C&B Notes

No Simpler

Einstein (supposedly) said, “Everything should be made as simple as possible, but not simpler.”  Trying to capture complex concepts in a single variable can lead to enormous mistakes.  This story about the Gaussian copula model dates back to the Financial Crisis and made us think about the shortcomings of using market volatility as a primary measure of risk.

For five years, Li’s formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before.  With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.  His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators.  And it became so deeply entrenched — and was making people so much money — that warnings about its limitations were largely ignored.  Then the model fell apart.  Cracks started appearing early on, when financial markets began behaving in ways that users of Li’s formula hadn’t expected.  The cracks became full-fledged canyons in 2008 — when ruptures in the financial system’s foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

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In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled “On Default Correlation: A Copula Function Approach.”  (In statistics, a copula is used to couple the behavior of two or more variables.)  Using some relatively simple math — by Wall Street standards, anyway — Li came up with an ingenious way to model default correlation without even looking at historical default data.  Instead, he used market data about the prices of instruments known as credit default swaps.

If you’re an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting.  Either way, you get a regular income stream — interest payments or insurance payments — and either way, if the borrower defaults, you lose a lot of money.  The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn’t constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.  Though credit default swaps were relatively new when Li’s paper came out, they soon became a bigger and more liquid market than the bonds on which they were based.

When the price of a credit default swap goes up, that indicates that default risk has risen.  Li’s breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market.  It’s hard to build a historical model to predict Alice’s or Britney’s behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice.  If it did, then there was a strong correlation between Alice’s and Britney’s default risks, as priced by the market.  Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

It was a brilliant simplification of an intractable problem.  And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool.  What happens when the number of pool members increases or when you mix negative correlations with positive ones?  Never mind all that, he said.  The only thing that matters is the final correlation number — one clean, simple, all-sufficient figure that sums up everything.

The effect on the securitization market was electric.  Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities.  And the first thing they did was start creating a huge number of brand-new triple-A securities.  Using Li’s copula approach meant that ratings agencies like Moody’s — or anybody wanting to model the risk of a tranche — no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

As a result, just about anything could be bundled and turned into a triple-A bond — corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them — an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included.  But it didn’t matter.  All you needed was Li’s copula function.

The CDS and CDO markets grew together, feeding on each other.  At the end of 2001, there was $920 billion in credit default swaps outstanding.  By the end of 2007, that number had skyrocketed to more than $62 trillion.  The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

At the heart of it all was Li’s formula.  When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable.  It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.

“The corporate CDO world relied almost exclusively on this copula-based correlation model,” says Darrell Duffie, a Stanford University finance professor who served on Moody’s Academic Advisory Research Committee.  The Gaussian copula soon became such a universally accepted part of the world’s financial vocabulary that brokers started quoting prices for bond tranches based on their correlations.  “Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus,” wrote derivatives guru Janet Tavakoli in 2006.

The damage was foreseeable and, in fact, foreseen.  In 1998, before Li had even invented his copula function, Paul Wilmott wrote that “the correlations between financial quantities are notoriously unstable.”  Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters.  And he wasn’t alone.  During the boom years, everybody could reel off reasons why the Gaussian copula function wasn’t perfect.  Li’s approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial.  Investment banks would regularly phone Stanford’s Duffie and ask him to come in and talk to them about exactly what Li’s copula was.  Every time, he would warn them that it was not suitable for use in risk management or valuation.


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