Recipe for Disaster: The Formula That Killed Wall Street

A snip from this month's WIRED cover story by Felix Salmon about a mathematical formula that played a critical role in the global economic collapse (which is worsening still as I type this blog post). Snip:

A year ago, it was hardly unthinkable that a math wizard like David X. Li 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 Gaussian 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. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

Recipe for Disaster: The Formula That Killed Wall Street (WIRED). BTW, the moral of the story as I see it is that we should STOP MATH NOW! Also: WIRED's other must-read story this month, Dan Roth on the move to bring radical transparency to the SEC. (Via @chr1sa, who I like to refer to as Original Recipe Chris Anderson)

Image above: "The Market Is Not Functioning Properly" by The Joy Of The Mundane, a creative commons licensed image via flickr.

Related Boing Boing blog post: How are you coping with collapse-anxiety?