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Math The Almighty Buck Science

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."
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The Math Formula That Lead To the Financial Crash

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  • economics ? (Score:5, Insightful)

    by Anonymous Coward on Saturday April 28, 2012 @10:38AM (#39831685)

    Nobel prize in economics.

    that's Nobel prize in pseudo-science.

    • Re:economics ? (Score:5, Informative)

      by PCM2 ( 4486 ) on Saturday April 28, 2012 @10:54AM (#39831771) Homepage

      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.

    • by Futurepower(R) ( 558542 ) <> on Saturday April 28, 2012 @12:17PM (#39832207) Homepage
      FRAUD ALERT: It was not a mathematical model that caused the problem. It was fraud. Financial organizations convinced investors that they had a "mathematical model" so that they could steal. The theft was ENTIRELY deliberate, as is described in detail in the 1997 book F.I.A.S.C.O.: Blood in the Water on Wall Street [], by Frank Partnoy. Somehow the issues were kept quiet for 11 more years until the theft could be completed in the 2008 financial crash. Traders called their work "ripping the client's face off" [].

      There are other editions of the book, such as this one published in 1999, Fiasco: The Inside Story of a Wall Street Trader [], and a 2009 I-told-you-so edition of the original name.

      Nothing has been done to reform the extremely corrupt financial system in the United States. No one in the SEC, U.S. Securities and Exchange Commission, the government organization that is supposed to police financial fraud, was prosecuted, even though the agency knew of the abuses. See the February 17, 2009 show Frontline: Inside the Meltdown. []

      Even though the U.S. dollar is experiencing rampant inflation in 2012, U.S. banks give less than 1% interest on savings. Those who would like to invest can't because the system is so corrupt it cannot be trusted. Corporations hold unprecedented amounts of cash. See, for example, the October 7, 2010 Washington Post article, U.S. companies buy back stock in droves as they hold record levels of cash. []

      F.I.A.S.C.O. stands for "Fixed Income Annual Sporting Clays Outing" (See page 100 of the 2009 edition.), held at a shooting range called "Sandanona, a club in upstate New York" (Page 97 of the 2009 edition). Traders would go there to shoot guns. The idea was to encourage their taste for violence so that they would be even more financially violent toward the customer.

      Perhaps the April 27, 2012 BBC article, Black-Scholes: The maths formula linked to the financial crash [] referenced in this Slashdot story was influenced by public relations agencies trying to get people to believe that the crash was caused by errors in mathematical thinking, and not by fraud, so that the financial industry can continue stealing.

      It would be helpful if Slashdot editors signed a statement about each story saying that they know of no conflict of interest, and no one was paid to run the story.
      • by BronsCon ( 927697 ) <> on Saturday April 28, 2012 @12:30PM (#39832273) Journal
        So, you're saying it was the bankers' black souls, and not their Black-Scholes, that caused all of this?
      • by jools33 ( 252092 ) on Saturday April 28, 2012 @01:31PM (#39832659)

        It amazes me that some people can see conspiracies everywhere. I've not posted a story before on slashdot - but it seems to me that you are seeing conspiracies where there are none. I have no relationship to the bbc - I don't live in Britain - and I have no interest in finance organizations - as a software engineer I design and write code for a living (and not for financial institutions). This article interested me from the perspective - that making false assumptions - and misuse of a formula or algorithm - can have unforeseen consequences beyond the original authors wildest dreams - which is what I find fascinating and the sole reason why I posted the story. I can guarantee you that I will not receive a single kronor (as I live in Sweden) for this article. I wonder how you think Slashdot editors are going to police the articles that get posted as you suggest. To my mind that kind of heavy editorial censorship would also be heavily criticised.

