The Math Formula That Lead To the Financial Crash 371
New submitter jools33 writes "The BBC has a fascinating story about how a mathematical formula revolutionized the world of finance — and ultimately could have been responsible for its downfall. The Black-Scholes mathematical model, introduced in the '70s, opened up the world of options, futures, and derivatives trading in a way that nothing before or since has accomplished. Its phenomenal success and widespread adoption lead to Myron Scholes winning a Nobel prize in economics. Yet the widespread adoption of the model may have been responsible for the financial crisis of the past few years. It's interesting to ponder how algorithms and formulas that we work on today could fundamentally influence humanity's future."
typo in headline (Score:4, Informative)
The past tense of lead is "led", not "lead". When "lead" is pronounced like "led", it's a metal. This mistake pops up everywhere. Correcting it here won't fix anything, but when someone on the internet is wrong, duty calls.
Theory and Application (Score:4, Informative)
Re:economics ? (Score:5, Informative)
It's worth pointing out that the "Nobel Prize in Economics" was not one of the original six prizes founded by Alfred Nobel. It is a separate award, which was invented by the Swedish central bank in 1968. Although it is presented along with the Nobel prizes, it is not technically a Nobel itself.
Re:Don't blame math (Score:5, Informative)
Then there was the failure of the CDS market. Companies made investments, then bought insurance policies to hedge their losses on the loans. But when the loans started to fail, the CDS/hedge couldn't be paid back (cough AIG cough) and they were fucked. I think that will eventually come out as being the ultimate failure- too many layers of reinsurance.
Re:Don't blame math (Score:5, Informative)
That's half the problem. The other is that poor mortgages were packaged into CDOs [wikipedia.org]. This in itself was OK, but the unsaleable bottom tranches of the CDOs were then repackaged into new CDOs. These should have been rated as entirely high risk (being a collection of mortgages that, due to the first CDO, were almost guaranteed to fail) but gullible ratings agencies still gave the top tranche a top rating. So investors worldwide were buying crap believing it to be a low risk investment.
Re:Theory and Application (Score:5, Informative)
The leverage problem was that they didn't just split the loans equally like that, they split the loans into tranches, or classes, of investor. The risk averse investor bought the high quality tranche, and for that got a higher guarantee of payment in exchange for a higher price (lower yield). The lower tranches were sold to suckers with the promise of potentially high rates of return. But as the individual loans started failing, the way the package was levered, the higher investors ended up getting paid, and the lower investors got nothing.
A quick example of the information problem was the practice of the 80-15-5 mortgage loans. Conventional wisdom says that when someone takes out a mortgage with zero down, that mortgage is more likely to fail. So again, conventional wisdom says that in order to hedge for that increased potential failure, you need to charge a higher interest rate. For some reason, and I agree it was probably lack of regulation, someone figured out that you could split the mortgage into three portions- standard risk (the 80%), higher risk (the 15%) and highest risk (the 5%). In the documents for the 80% loan, you could then say that this loan had 20% down, and you'd get the good rate. Then you do the same with the 15% loan- "hey, this loan has 5% down, give us the OK rate". Then you would only end up paying the super high risk rate on 5% of the balance of the mortgage instead of the whole thing. The problem there was that the whole loan had the high risk, but the investors in the 80% and the 15% didn't know it.
What really happened... (Score:2, Informative)
What really happened is this:
#1. Large central banks control the issuing of currency, to governments. This, however, is a loan. Repayable with interest.
#2. The very same large central banks (eg. The Federal Reserve) accept payment only in the currency they themselves issued, or that of another large central bank.
#3. The loan (issue of currency) is therefore impossible to repay, because the interest payments cannot be made without issuing more currency. (Loans with interest)
#4. We have now reached the point where the interest payments outstrip the available currency. Take a look at http://USdebtClock.org (Figures there are sourced from the US Treasury)
#5. The system crashes and burns, because it's an impossible formula. (Happened already, the effects have not been felt yet, not even in Greece. What's yet to come is far, far worse.)
This is why the EU and US are fucked. Who are they actually in debt to? Large central banks, typically of other nations. When two nations are in debt to each other, (as is very often the case, eg. Spain & Italy, which owe each other tens of billions of euros) why is the debt not cancelled out to the extent possible?
Because of the interest payments!
It's really very simple when you look at how the money is created in the first place, to see that the only thing it can possibly end in is debt and the enslavement of entire nations... Exactly as designed.
Oh, also... None of these central banks are using gold reserves any more, that's old hat. No, they've sold those off and now hold reserves of foreign currency instead...
But if none of them have any gold left, and simply have foreign currency issued by banks that also have no gold left... Ultimately, it's all entirely worthless anyway.
Re:Guns are don't kill people (Score:5, Informative)
You are both right. The fund managers and their pet quants did not understand the whole process and the effects of their actions, all they knew was they were 'printing money' out of thin air every day. Cannot say they were not warned by many, including the father of quantitative analysis; the late, great Mr. Mandelbrot [goodreads.com]. Yeah, the fractal guy. Taleb [wikipedia.org] was also an ardent 'wet blanket'. Both predicted this mess years before it happened. Nothing has changed, toxic assets are STILL accumulating in many funds' portfolios. Who cares? The Guv will bail them out after they're done raping the markets.
