The Problem with Models…

Commentary from Luke Froeb, great Owen prof.:

Very interesting story in the latest issue of Wired.
The story claims that one of the main causes of the financial meltdown
can be traced to a mathematical formula created by David Li. The
formula (a Gaussian copula function) was designed to measure the
correlation among returns of all of the various assets that made up
collateralized debt obligations. The big problem with coming up with
such a formula was the lack of information regarding the relationships
among the underlying assets. Li's solution was to use past credit
default swap prices as an indicator of correlation returns.

idea, but the problem was that the only CDS pricing information came
from a time when home values were on a continuing upward trend. The
inputs into the model (and therefore the output) weren't valid during
time of decreasing home values. And, apparently, just about everybody
was using the formula to price CDOs. Oops!

The Wired article has also caught the attention of our friends over at O&M.

Remember the words of Warren Buffett: "Beware of geeks . . . bearing formulas"

Recipe for Disaster: The Formula That Killed Wall Street

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