      • In the Berkshire Hathaway 2002 Annual Report [] (PDF file), Warren Buffett said this on page 13:

        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.
        • by CodeBuster ( 516420 ) on Saturday April 28, 2012 @07:41PM (#39834233)

          No one can say the fraud was unknown

          It's not fraud as long as the liabilities created by the derivatives are reported on the balance sheet. The liabilities may be difficult to quantify, but as long as they're disclosed the diligent investor can decide for themselves how they're going to respond. What Buffet was saying was that it was very difficult, in his opinion, to estimate the risks in these complex derivatives transactions and Warren Buffet is well known for refusing to invest in things which he either doesn't understand or cannot reliably quantify (his avoidance of high tech investments are another example of this). Just because an investment is high risk or because foolish investors don't or cannot understand the risks that they're really taking doesn't make it fraud. This is an important distinction that's often lost upon the Occupy people and those who decry "preditory lending" or "cutthroat capitalism". Personally, I agree with Buffet and don't invest in futures or derivatives because I don't understand them. Indeed, I suspect that few people, even among professional traders, actually do. So when someone tells me that they fully understand all of the risks associated with their derivatives trade I know that they're either a savant or a liar. However, just because an investment is complex and risky (the two often go hand in glove) doesn't automatically make it fraudulent. As with most things in life, if it sounds too good to be true, it probably is.

      • by stinerman ( 812158 ) <> on Saturday April 28, 2012 @02:18PM (#39832941) Homepage

        Even though the U.S. dollar is experiencing rampant inflation in 2012

        This is a false statement, unless you consider low single digits to be rampant.

        The CPI and BPP [] 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.

      • by bzipitidoo ( 647217 ) <> on Saturday April 28, 2012 @02:40PM (#39833025) Journal

        Fraud is a big problem, but not the worst problem. I've grown concerned that we're all engaged in mass delusion. We think the world works a particular way, but we may be wrong. We can produce what seems to be supporting evidence. I am referring to a much more fundamental idea of finance: the formulas for rates. They're neat and simple, and wrong. Implicit in compound interest is exponential growth. The universe doesn't support exponential growth.

        Historically, depending on who you talk to, the stock market has averaged an annual rate of return of 7% or 10% or even more. But that record is only about 100 years long. Can the stock market keep up 7% growth for another 100 years? If it can, how about 1000 years?

      • by Grumbleduke ( 789126 ) on Sunday April 29, 2012 @03:55PM (#39839133) Journal

        Shortly after acquiring a maths degree I was interviewed for a job in a certain major investment bank, to deal with their "really complex" deals. In preparation, I was given a bundle of notes on the maths behind trading, including the Black-Scholes 'formula'. It was quite interesting, essentially being an application of Brownian motion [], with some fancy economic terms involved. So basically, the whole financial model is based on the fact that they have absolutely no idea whether stuff will get better or worse, so just add layer and layer of complexity to try to even it all out.

        Of course, that's only half the problem with the financial industries. I then actually went to the interview, and it turned out the job seemed to involve simply keeping an eye on spreadsheets to see what they're doing, rather than any actual maths. The person interviewing me (who would have been my boss's boss) clearly had no clue about any serious maths, or the differential equations underpinning his entire industry, but had a firm handshake and sounded confident.

        Needless to say I didn't get the job, nor want it. But it doesn't surprise me that there was a massive financial crisis - the whole sector seems little more than a confidence scam on the rest of society. "Give us your money and we'll make you more money."

    • by u38cg ( 607297 )
      This is a common refrain. Yet economics is a hard, hard, science - why else do we understand it so badly? Newtons invented calculus and a few mere centuries later we built atom bombs and mapped out the history of the universe nanoseconds after its birth. Yet for all the history of human commerce, we barely understand a subject that affects all of us, every single day.
  • Don't blame math (Score:5, Insightful)

    by koan ( 80826 ) on Saturday April 28, 2012 @10:41AM (#39831695)

    It was human stupidity and greed.

    • Re: (Score:2, Funny)

      by Anonymous Coward
      Yeah, here I was thinking it was because banks lent lots of money to people and countries who couldn't afford it, then acted surprised when they didn't get it back again. Not it turns out it was Math all along. Damn you, Math!
      • Re: (Score:3, Insightful)

        by nickleaton ( 966500 )
        Primarily. However, the real blame doesn't lie with the banks, it lies with governments. It is lending as you say, but its governments borrowing and lying about their borrowing. The main method, and the sums involved are huge, and they are unfunded pensions liabilities. Take the money up front and spend it. Then rely on future taxpayers to pay the bills. Just like in the US and the subprime mortgages, its easy or no payouts up front, but lots of money flowing in. Then it tips. All back end loaded. Now if
        • Re:Don't blame math (Score:5, Interesting)

          by Anonymous Coward on Saturday April 28, 2012 @11:12AM (#39831845)

          The real problem is that the "solution" - bailing out of the banks by the governments that were the source of the problem, is no real solution. It creates a delay. And while a delay was certainly necessary once they let it become as bad as it became, it will just repeat. A lot of Hedge funds are going to become rich - again.

