Comments on: The Risk Management Formula That Killed Wall Street

By: The Ascent of Money: A Financial History of the World | Compliance Building

The Ascent of Money: A Financial History of the World | Compliance Building — Mon, 16 Aug 2010 12:30:06 +0000

[...] fatal flaw sounds much like the flaw in the Gaussian copula function that failed in assessing the risks for mortgage backed securities. They used ten years worth of [...]

By: Credit Rating Agency Reform | Compliance Building

Credit Rating Agency Reform | Compliance Building — Thu, 23 Apr 2009 11:01:46 +0000

[...] On the other hand, the structured finance products are not actively managed. You have a bunch of income coming in and you structure that income flow into tranches. The default rate is governed by the quality of the assets and the larger economy’s effect on the cash flow from those assets. The rating process is complicated in a different way because you need to look at the variables that may affect the performance and how they may be correlated. I wrote before on how the rating agencies got this wrong: The Risk Management Formula That Killed Wall Street. [...]

By: Compliance Building · Ways Companies Mismanage Risk

Compliance Building · Ways Companies Mismanage Risk — Wed, 25 Mar 2009 11:00:22 +0000

[...] lost a sense of of how the pieces of their risk management worked together. (See my earlier post: The Risk Management Formula That Killed Wall Street.) You need to understand the data, understand the weaknesses of the formulas that manipulate the [...]

By: Doug

Doug — Fri, 27 Feb 2009 00:22:49 +0000

Dhlii -
I do not think it is the lack of a free market. I think it is illustrative of the herd mentality on (what is left of) Wall Street. It overreacts to good news, oversells for bad news and abuses the same strategies.

By: dhlii

dhlii — Thu, 26 Feb 2009 23:06:44 +0000

In a truly free market there are supposed to be multiple buyers and sellors and they are not all supposed to be using exactly the same model. This greatly increases the odds of red flags popping up. Part of the problem with “too big to fail” is that those institutions are “too big to succeed”. If diversification matters for individual investors – then it matters for the rest of the marketplace too. When everyone is going the same direction – whether following the same formula, or a single guru, or a government mandate, then on occasion everyone will be wrong – and it is that failure case that invites disaster. It is not that Merrill Lynch improperly assessed the risk of mortgage backed securities, it is that virtually everyone used the same risk model.

By: Doug Cornelius

Doug Cornelius — Thu, 26 Feb 2009 00:34:01 +0000

Toby -

Thanks for stopping by.

It sounds like the dynamic of having an ultra-smart economist coming up with a formula being used by managers who do not understand the underlying weaknesses and assumptions in using the formula. It is pretty clear form the fall-out on Wall Street (and the survivors) as to who understood the math.

By: Toby Brown

Toby Brown — Wed, 25 Feb 2009 23:08:13 +0000

As a recovering economist, this is an interesting concept. I thought only ivory tower econ professors made such leaps of faith. People have always questioned why economists aren’t all rich. Now we now why. Just because a math formula sounds sophisticated and powerful, does not mean you shouldn’t question the assumptions.

Nice post.