Bollocks (Score:4, Informative)
BS had zero to do with any of the problems which led to the various market meltdowns. What did? Ignorance of liquidity (more precisely, lack of liquidity), counterparty risk, seriously flawed assumptions about various correlations (think gdp, unemployment, geography, subprime mortgages), significant excess leverage financed at exceptionally low interest rates, creation of intstruments which allowed some holders to game the system (credit default swaps) and lastly, ignorance and greed. There are, of course, myriad other contributors but BS is not one of them.
Disclaimer: besides having a masters degree in computational finance I worked in the industry for nearly two decades.
Re:A math model? That must be a fancy name for (Score:2, Informative)
Superwiz, were you asleep over the past few years, or perhaps while'd it away playing shoot 'em up video games?
It took me about two minutes to find the following. Note these are major news outlets with experienced financial reporters, not bloggers.
Go ahead and forward my post to whichever banks you want.
- OP
http://www.sec.gov/news/press/2010/2010-59.htm
http://www.bloomberg.com/news/2011-01-24/countrywide-sued-by-investors-in-mortgage-backed-securities.html
http://www.forbes.com/2009/04/08/borrower-subprime-mortgage-loan-opinions-contributors-lenders.html
http://www.cbsnews.com/8301-505123_162-57387779/big-banks-could-face-mortgage-fraud-charges/
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ax3yON_uNe7I
Quote from the book: (Score:2, Informative)
"As the quick-learning derivatives salesmen began to have more and more violent thoughts, the securities they sold became more violent, as well. In 1986 a typical salesman subscribed to Time or perhaps Playboy, played golf, and sold corporate and government bonds. By 1994 that same salesman read Soldier of Fortune and Guns and Ammo, shot doves, and sold leveraged-indexed-inverse-floating-dual-currency structured notes. This was no coincidence."
Warren Buffett called derivatives "time bombs". (Score:5, Informative)
"Derivatives
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system."
From page 14:
"I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham."
On page 15:
"In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." [my emphasis]
Warren Buffett, the world's most famous investor, published that in 2003. It was widely reported. No one can say the fraud was unknown, or that the present severe economic problems are due to a faulty mathematical formula.
Re:Not economics; theft. (Score:5, Informative)
This is a false statement, unless you consider low single digits to be rampant.
The CPI and BPP [mit.edu] bear this out. The CPI is done by the government, so if there was enough of a conspiracy, they could conspire to keep the official numbers down. I don't think any alleged conspiracy could reach the BPP.
Re:What really happened... (Score:4, Informative)
I've heard this repeated several times but it's a load of misinformed crap. It's one of those "makes sense to someone who knows nothing but is totally false" myths.
When a central bank creates money through a loan and it is later paid back, it is only the principal of the loan that is created and destroyed. The interest portion is considered the bank's profit and is paid out to the bank's shareholders (whoever that may be, it differs depending on which country you're talking about, but usually member banks and/or the government). That money is not destroyed and re-enters circulation. How would it even make sense for the interest to be destroyed as well?? That would totally break the concept of double-entry accounting (which central banks do still follow).
I don't know where this myth started but it's 100% false. I realise the financial crisis has made everyone interested and out for easy answers, but "the only thing it can possibly end in is debt and the enslavement of entire nations... Exactly as designed"? Please. I hate bankers as much as the next person but i wish we could focus on the real problem (outright, unpunished fraud) rather than this kind of fairytale crap.
Nothing wrong with Black-Scholes (Score:4, Informative)
1. The time remaining until the contract expires
2. The current price of the undelying asset
3. The strike price (the contract gives its buyer the right or "option" to buy the asset at the strike price)
4. The risk-free rate of return on cash (return that could be earned by putting your money into, say, treasuries rather than stock)
5. The volatility of the underlying asset.
At the time the contract is written, the first four of these values are known (assuming of course that the risk-free rate stays constant, which is pretty close to a sure bet). The LAST value is the problem. It says how much the stock will fluctuate, between the present time and the time of expiry. This is unknown, because, after all, it requires knowledge of the future. Usually, PAST volatility is used in its place, going with the assumption that the stock will behave in the future the same way it behaved in the recent past.
If the stock suddenly becomes very quiet, and stops fluctuating, the buyer payed too much for the contract, on average. If the stock gets very wild, the buyer got a bargain, on average. In either case, the contract buyer and seller guessed wrong. They should have used a different volatility to price the option.
Of course, stock fluctuations do NOT follow a normal curve, after all. And option traders do NOT follow Black-Scholes exactly either (see "volatility smile"). But the much bigger flaw, I think, is lack of clairvoyance. The formula requires knowledge of the future.
Price increases are far more than interest rates. (Score:4, Informative)
Food, +4.8% -- Food Price Outlook, 2012 [usda.gov]
Quote: "The food-at-home Consumer Price Index (CPI), in turn, increased more than expectedâ"4.8 percent in 2011â"which means that food price inflation was not as strong as in 2008 when it increased 6.4 percent over 2007."
Medical treatment, +8.5% -- Medical cost trends for 2012 [pwc.com]
"This year's report from PwC's Health Research Institute finds that the medical cost trend is expected to increase from 8% in 2011 to 8.5% in 2012."
University tuition, +8.3% -- College costs climb, yet again. [cnn.com]
"Tuition at the average public university jumped 8.3% to $8,244."
Gas, +208% -- Historical Price Charts [gasbuddy.com]