          Solving the problem would take a prolonged crash that lasts - well lasts until the system rebalances. That sounds cute in theory but in practice it means that it must last until the baby boomer retirees (a big portion of them) are dead. It also means Obama and the democrats have chosen very close to the worst moment in the nation's history for their national healthcare. It will be a disaster much sooner than even the worst of the republicans projected. It will become a disaster in the next 3 years.

          And nobody can really do anything at this point - well I guess baby boomers could commit suicide in large numbers but ... - it's like watching a ship about to crash from the top of it's deck. There's nothing to do but watch. If you're a hedge fund manager you play a few games betting on the ship crashing while the captain assures everyone everything's fine and the ship is unsinkable.

          This situation also means the real crash hasn't come yet. It will happen not this year but by the end of next year.

          • by Opportunist ( 166417 ) on Saturday April 28, 2012 @11:37AM (#39831947)

            Not only that, but it also sends a very, very dangerous message to the banks: Playing risky with high stakes is the way to go. If you win, lots of money for you. If you lose, you get bailed out.

            That's NOT a sustainable business model. Impending crash notwithstanding, this idiocy alone would already suffice to send the economy down the drain.

            • by marnues ( 906739 )
              No need to blame the banks. It was a systemic problem that was not created exclusively by the banks (Ratings agencies told them the risk was low), by finance (derivatives are actually an excellent financial tool when used intelligently), by government (government backed credit has been used since time immemorial, some for good some for bad, regarding both intention and result), by salesmen (the micro-economics were sound), by buyers (again with the micro-economics), or by the ratings agencies. I don't hav
      • Re:Don't blame math (Score:5, Informative)

        by swalve ( 1980968 ) on Saturday April 28, 2012 @10:59AM (#39831797)
        It wasn't even just that, it was that they made the mistake of assuming that the higher interest they were getting from the risky loans was pure profit, instead of a hedge against the higher risk. If my portfolio of loans has a 10% chance of not being paid back, I would have to charge at least 10% interest to break even. They did that, but they booked and distributed the profit before the loans started to fail. It was basically a gross profit versus net profit mistake.

        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.
        • This is a pretty good anaylsis. All these people saying "its the banks", "it's the governments", "its human greed" are not contributing anything worthwhile. Thanks.

          • by Sir_Sri ( 199544 ) on Saturday April 28, 2012 @12:28PM (#39832261)

            Except that it's banks making the decisions, and governments writing rules that allow them to do various things, and create environments that cause problems.

            Human greed always contributes. It is both what drives our economy forward, and causes it to run into a wall occasionally. We always want something just out of reach. It gives us something to work for, but it also means that if you overestimate, even by a few percent you can cause a 'bust'. When the people doing this are controlling (not necessarily owning, just controlling) 80% of the countries wealth with a relatively small handful of people you can see where this goes badly.

            To use the example given, if there's a 10% chance of loans not being paid back, but for the last 5 years I've only had a 3% default rate rather than 10, either

            1.The 10% chance of failure estimate is wrong,
            2. this is an effect that's longer than 5 years or
            3. I should be allowed to change how I count the difference. (the lag effect is long enough I should be able to do something else with the money rather than just sit on it for another 5 years sort of thing)

            Enter the government, who, by the way, is largely run by people who have money, and as an institution cares very much about investment returns and interest rates, and they look at your problem. The government probably set the 5 year threshold, it may not have any connection to anything that matters, but it seemed like a good number when someone thought it up. It's possible my estimate is wrong, or worse, the government approved estimation technique is wrong, which means everyones estimate is wrong. Lastly, the government will change how that money can be counted, and what I can do with it. This last point is really the most insidious. Politicians will want to write rules that advantage them when they leave government, and that will advantage their investment portfolios. That means going along with changing how risks are counted, or how to handle the difference between calculated and actual risk in a way that will most benefit themselves personally when they leave. Whatever looks like it will help the bottom line the most right now. And that is very bad policy.

