Wednesday, February 25, 2009

Chinese Peasant Responsible for Financial Crisis

It turns out that the "math wizard" who created the mathematical formulas behind the world's collapsed financial systems comes from rural China.

From Wired:

A year ago, it was hardly unthinkable that a math wizard like David X. Lee 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 Gaussia 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.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon.

Read On
This is a very interesting, though very complicated, article. I'd be lying if I said I understood everything in it. But while it, and the basics of the financial crisis, are hard to figure out, I believe it is important for people to try to understand what is going on and why it came about.

There are a few different explanations and sources of information which I've found to be particularly enlightening on this subject.

First, the National Public Radio program "This American Life: The Giant Pool of Money" did a fantastic piece last May profiling a number of the people responsible for the crisis and the basics of contemporary finance. I already mentioned this program on my blog a couple weeks ago, but I believe the program is so good that it is worth bringing up again. The program can be heard for free here. I highly reccomend listening to this hour-long show for a thorough explanation of the financial collapse in layman's terms.

Second, the Public Broadcasting Services program "Frontline: Inside the Meltdown" profiled the collapse of Bear Stears, Lehman Brothers, and the fallout of those bankruptcies in a program that aired last week. The hour-long program can be watched for free on the internet here. This show helped me understand why and how the demise of Lehman Brothers nearly ruined the global economy a few months ago. It also does an excellent job of profiling the most important people trying to contain crisis: Hank Paulson, Ben Bernanke, and Tim Geithner.

Third, this short video from Jonathan Jarvis attempts to give a visual explanation of the credit crunch. If you have about eleven minutes free, this is worth watching:

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

And finally, I think that this article on "Complexity Theory" is insightful in explaining how a crash in our complex world was inevitable:


A discernible change is taking place in the forum of environmental awareness. As the subject matures and our insights deepen, specific concerns are now accompanied by a general uneasiness as leading philosophers and scientists begin to examine the structure of our modern civilization and question its viability. One of these new avenues of consideration is Complexity Theory.

Complexity Theory argues that societies become progressively more unstable and vulnerable as the network of interconnections within them increases -- not particularly good news for a globalizing system in which increasing complexity is precisely the thrust of economics, finance, manufacturing, technology and almost everything else we do. The sobering implications may explain why many proponents of Complexity Theory preface their comments with an apology. "We don't want to tell you this," goes the essence of their message, "but we think you should know."

When the New Scientist published two articles on Complexity Theory (Apr. 5/08), its editor anticipated some reader discomfort. "We are predisposed to pay attention to bad news," noted the editorial. "There is a good reason for this. We need to be warned of difficulty and danger so we can protect ourselves.... [But] if the warning is too scary or distressing, we attack the messenger as a doom monger."

Complexity Theory comes with its hint of doom, ominously reminding us that no civilization has ever survived the stresses of history, with the possible exception of China and Byzantium -- in a much reduced state for 450 years following the 15th century Arab invasions. But Sumer, Persia, Egypt, Greece, Maya and even Rome all collapsed, primarily because they succumbed to overwhelming complexities.

Joseph Tainter, writing in The Collapse of Complex Societies, explains why. "For the past 10,000 years, problem solving has produced increasing complexity in human societies" (Ibid.). Food production is a classical example. Each time people find the solution to a food shortage -- irrigation, fertilizer or plants with higher yields-- the population rises to meet the food supply and the next problem to solve is more complicated and challenging. Every solution adds extra levels of organization, complexity and interdependence, which adds inefficiency and diminishing returns for the total amount of energy expended.

Progress is a process of perpetual problem solving, with each new solution adding more specialists and more layers of peripheral tasks that don't directly address the problems being solved. A civilization finally peaks at its maximum level of complexity when all its efforts are being used just to maintain its equilibrium. Then an unusual adversity arises: invaders, crop failure, disease, climate change, depletion of a critical natural resource, or anything that stresses a structure already precariously balanced. Then the civilization collapses and reorganizes itself at a simpler level.

Read On
Although Complexity Theory says that our contemporary societies are doomed for collapse, I find something comforting in the idea. I don't think I'm sadistic or anything. Instead, I like how the theory highlights the absurdity that is life in today's world.

The lead on the David X. Lee article is great. When things were booming, the minds behind our world's complexity were destined for Nobel Prizes. Now, they're the objects of scorn to the millions upon millions of people who were burned by the interconnectedness they gave the world.


Taylor O said...

That is an interesting side story to a part of the financial crisis.

However, the Government is the fundamental cause of the financial crisis. Excess credit from the Federal Reserve, FDIC Insurance, over investment in affordable (sub-prime) housing and unpredictable government action are what misled all of us.

These policies enabled, encouraged or made possible the resulting mistakes in the market (failure of the ratings agencies, risky startup banks failing like WaMu).

I know this link may be blocked in China because the site was while I was there but John Allison of BB&T bank, one of the few banks to have little subprime exposure and one of the only long tenured CEOs of a financial institution (25 years) has a fantastic analysis of the situation.

Mark said...

