Recipe for Disaster: The Formula That Killed Wall Street

The Gaussian copula formula.
“The most dangerous part is when people believe everything coming out of it.” Mr. Li, the inventor of the Gaussian copula function.
Key explains: “I had a whole lot of people working for me who were at the cutting edge of delivering quite complex and new and innovative products. They tended to either be a new product or into a new market, usually the emerging markets, Russia, Brazil, Argentina. I wasn’t the guy sitting there dreaming it all up, but I was the guy who was responsible for those people.” Did he foresee the problems which resulted in the sub-prime crisis? “Was it hard to predict? Not really.” John Key, 19 July, In search of John Key.
The mr. Li named in this article was never employed by Merrill Lynch, he was however by no means the only “Quant” on Wall street. John Key knows all about quants and what they are capable of. It was after all two of the original quants that made Merrill Lynch both rich and poor while John Key was both Global head for Foreign Exchange and European head for Bonds and Derivatives when Merrill Lynch stood to loose $ 1.5 billion (according to John Key) when the LTCM hedgefund collapsed after their computer model turned out not to cater for the fact that Money markets (in this case the Russian Rouble) can actually default. It was after all the fact that he was tasked to fire all his colleagues and he did so with a big grin on his face that people started to call him the “Smiling Assassin”.
In the mid-’80s, Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly… until one of them devastated the global economy.
Photo: Jim Krantz/Gallery Stock

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li’s work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

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.

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