            After that, the whole situation is exacerbated by other government policies which aren't directly applicable to what we just talked about. Wealth distribution that has become less equal pushes more money into a smaller number of hands, meaning when they make mistakes they take a larger chunk of the economy with them. The government has written rules (about unions, trade, taxes etc.) that significantly impact wealth distribution.

            The government also controls the currency supply, and acts as the insurer of last resort, if it feels like it. Currency supply isn't as much of an issue in this recession compared to the great depression (where the gold standard exacerbated the problem for those still on it). The government has mostly managed to avoid a deflationary spiral, although that's about the only good thing you can say, and it's not even that strong a statement. But the insurer of last resort, if it feels like it is a serious problem. When a company (bank or otherwise) starts to spiral out of control, especially with the CDS situation where there was essentially a bank run, how quickly the government moves to insure banks, how much it's willing to insure etc all can determine how bad the crash is.

            If this sounds a lot like the great depression, it's because it is. Other than the gold standard issue* basically all of the same principles and problems and theories apply. There are substantial differences in specific, but: massive overburdening debt on consumers and banks, check. Significant wealth inequality, check. "Austrians" (the economic school of thought) claiming too much money supply previously, check. The same group claiming government policies to help were counter productive, check. Excess production capacity, (now largely driven by production in china rather than electrification and motorization) chec

            • by Prune ( 557140 )

              Saying Germany and France control the Euro is misleading since France's influence on the Euro was never equal to Germany's and lately has diminished further. The Eurozone troubles are a classic case of merchantilism. Germany's policies of trade surplus made possible by domestic wage suppression, combined with a single currency, is benefiting within the Eurozone only those at the top of German industry and finance. The resulting disaster was predicted decades ago by Modern Monetary Theorists.

              • by Sir_Sri ( 199544 )

                France's economy is big enough it influences the euro both directly and indirectly. What happens to greece is about the same as what happens to north carolina, sure, it can be bad there, but over all it's not that much of a problem. France on the other hand is about 1/5th of the eurozone (compared to germany 1/4), what happens there will significantly alter the value of the euro. Italy is about the same with spain a distant 4th. The 'big 3' of France, Germany and Italy should reasonably define the euro

        • Re:Don't blame math (Score:5, Informative)

          by Anonymous Coward on Saturday April 28, 2012 @11:14AM (#39831859)

          That's half the problem. The other is that poor mortgages were packaged into CDOs []. 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:Don't blame math (Score:5, Interesting)

            by tqk ( 413719 ) <> on Saturday April 28, 2012 @01:25PM (#39832629)

            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.

            The ratings agencies weren't gullible. They were in on it too. They were paid for their ratings by the people asking for the ratings. If they'd done their jobs and rated them poor, those buying the ratings would go elsewhere for them.

            The ratings agencies ought to be sort of like Consumer Reports. Instead, they are just another business out to make a quick buck like everyone else. Investors should have seen this coming, but no-one thinks long-term investing anymore. Fundamentals? What are those?

            I agree with those above who say it hasn't finished yet. The bailouts just bought the Too Big To Fails some time. They should have been allowed to fail, but politicians couldn't accept that when their cushy jobs were on the line.

    • Re: (Score:3, Insightful)

      It was human stupidity and greed.

      At least the stupidity part is shared with the slashdot headline. It should be "led" (verb, past tense), not "lead" (noun, heavy metal / verb, present tense).

    • by Auroch ( 1403671 )

      It was human stupidity and greed.

      Incorrect. Human stupidity and greed have been around for a long time, and if they were the leading factor, then we'd have a financial crash every few minutes (seconds?).

      Human greed may have been the finger that pushed the button(s), but there was an entire system that was set up based on a series of "tools", including some fancy algorithms.

    • But it's proven now that you cannot only count on human being stupid and greedy, you can actually calculate it.

      The system works...

    • by ultranova ( 717540 ) on Saturday April 28, 2012 @01:19PM (#39832573)

      It was human stupidity and greed.

      It was the greedy preying on the stupid to the detriment of the rest of us. But an unchained wolf will hunt when it sees food, and so will a sociopathic CEO. The blame lies with those who let them run free in the first place by deregulating the financial sector, not on animals following their instincts.

      • The blame lies with those who let them run free in the first place by deregulating the financial sector, not on animals following their instincts.

