Pr[TA<1, TB<1] = Φ2(Φ -1(FA(1)), Φ-1(FB(1),γ)That little formula is a big part of why your 401K is in the toilet right now.
Wired tells us why in, Recipe for Disaster: The Formula That Killed Wall Street
A spectacularly informative read.
The boiled down version is this:
A guy named David Li came up with this formula to model the risks of bonds. He ignores all the complex risk factors that have stymied analysts for decades and just focuses on the cost of insuring the bonds. The price of the bond insurance (Credit Default Swaps) goes up, the bond is risky. The CDS price goes down, the bond is safe.
Li intended this as a limited tool for limited use - but it was so easy to misunderstand, this equation becomes almost ubiquitous in rating the risk of investments like CDOs.
By way of analogy, Li's saying use CDS's as a sort of Intrade for bond investments.
You can see the obvious risks there, but Wall Street chose not to care. After all, they were making money.
Read the article, it's just brilliant.
A whole bunch of smart people using a tool they don't understand to sell crap investments to the world.
(H/t CJR)
Late edit: By way of equal time, here's a thundering counterpoint to the article via Falkenblog.
2 comments:
In the end it is the system of remuneration which encouraged short term profits over long term stability, along with the backstop mentality. Oh, and let's not forget the herd mentality.
These people get so much up front they just don't care that much about the long term.
I'm sure Fuld is weeping about trashing Lehman, but that half a billion(yes, with a 'B') dollars according to WIKI, makes for a softer blow.
I would imagine if his pay(and other's) was more reasonable and delivered over a period of many years based on profits, things today would be rather different.
Exactly.
You wonder if a bonus could have a vested structure - kind of like how some retirement plans are structured.
Like, we put the bonus in trust for you and if the earnings play out over 5 years, you get something.
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