Comments on: The dangerous Gaussian copula function http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/ A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 http://wordpress.org/?v=4.2.5 By: JimPivonka http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40583 Sat, 23 Jun 2012 15:40:07 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40583 I think this an exceptionally informative, helpful comment thread. For better or worse I have elsewhere represented the following as a fair summary of the relationship of the GCF to valuation of derivatives, as they – and it – contributed to mortgage fraud and the run up and crash in housing prices. Am I wrong?

What caused the Great Recession in 2008? A crash in the money supply, which the Greenspan Fed had allowed to grow based on debt derivatives. When the values of those derivatives crashed, the money supply went too. Why had credit derivatives become so important in financial institutions operations? Because they allowed the institutions to escape effective regulation and evaluation of their investment instruments and behavior, and they were very, very, important to the booking of immediate profit on which the bonuses allocated to traders were based.

How did mortgages become involved in this cycle? Mortgages were the most readily available, least regulated, financial instrument which could be used in the creation of credit derivatives. As the demand for credit derivatives grew, the demand for mortgages grew. Traders needed the derivatives to show “profits”, their institutions needed mortgages to create derivatives, mortgage bankers needed borrowers to sell mortgages, borrowers needed housing values inflated by (essentially) fraudulent appraisals to justify the credit they were obtaining.

At the root, the entire cycle depended on the ability of institutions to create, and traders to sell, financial instruments which were rated very highly by – it is now clear – incompetent and complicit credit rating agencies. Much of the valuation and rating of these instruments was supported by mathematical modelling tools which were always suspect, and have now been shown to be dangerous.

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By: ARutledge http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40561 Fri, 22 Jun 2012 22:52:07 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40561 Yes, Gaussian copulas didn’t help. But the main problem is with the CDO model itself. It uses ratings, not empirical data, to forecast total expected pool losses. If the credit is essentially static, fine. If its payment certainty is likely to deteriorate, there is a financial incentive to refinance before the market discovers there’s a problem. Hence the disastrous results of 2003 CBOs and with RMBS CDOs.

The FCIC picked up on this point. Dr. MacKenzie didn’t seem to get it even after he spent half a day with us.

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By: Th.M http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40528 Fri, 22 Jun 2012 12:12:12 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40528 I think the conclusion of MacKenzie is basically sound:

“The way in which […] a class of model that was widely disliked, nevertheless helped achieve economically crucial outcomes […] shows that cultural resources can co-ordinate action even in the presence of widespread scepticism as to their worth.”

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By: dsquared http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40521 Fri, 22 Jun 2012 09:25:01 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40521 IIRC, from the prehistory of your various blogs, the guys who marketed the ABN Amro CPDO (and who for a while convinced you that it wasn’t a suicidal product) certainly did appear to believe that their modelling approach showed it couldn’t fail. (http://www.interfluidity.com/posts/1163 459977.shtml , blast from the past)

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By: EPB http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40501 Thu, 21 Jun 2012 19:51:32 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40501 Agree, @fursty — Wall Street was the drunk driver that survived the crash, the economy (the ‘rest of us’) was the victim.

Does anyone in the BACK of the limo ever get hurt?

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By: Eericsonjr http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40500 Thu, 21 Jun 2012 19:31:06 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40500 “She’s a model and she’s looking good.”

Hey, Felix: can anyone actually “touch a CDO?”

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By: Mitchn http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40498 Thu, 21 Jun 2012 18:53:17 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40498 In other words, most of the people who “modeled” their way to million-dollar bonuses were just as clueless as the people who bought the crap Wall Street was peddling.

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By: JayCM http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40493 Thu, 21 Jun 2012 18:28:42 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40493 The problem isn’t that anyone really believed the numbers. The problem is that Wall Street as an institution craves numbers, and if the numbers are unreliable but better numbers aren’t available, they’ll use what they can get. Then the incentive is to maximize whatever costs the numbers don’t measure. This time it was risk, the next time it’ll be something else.

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By: MrRFox http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40483 Thu, 21 Jun 2012 15:18:57 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40483 @Fursty – about this –

“The real solution has to come from elsewhere.”

When you think it all through from every angle, is it possible to realistically conclude that “elsewhere” could be any place that doesn’t involve the barrel of a gun?

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By: f.fursty http://blogs.reuters.com/felix-salmon/2012/06/21/the-dangerous-gaussian-copula-function/comment-page-1/#comment-40481 Thu, 21 Jun 2012 14:48:16 +0000 http://blogs.reuters.com/felix-salmon/?p=15297#comment-40481 Yup, I think the point is that it’s not this particular model or any model that “killed” Wall Street. If they hadn’t come up with this one, they would have found another way to juice profits by ignoring and offloading risk. One needs to focus on much larger issues, including the way banks are organized, incentives, regulations, the financialization of our economy, etc. etc. Things you regularly discuss.

This is not to say that it’s not interesting and important to know that particular mechanics by which this latest crash happened, and that research is not therefore valuable. It is rather to say that focusing on the model as the source of Wall Street’s problems — what “killed” it — is too small an answer. Getting rid of that model will not solve the essential societal risk that Wall Street poses to the rest of us. They will find another way to bring down the economy while making themselves rich. The real solution has to come from elsewhere.

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