        The deregulators absolutely deserve blame, but so do the predators here. They aren't animals, they are people who have free will and the ability to make moral decisions and thus they have culpability unlike an actual wolf.

  • typo in headline (Score:4, Informative)

    by mrgil ( 126184 ) on Saturday April 28, 2012 @10:42AM (#39831705)

    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.

  • by gmuslera ( 3436 ) * on Saturday April 28, 2012 @10:42AM (#39831707) Homepage Journal
    People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.
    • by Guppy ( 12314 ) on Saturday April 28, 2012 @10:51AM (#39831755)

      People do. The downfall was made by people using tools (like that formula) without understanding all that required or implied.

      Quite so. A risk evaluation that says "95% of the time you will lose less than X" implies "5% of the time you will lose a more than X".
      With the stinger being that it says nothing of the range and distribution of values of "more than X".

    • by timeOday ( 582209 ) on Saturday April 28, 2012 @10:53AM (#39831767)
      You're so sure they didn't understand what they were doing? Maybe they didn't care. None of them returned their commissions on all the trades and phony "profits" they took out of the system, and practically nobody went to jail. They won. Furthermore nothing much has changed. It will happen again.
      • Well who really is to blame? The banks for taking advantage of vehicles that were seen as revolutionary and safe, hedge funds for generating extreme demand for said vehicles despite their safety going beyond common sense once the market grew, the credit reporting companies that kept the insurers credit ratings despite being undercapitalized to fulfill the insured debt obligations, or the government administration that saw the rise of the derivatives market amd subsequent housing bubble but chose to not inte
      • by tunapez ( 1161697 ) on Saturday April 28, 2012 @11:51AM (#39832067)

        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 []. Yeah, the fractal guy. Taleb [] 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.

    • by circletimessquare ( 444983 ) <circletimessquare&gmail,com> on Saturday April 28, 2012 @11:35AM (#39831937) Homepage Journal

      the purpose of a tool has a meaning

      give everyone a toilet brush, toilets will get cleaned. give everyone a hammer, nails will get pounded. give everyone a gun, people will get shot

      the availability and easy access of a tool with an intended purpose and meaning makes certain outcomes easier. it's not complicated

      the tool itself, and the presence of the tool, has significance. we all reach the limits of our temper at various points in our lives. we will confuse our teenage son sneaking into the house in the dark with an intruder. we will be drunk and clumsy. and in those situations, whether or not a gun is in easy reach radically changes the outcome of the situation

      the purpose and presence of the tool matters

      the proper quote is

      "guns don't kill people, people with guns do"

      if you want guns to be legal, fine. but don't depend upon flimsy easily dismantled logic to justify your beliefs

  • by ehynes ( 617617 ) on Saturday April 28, 2012 @10:43AM (#39831715) Homepage
    Plenty of financial collapses have preceded the current one without the benefit of Black-Scholes. What did they, and the current collapse, all have in common? Excess credit.
    • Re: (Score:3, Insightful)

      by Anonymous Coward

      In this case, Black-Scholes led to the excess credit by creating too much investor confidence in the loans being given. Because it models risk as a thin-tailed distribution, its use systemically encourages risk taking.

    • by hey! ( 33014 )

      The difference here is how the existence of that excess credit was justified. The model says you can create riskless investment positions, in which case, why not extend more credit? You've got the risk of default covered. As long as not too many people are doing that, you're actually in pretty good shape. When enough people are doing it, you end up with people shoring each other's absolutely safe investments up, a situation ripe for a chain reaction.

    • The previous financial collapses were caused by using the Black-Holes mathematical model. Black-Scholes just spruced that one up a bit.
  • by Anonymous Coward

    The one in 98 (yes there was one there the US gov fixed that one then kept it fairly quiet). Then the one in 2000 and the one in 2003 and the big one in 2008.

    Hedge funds are killing us with 'liquidity'. But for a short time they make us boatloads of money!

    The way it was explained to me was *IF* the market does not move in one direction or the other much this formula works. If it starts to move in either direction your going to get hit...

