Saturday, March 7, 2009

The formula that crashed the world

Fascinating article from Wired magazine about the formula (or to be exact "Gaussian copula function" !!) that was at the heart of the global financial market crash and subsequently the economic crash.

How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion-dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers.

The CDO (Collateralized Debt Obligation) and CDS (Credit Default Swap) financial instruments fed on this formula.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

Wall Street loved it...

At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.

This article is definitely worth a read if you want to see how something simple could be turned into a self-fulfilling prophecy and then run through the greed machine of Wall Street and global financial markets with devastating effects.

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