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The real world of Wall Street

March 16, 2009

People often contrast “the real world” against the world of academia. (The conjunction of “real world” and “academia” gets over a million hits on Google. I assume that only a tiny fraction refer to humanities dissertations about the MTV show.)  The idea is that we live in a world of ideas, protected from reality. We traffic in fuzzy abstractions, and the things we do are only tenuously connected to anything of tangible value to the world that most people live and work in.

I happen to think that’s not a very accurate view of academic psychology. But it has occurred to me that the indictment against the ivory tower seems to apply quite well to the supposedly real world of Wall Street finance over the last couple of decades.

That observation jumped out at me reading Wired‘s March cover story on quantitative finance. The article focuses on a statistician, David Li, who chose Wall Street over academia. Li came up with new a way to calculate the probability that a bundle of securities would all default at once. Previously, this had been done by looking at the historical performance of similar securities, which meant that new types of securities could not be priced with much confidence. Li’s approach bypassed the historical approach and quickly became the de facto standard on Wall Street:

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. [emphasis added]

As other observers have pointed out before, a major problem with the derivatives market was that it was so far removed from the actual value of whatever the derivatives were derived from — mortgaged houses, the capital and products of a corporation, etc. Wall Street, in other words, was trading abstractions without really thinking about their relationship to the real world. Sound familiar?

And what’s especially interesting about the Wired article is who it credits for sounding the alarm bells (which were ignored by Wall Street for a decade). It was a bunch of academics:

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.

Real world, indeed.

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