Wired magazine had a great article explaining the causes behind our credit problems. Unfortunately, they blamed math as the root cause of the problem, which is silly. It’s like blaming a hammer for smashing your thumb.
A decade ago, most investors didn’t like to put their money into mortgage pools (unless they were backed by the US federal government) because they couldn’t quantify the risk. Then along came a clever guy named David Li who developed a formula to measure the amount of risk.
This formula came to be used in finance all over the world to measure the risk of baskets of mortgages and other types of debt. The main problem before Li came along was that although financial markets could measure the risk of an individual mortgage, they couldn’t measure correlation: the degree to which debtors tend to default at the same time. Li had a solution.
However, Li didn’t really work out the correlation himself. He examined the movement in prices of individual debts (in the credit default swap market) to estimate what the market thought the correlation was. Li just trusted the market to get the correlation right.
Li’s formula just assumed that the recent history of actual prices gave a good measure of the likelihood that multiple debtors would default at the same time. So, as long as markets ticked along well and had few defaults, Li’s formula predicted that the world would continue to move along smoothly.
This is essentially the same as believing that the future will always be the same as recent history. If it hasn’t rained for a month, then it’s safe to set up priceless paintings outside because it’s never going to rain, right? When the credit crisis finally hit, it became obvious that Li’s formula hopelessly underestimated the correlation of debt defaults.
I see little reason to blame Li for all this. No doubt his formula is useful in some areas and less useful in others. Those who use a formula without understanding its limitations should blame themselves for a bad outcome.
Of course there were people who understood the limitations of Li’s formula, but it was hard to get the attention of bankers who were raking in millions of dollars. They were guilty of momentum-based thinking as well. They had been using Li’s formula and making money consistently. Why would they want to stop? Picking up coins on a highway is profitable until that terrible road kill moment.