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Wednesday, February 25, 2009

One (and only one) contributing factor to the meltdown

Wired Magazine has a fairly good article describing one of the contributory factors to the meltdown - the Credit Default Swap market and the underlying model used to "price" the swaps.

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

What's the Gaussian copula model? Don't worry, most of the asset managers of the financial world don't and didn't know either. Here's a breakdown from Wired's story:

The upshot is that a single equation model was used to price credit default swaps regardless of what the underlying assets were. This sounds incredibly naive, and we see the results.

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