Jeffrey Snider is a smart man who understands the murky world of modern-day global finance, and he has a gift for explaining it. His articles are not short, and they are complex, but arcane artifices such as Gaussian Copulas do not lend themselves to shorthand. Still, he does a good job helping the ordinary Joe understand very complex financial subjects.
In The Fed is Actually Bailing Itself Out, he explains Credit Default Swaps.
“It all worked so well, until it didn't.”
“Since credit default swap trading had been growing in substance and depth since their first use in the 1980's, this market-based correlation assumption fit nicely into the expectations of structured credit investors and traders, offering real-time pricing of the previously illiquid asset class.
The proliferation of securitization came directly from this complex math, which itself was nothing more than a shortcut of circular logic (the market needs estimates of future default correlation to price assets, so the assets get their correlation estimates from the market).”They constructed mathematical models to price previously-unquantifiable tranches of securitized debt. The models relied heavily on recent history, violating the simple truth, “Past performance is no guarantee of future returns.”
You don’t need to be a math genius to see the tragic flaw to all of this: Hubris. And a naïve credulity and blind obeisance to mathematical modeling, all at the expense of common sense, human nature, and financial history. The greedy bastards chucked it all over for the fantasy of an eternal fountain of wealth.
The Loop: “correlations of greater than 100%”
A rush of demand for default swaps pushed many idiosyncratic instruments in the same direction at the same time. Since the Gaussian copulas interpreted similar moves as correlation, this meant that the mathematical indication of correlation "measurements" rose with these new fears. And of course, as interpretations of rising correlations made their way into the math of pricing models, tranche pricing became even more problematic. That forced incrementally more demand for credit default swaps, feeding back into estimates of correlations rising even higher, further heightening fear and the need to hedge, and so on.This is the result of the folly that government-funded central planning and sophisticated modeling can replace human nature and common sense. More insidiously, it takes away our economic freedom and erodes our savings and buying power through monetarism’s manipulation of fiat currency. It is the antithesis of the free market.
[…] it was not uncommon for traders to quote various mortgage bond tranches in correlations of greater than 100%. Of course that makes no logical sense within the confines of what correlation is supposed to confer or what mathematics actually defines, but the market realities of the period introduced by David Li's shortcut undercut the ability of the marketplace to make sense of itself.
