Of all the pieces about how the financial crisis unfolded, Felix Salmon's careful account of the mathematical formula that allowed Wall Street to defy reality and common sense for so long was one of the most helpful. It's in some ways an impenetrable story of self-interest and blindness and greed; in other ways, it is simply a parable of how human beings can only rely on rules they can actually understand. They were, we now realize, winging it. Until reality bit:
For five years, [David X.] 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 entrenchedand was making people so much moneythat 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 2008when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.
And it wasn't the math-wizard's fault. It's what the fools and greedheads did with his creation.
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