when any specialised group loses touch with the underlying reality of the area they work in and instead works through over-simplified models that are supposed to make it easier. The problem is, these models also introduce sources of error, as the finer points are discarded or ignored, until their effects over time become overwhelmingly and critically relevant.....and make a mess of everything. "Oops! We broke the model!"
The time-honoured equivalent, in public or private technocracies, would be the disasters wrought by managers / executives driving organisations through spreadsheets instead of looking at the real business and the real people in it. The sort of logic that saw people burn down villages in order to "save" them.
Bankers everywhere took their eyes off the only ball they really need to be watching: risk.
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