Tuesday, February 24, 2009

The Formula That Killed Wall Street


This is very good look at a central aspect of the MBS (mortgage backed securities) ratings alchemy. How do you turn subprime slope into AAA gems. Look inside the black box with this article.

A "quant" came up with a mathematical model that supposedly drastically reduced or even eliminated risk (at least that is how it was interpreted by the bankers). Banks used the model to lever up to the moon. The whole thing fell apart in less than 10 years and the model's deficiencies were dramatically exposed. Where have we heard this story before? Several generations ago… far enough back that no one remembers it? Of course not. It was only last decade when the quants at Long Term Capital Management started the hedge fund based on their own risk-crushing model of bond arbitrage. And they levered up. And in less than 5 years, the hedge fund imploded right down on top of the model, the fund's partners, and its investors. Déjà vu all over again.

(end of post; ignore continue reading statement below)

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