hi all, Ive been wanting to write this post for a long time, ever since I found an excellent article in wired that was in fact a cover story. "the formula that brought down wall st" . it talks about the "gaussian copula" function.
as a younger dude I had dreams of making it big as a "quant". (short for "quantitative analysis"). for many years Ive played around with the statistics of stock markets, and statistical analysis, and put in a level of work that might be a little embarrassingly large looking at it in retrospect.
its a very interesting area to work in, and its some of the most unruly data you can possibly work with. I do think there are very slim trends that can be datamined out of it. but when you add up transaction costs [cost to buy and sell] and "slippage", the tendency of a stock to cost more than the published price, and then add up all the tax complexity, its a very difficult area.
there is a whole other line of thinking by Nassem Taleb, now a very high profile/fierce critic of mathematics [or the inherent limitations, and its deceptive risks], who argues that anything using correlation analysis in finance is mistaken. I tend to agree with this pt of view.
now, I agree with all these analyses, but during the crash/panic of 2008, a lot of different voices and ideas were heard about what "caused" our system to crash. it does seem clear there was some kind of systemic problem.
my bottom line/conclusion after a lot of reading and thinking on the subject. the basic issue seems to be vast mortgage pools made out of subprime loans that were a relatively new financial invention. therefore, our regulatory bodies did not keep up with the risks. clearly, a large subprime pool of stocks, after actively traded a lot, paradoxically/counterintuitively begins to take on the risks of an index of stocks.
so roughly, we had rules to regulate this that were either very weak or poorly thought out, not thorough, patchwork. it was a hodgepodge. there was no agency that you could point to in particular that was responsible for the failure.
in my opinion the Fed deserves the most blame, but again there, the administration/headed run by Bernanke [who at the moment, I am strongly hoping/advocating he not be reconfirmed] has resisted strongly the implication that it failed spectacularly. this is the familiar bureacratic excuse, "its not my job" at the level of entire government agencies. "its not my department". "its not my agency"
think about it. in a well designed system, it wouldnt matter if individual corporations used wrong math formulas to value their assets. isnt that the role of regulation? Too Big to Fail is a massive Fail itself. its the role of regulation to prevent the kind of systemic failure that we exprienced in 2008.
so yeah, math is powerful, amazing, and magical at times, and the quants increasingly run wall street, but you cant really blame quants for the problem of systemic blindness and "not my agency" (by the way, "not my agency" is also virtually exactly the same problem we have with the multibilliondollar so called "intelligence" complex, but thats a whole other can of worms....).
we need a regulatory regime that can deal with all the fast paced "financial innovation", some of which of legitimate, much of which is not. the regulatory system's job is to be dubious, recognize smoke and mirrors when it finds it.
it would also seem we need an expert in "bureacratic architecture". we already have multibilliondollar regulatory agencies who historically, effectively add up to something that is less than the sum of their parts!! how do you build a system that coordinates multiple agencies and avoids holes and cracks between them? this is a sort of deep zen question that nobody in government asks. because they are like fish swimming in water. the invisible ubiquitous water is "agency glasses" or "agency lens".
and the idea of creating a new consumer protection agency is probably a feeble and destined-to-fail idea, in my opinion. agencies already existed whose job it was to regulate, and they failed. you do not solve that problem by introducing a new agency. but thats washington, if you want to make a bold move, you suggest that we need a new agency....
The Minds Behind the Meltdown
How a swashbuckling breed of mathematicians and computer scientists nearly destroyed Wall Street
How maths killed Lehman Brothers
by Horatio Boedihardjo
Recipe for Disaster: The Formula That Killed Wall Street
Why nerds must rescue the American economy
Lack of math skills contributes to consumers getting ripped off
Darpa: U.S. Geek Shortage Is National Security Risk