The Great Recession – Made In China?

Economics has never been a science – and it is even less now than a few years ago.
–Paul Samuelson

Did the arcane formulation above, devised by a Chinese mathematician named  Lǐ Xiánglín, collapse the world’s financial markets just as surely as E=MC² destroyed the cities of Hiroshima and Nagasaki in 1945?  Well, it sure didn’t help.

Lǐ Xiánglín, as David X. Li, unveiled his brainchild (On Default Correlation: A Copula Function Approach) in 2000, 13 years after being dispatched to Canada from the People’s Republic in order to study capitalists in their own lair.  Li’s formula, known as a Gaussian copula function, was

used to figure out the risk in a pool of debts, like a mortgage-backed security. Or, to put the matter in the negative: It puts a number value on the danger that the mortgages could default at the same time. (Gaussian refers to a normal distribution, or bell curve, and copula refers to the behavior of more than one variable.)

Formula From Hell (Forbes)

While Li was modeling his equation, the U.S. Congress was busy repealing the part of the Glass–Steagall Act that had prohibited a bank from offering a full range of investment, commercial banking, and insurance services.  This was part of a compromise effected by Democratic senators Christopher Dodd and Charles Shumer in order to expand the scope of the Community Reinvestment Act, a piece of liberal legislation that essentially coerced financial institutions into granting mortgage loans to low-income applicants.  So when Li published his paper, it was received by bankers and Wall Street traders like manna from heaven.  It allowed them to price (and sell) what would normally be high-risk securities in packages called Collateralized Debt Obligations (CDOs).  The boom was on; and

[…] for five years, Li’s formula…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. (Recipe For Disaster: The Formula That Killed Wall Street)

Following the 2008 debacle, David X. Li returned to the People’s Republic to resume life  as Lǐ Xiánglín.  He is now in charge of the risk-management department of China International Capital Corporation, an interesting posting for the man who manufactured the rope by which the Western economies hung themselves.

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About Bob Mack

Retired since 2003. Military Service: U.S. Army, 36th Artillery Group, Babenhausen, Germany 1966-67; 1st Signal Brigade, Republic of Vietnam, 1967-68 Attended University of Miami, 1969-73
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3 Responses to The Great Recession – Made In China?

  1. While Li was modeling his equation, the U.S. Congress was busy repealing the part of the Glass–Steagall Act that had prohibited a bank from offering a full range of investment, commercial banking, and insurance services.

    One of the linchpins that has played into our recession.

    Good post, Bob.

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