  • Greed was responsible for the financial crash. If this algorithm hadnt even existed, we still would have been in the same mess we're in.
    • Saying greed causes financial collapses is like saying gravity causes plane crashes; while trivially true, it doesn't give us much insight into the nature of the problem.
  • by alphatel ( 1450715 ) * on Saturday April 28, 2012 @10:46AM (#39831733)
    Deregulation, not models, permitted bad behavior. Banks that guarantee loans simply should not be emulsifying them into packaged trades, and then hedging their own equity on the loan derivatives. It's like taking a tulip bulb, selling interest in a tenth of the bulb with 1000:1 equity, and then saying it's more stable. Once it goes the wrong way you are screwed and you know it (but you just don't want to believe it could ever happen).
    • by swalve ( 1980968 ) on Saturday April 28, 2012 @11:20AM (#39831871)
      The emulsifying you are talking about wasn't the problem so much as was the leverage and the short information horizon. An investor could buy one mortgage and take on binary risk- it pays off, or it fails. That's a lot of risk. So he can pool his money with a bunch of other people and buy 1% of 100 loans. The risk of any loan failing is spread across all the investors. That, in itself, is a good idea, it is just basic diversification.

      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.
    • Well, you could argue that any bank doing that would just eventually fail due to their policy of underestimating risks. The problem is that the bank gets to take down everyone around them as well. Why are banks so huge and powerful?

      Perhaps if banks were treated like normal businesses it wouldn't be such a big deal when they fail. Then again there is a 200 year history of special treatment (bank holidays, etc) so it would be a shock to the system to do that now.

    • by TubeSteak ( 669689 ) on Saturday April 28, 2012 @11:39AM (#39831963) Journal

      Deregulation, not models, permitted bad behavior.

      Banks were faking/changing loan documents, lying to customers, and pushing customers into bad (but profitable) loans.
      All the regulation in the world won't help if there's no one enforcing the rules.

  • The Black-Scholes formula leads to crash because it misses components which account for: a) looking at the formula, b) using the formula.
    • Exactly. The Black-Scholes formula (and most other formulas which attempt to predict market behavior) are structured on the theory that people make decisions regarding buying and selling based on factors primarily concerned with the value of the financial instrument being traded vs the value of other financial instruments that are available to the buyer and seller. The problem with the formula happens when people start to make decisions regarding the market on the basis of the formula rather than their perc
  • by Anonymous Coward on Saturday April 28, 2012 @10:51AM (#39831757)

    Interesting, but really, blaming the seed on Jack looting the giant's castle? I used to write risk analysis software for the traders and market makers at the options exchange in Chicago (CBOE) and am intimately familiar with Black-Scholes algorithm (I've implemented it more than once). In the article, the sub-text to one photo, "Options allow a trader to have a delicious risk-free portfolio", is totally bogus! Options allow a trader to MINIMIZE the risk in their portfolios, and BS (no pun intended) helps traders to do that in a mathematically/statistically rigorous way. Misuse of any tool (using a hammer to kill someone, for example) is not the tool's fault, but the wielder of the tool!


  • Amazing how mankind is able to create from A to Z the very rules that eventually lead to its failure.
  • old news (Score:3, Interesting)

    by Anonymous Coward on Saturday April 28, 2012 @10:54AM (#39831773)

    This was covered by the guardian a whole two months back. Link [] Partly debunked here []

  • by Anonymous Coward on Saturday April 28, 2012 @10:55AM (#39831775)

    1. Approve $300K mortgages for people earning $35K/yr, falsifying documents as needed

    2. Bundle slices of thousands of these mortgages into derivatives along with "insurance" against the mortgages defaulting and "insurance" against the bundles failing, etc, under the direction of math and finance PhD's []. Sell these "Triple-A-rated securities" to gullible investors worldwide.

    3. ??

    4. Profit!

    8-figure pay packages for bankers and 7-figure for mortgage brokers, real estate agents, workers in credit rating agencies, etc. until the music stops. But hey, you won't need to defend your resume when you've got enough millions in the bank.

    5. Watch housing prices rise by 30-50 percent/yr

    6. Goto step 1.

  • by superwiz ( 655733 ) on Saturday April 28, 2012 @11:13AM (#39831851) Journal
    The formula calculates what can be expected based on what is known.... That's all. What's next? Are we gonna start blaming actuarial tables for people dying in car crashes?
  • by Antique Geekmeister ( 740220 ) on Saturday April 28, 2012 @11:26AM (#39831901)

    I highly recommend the opera at [], from the Ig Nobel prizes a few years ago. It captured the most recent banking crisis rather well, and without the need to blame human greed on misused mathematical formula.

