The villain has been found! And he's Chinese to boot! Now we can all relax and start hoping that the recession will go away soon. Once the witch is hanged, the town can get on with their lives ...
Or so the economics world thinks. An article in Wired discusses how the financial world used the Gaussian Copula function (now now, no giggles please) to estimate the degree of correlation between two mortgages - so, as we all by now, they could be diced into allegedly uncorrelated tranches and reassembled into AAA rated securities by magic. And from there began the great slide from which the global economy doesn't seem to be recovering any time soon.
Only, it wouldn't matter which function you use, the real problem in the whole story is the assumption that correlation between CDS prices and actual risk was solid.
Ok, I'll say that again in English. Certain securities called CDSs are bought and sold, which are essentially insurance against the risk that borrowers will default on loans. What Li did was use the correlation of prices of two different CDSs as an estimate of the correlation of their underlying risk, with some mathematical jugglery thrown in for good measure (or to confuse the non-quant MBA types, take your pick). Pricing a security based on prices of securities isn't good logic - that, folks is the financial equivalent of the good old logical fallacy of the circular argument. And as good circular arguments do, this one came apart when reality sneezed.
Not convinced? Consider the textbook example of circular argument
I believe in the existence of [insert favourite divine being] because it says so in [insert favourite religious text]
I know [favourite religious text] is true because it is the word of [favourite divine being]
The fallacy there is obvious to most, except to fundies, to whom that sounds perfectly logical.
Apparently, it wasn't obvious to the Wall Street types when they saw it, but in terms of their religion - the Market.
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