I agree that Greenspan's ultra-low interest rates were the driving force behind this mess.

As my favorite financial blog - The Automatic Earth - said back on September 16th:

At the Automatic Earth, two principles have always been unshakable and unmoveable.

The first is that all the virtual money, the casino toilet paper, created in the past two decades through the introduction of the "innovative and creative" financial -debt- instruments so lauded by the capo di tutti capi, Alan Greenspan, will have to disappear, never to be seen again.

The second is that this will lead to the mother-fcuker of all deflations. The only possible outcome left in its wake will be individual and societal debt burdens so high that the Great Depression and the wars it engendered will seem and feel like a sun-drenched dreamy all-the-icecream-you-can-eat kindergarten birthday bash in Disneyland.

Love the casino toilet paper reference.

If you have the stomach to keep reading this post, it can be found here -

But saying that the government is the "fundamental" cause is debatable to me.

I've read a lot of free-market advocates on one side and hardcore right-wingers on another saying that government intervention such as the Community Reinvestment Act is primarily what caused banks to give out money to people who weren't good for it.

That conflicts with just about everything I understand of this situation.

From the way that I've pieced together things went down, Wall St. got so addicted to mortgage-backed securities and collateralized debt obligations that the only fix was to give shadier and shadier people huge sums of money so they could buy houses.

It doesn't appear to me that the government, ACORN, Barney Frank, or Barack Obama (all people I've seen accused in the CRA as the ultimate culprit accusations) were holding guns to their heads so they would give out loans to poor people.

And I've also read that CRA loans haven't, actually, been that big of a problem:

Some legal and financial experts note that CRA regulated loans tend to be safe and profitable, and that subprime excesses came mainly from institutions not regulated by the CRA. In the February 2008 House hearing, law professor Michael S. Barr, a Treasury Department official under President Clinton,[67][34] stated that a Federal Reserve survey showed that affected institutions considered CRA loans profitable and not overly risky. He noted that approximately 50% of the subprime loans were made by independent mortgage companies that were not regulated by the CRA, and another 25% to 30% came from only partially CRA regulated bank subsidiaries and affiliates. Barr noted that institutions fully regulated by CRA made "perhaps one in four" sub-prime loans, and that "the worst and most widespread abuses occurred in the institutions with the least federal oversight".[68]

That comes from here -

Now you didn't specifically mention CRA, Taylor, but I just wanted to get that off my chest since the more I've learned about the crisis, the less it seems to me that CRA causing this crisis is a reasonable explanation.

So while I do agree that Greenspan is a guilty party in this fiasco, I also believe that Wall St. financiers who got hooked on bundling mortgages as investments are pretty damn guilty as well.

One can say that Greenspan's rates caused them to go down the sub-prime path, but Wall St.'s eagerness in giving sub-prime borrowers money according to ridiculous adjustable-rate mortgages has a huge part to play in this whole mess.

Taylor O said...

Government absolutely is the fundamental cause; they basic fact is that fiat currency exists and guessing what a market interest rate will be is never going to be correct because no central planner (Greenspan or otherwise) is omniscient and also politically omnipotent.

Beyond that, government set up Fannie and Freddie up with leverage hundreds of times higher than is allowed for a private bank. This necessarily is itself an over investment in housing. Congress could not tame the two either. They've had problems with their operation for awhile. The CRA itself didn't directly affect much capital but it set the tone along with many other such misguided 'affordable housing' programs or veiled threats that encouraged banks to overlook proper lending standards.

However, unlike those on the fascist right, I think those banks are still at fault and should have failed as a result. Failure of companies is an absolutely essential part of capitalism for it to work correctly. Resources need to be taken away from the banks that made bad decisions by the natural action of the market. Better organizations could then fill that void and the downturn would be hard but softer than this prolonged recession.

Had there been a free market for money, a gold standard and other real money, lending would be only leveraged 1 to 1 like it was prior to the Fed not Fannie and Freddie style hundreds and even a thousand to one and then none of this would have even had the opportunity to happen.

That said, there was some major f*** ups on Wall Street and those firms deserve to have major losses or fail for that (*for the most part). If they gave bad loans, regardless of who told them to make them, they should suffer the consequences. Also, the three major ratings agencies should be sued to oblivion after their failure to catch the risky nature of the AAA rated mortgage securities that included subprime mortgages. Mortgages that didn't pay down the principle should never be offered by a bank or those terrible ARMs either. Ethically those are atrocious and I wouldn't offer them to my customers if I was a bank, because treating a customer like a an honest equal, a trader, is beneficial for everyone long term.

*I say for the most part because there were some that were cash positive but because of Fair Value Accounting had to mark down assets immediately, then raise impossible to get capital as soon as that happened because of the percentage of assets they are required to have.

At any rate, once there isn't a government pronouncement on the news every few days, then individuals are able to act with reasonable certainty about the future, capital will begin to return. Things could have gotten a lot better more quickly but with the exacerbating actions like bailing out a car maker that's been irrelevant since 1970, that made promises it could never keep, it will be a slow year or so and then things will begin to improve.

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