  • by Guppy ( 12314 ) on Saturday April 28, 2012 @11:29AM (#39831913)

    Once Risk became a commodity capable of being bought and sold, it was only a matter of time before market responded by producing more Risk.

  • by Anonymous Coward

    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

    • by zippthorne ( 748122 ) on Saturday April 28, 2012 @05:05PM (#39833595) Journal

      And when they did hold gold, gold wasn't actually useful for much of anything except looking pretty. So it's always been nothing.

      • by wrook ( 134116 )

        What's worse is that if you base all currencies on the same finite resource, the rich countries corner the market in that resource. If you want to bolster your currency, you have to buy the resource, but nobody is selling. This raises the price of the resource, strengthening the rich country's position and weakening the poor country's position. This actually happened and it led to the abandonment of the gold standard.

    • by ZigMonty ( 524212 ) <> on Saturday April 28, 2012 @08:34PM (#39834493)

      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.

  • by dupup ( 784652 ) on Saturday April 28, 2012 @11:42AM (#39832007)

    The equation was not at fault: the output is only as good as the inputs. The real problem was the instruments being traded: credit default swaps. These are of dubious merit and much more complicated than more traditional underlying instruments (the thing on which you hold an option contract). For example, suppose you have an option to be 100 shares of Google at a given price. It's easy to evaluate the value of the underlying instrument because there's an efficient market for it: Google is traded on a public exchange and the value is agreed upon within a penny, generally. Black-Scholes works on Google options just fine and you can minimize your risk reasonable well using it.

    The credit default swaps were much more difficult to evaluate because of the lack of an efficient market for them. The essential nature of the underlying instrument were very high risk mortgages, not too different in concept from so-called junk bonds. The potential return was high because the interest rate was high. The potential risk was high because the risk of default was high, making the underlying instrument worth very little, much less than face value. So take these risky mortgages and then buy insurance policies for them, this is standard practice. That hedges the risk of the actual mortgage itself. Bundle the mortgage and the insurance policy up into a quasi-mutual fund like product: you have x number of mortgage/insurance policy bundles with average risk of default at y. Getting more difficult to put a value on, especially since there is no regulated exchange for them and little oversight.

    Not done yet. Add in that deregulation rules passed during the Clinton era allowed the banks that issue the mortgages and buy the insurance policies to also use their assets to trade on their own. This group within a group is called "proprietary trading". So, the prop-trading groups within the banks buy and sell the mortgages and insurance policies to each other in order to generate income for the bank. There are also other groups that buy and sell these instruments that don't actually issue mortgages. These are called speculative traders.

    Finally, to put the finishing touches on this pile of doo, have a group create a new instrument: a binary option (it does or it doesn't) on a bundle of high-risk mortgages and their insurance policies. A binary option is essentially a gamble: it pays out if something happens, it does not pay out if something doesn't happen. Now you're buying and selling options contracts which predict whether a group of mortgages will fail or not. There's no regulation, no formal exchange (which helps create market efficiency). There's no reliable way to determine the value of the underlying instrument because it depends on knowing how many of the mortgages will fail. And don't forget that the banks were using their investment customers to create demand for a product they wanted to sell ("I think you should invest in such-and-such") without telling the customers that the banks themselves would be profiting by selling questionable instruments to their own customers.

    This is the magic of unregulated capitalism (almost - the banks should have been allowed to fail in a purely unregulated capitalism system). Nothing wrong with Black-Scholes here. The real problem at the core is that the banks involved are so driven by short-term success that there is no room for sanity. Wrap it all up with the fact that the banks know they will be bailed out by the Feds if they fail. There is no penalty for risk and no regulatory oversight. Gotta have one or the other or we just plain deserve this insanity.

  • I don't read a lot in my spare time, but one author I like is William Poundstone. I was going on an international trip and I wanted a book to take with me to read to kill time, so I bought his book _Fortune's Formula_. Essentially the book is about some Bell Labs geniuses who came up with mathematical models that allowed them first to make money at casinos and then to exploit weaknesses in the US stock market to make money. Scholes is featured in the book, but he's not a main character. I offer the following 2 quotes directly from the book which are on this very subject.

