Marketplace Scratch Pad

The new Manhattan Project

Scott Jagow Feb 24, 2009

As we watch the stock market sink to 1997 levels, this article in Wired Magazine should send chills down your spine. It says a formula created by a Chinese-born mathematician, David X. Li, might have set in motion the collapse of Wall Street and our economy. This model was invented to reduce financial uncertainty, and for a while it worked. Until it didn’t.

The formula is known as the Gaussian Copula Function. In this complex-looking-but-ultimately-too-simple equation, financial institutions saw major dollar signs. They started using it to do something they couldn’t do before: price multiple securities and assess their risk. Yes, I’m talking about bundled-up mortgage-backed securities.

From the article:

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.

It’s limitations became abundantly clear last year, “when financial markets began behaving in ways that users of Li’s formula hadn’t expected.”

Li won’t talk about it now. He works in China in the risk management department of China International Capital Corporation.

But he has said this about his model: “The most dangerous part is when people believe everything coming out of it.”

It kind of makes you think about Albert Einstein and the atomic bomb. Einstein’s Theory of Relativity was the starting point. Li didn’t send a letter urging his bomb to be built, but he told Wall Streeters they didn’t have to look beyond his simple formula. That’s all they needed to make a fortune.

And now Einstein’s words ring true:

The difference between stupidity and genius is that genius has its limits.

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