    "LTCM was simply in the position of a gambler who goes to a casino where the pit boss gives him unlimited credit." (page 283) Note that LTCM was the fund that Scholes helped run. The book further goes on to state that in real life, nobody gets truly "unlimited credit". A casino will not loan more money than they can collect. But LTCM's business model depended on credit never running out to them.

    "Warren Buffet marveled at how 'ten or 15 guys with an average IQ of maybe 170' could get themselves 'into a position where they can lose all their money.'" (page 291) It's a big simplification, but basically LTCM got burned by the Russian currency collapse which started a chain of events that killed them.
  • Bollocks (Score:4, Informative)

    by Lawrence_Bird ( 67278 ) on Saturday April 28, 2012 @12:07PM (#39832157) Homepage

    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.

  • by decora ( 1710862 ) on Saturday April 28, 2012 @02:09PM (#39832887) Journal

    myron scholes or any of the other tools that enabled the 2008 crash, including CDOs, securitization, etc.

    Edwrd Chancellor has a much, much more accurate , and scientific approach to crises - and that is to catalog and record them and their details, going back to Tulipmania and before. His book "Devil take the hindmost" came out before the 2008 crash, but basically what he is doing is proving that History is much more of a 'science' than economics --- at least in History, they try to gather actual data before making theories, and throw out the theories when the facts dont match.

    the various attempts to 'blame math' for the crash of 2008 are little more than attempts to cover up the massive fraud that was perpetrated on the taxpayers of the planet. you make a huge amount of horrible loans to people you know cannot pay them back, resell the loans to people and lie about it, then get the government to bail you out when the whole system is about to collapse. you dont need a formula to do that, it is the basic feature of every economic bubble and its bursting. Fraud.

    the difference here is that the fraudsters have completely made an end run around all the rules implemented after the 1929 crash to prevent this sort of thing, they practically own the politicians that are supposed to regulate them, and they insinuate themselves into positions of power in the political class. thats the difference - that we are actually regressing backwards in our civilization, and having the free market run less well than it did previously, and watching entrepenurial capitalism die a nasty death by its own supposed proponents.

  • by Just Brew It! ( 636086 ) on Saturday April 28, 2012 @03:28PM (#39833191)

    Black-Scholes is sound in a statistical/mathematical sense. Unfortunately it makes implicit assumptions about how the market operates that simply aren't true, so it was bound to fail. Financial engineers -- and I use the word "engineers" loosely here! -- accepted the assumptions as gospel because their jobs/bonuses depended on it.

    I used to work in that industry. It will be a cold day in Hell before I go back.

    The only way to prevent another train wreck is to remove the incentives for "too big to fail" banks to take unreasonable risks with other peoples' money, based on the assumption that the government will bail them out if things go badly.

  • by hughbar ( 579555 ) on Saturday April 28, 2012 @03:39PM (#39833241) Homepage
    Actually reading through the BBC story, I feel it's yet another example of the BBC's declining grasp of anything technical. Long term capital management called into question Black-Scholes and demonstrated extreme events in markets, sure. But the elements of the recent crash were also to do with greed, arrogance, mis-selling [of mortgages that were then securitised in un-auditable and therefore un-priceable mixtures] bad-fatih [banks selling both complex derivatives AND insurance for the failure of these complex derivatives] and a general credit-bubble that distorted asset pricing. Michael Lewis' the Big Short: [] is very good on the detail of this.

    Then, because the firewalls between speculation and retail banking had been removed, there was a great deal of general contagion and bank to bank movements froze.

    However, one can't conclude that all mathematical pricing is wrong from these two separate events. One can reach conclusions regulation, capital adequacy, firewalls etc/ Above all, if the public is well protected and genuine industry is well protected, these idiots [of which I was one once] can do what they like and then suffer the consequences.
  • by AlejoHausner ( 1047558 ) on Saturday April 28, 2012 @08:38PM (#39834519) Homepage
    Actually, the Black-Scholes formula is innocent. Sure, it assumes that stock movements follow a standard distribution, but that's not as big a sin as is being made out in the article. The formula computes the fair price for an option contract. Such a contract gives its owner the right (or "option") to buy or sell some asset up to a future date (the expiry date), at some given price (the "strike" price). The formula uses the following values:

    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.

"I prefer the blunted cudgels of the followers of the Serpent God." -- Sean Doran the Younger