bugfox blog

In The Quiet Coup Simon Johnson, former chief economist for the International Monetary Fund (IMF), says that the current financial crisis resembles on a larger scale the sort of messes that emerging markets get into. He says that if we don’t want things to get worse we need to impose the kind of reforms that the IMF would demand of a small country that came to it for help.

Megan McArdle seems sympathetic to this notion, but in Foreigners + Money = Crisis? she points to claims that the IMF thoroughly botched its handling of the Asian financial crisis of 1998, which like the current crisis had a lot to do with countries being flooded with volitile foreign investment.

Wired tracks down the actual mathematical formula used by the investment bankers and credit rating agencies to wreck the economy.

Maybe it’s unfair to blame David X. Li, who did warn that his formula was being used inappropriately. (On the other hand, he did say it was “better than nothing”, which seems not to have been the case.) Probably if the Gaussian copula function did not exist, the whiz kids would have found something else.

Greg Newton dug up a series of photos that seems to do a nice job of explaining the system.

Michael Lewis, the author of Liar’s Poker, delivers a blow by blow account of the final days of the subprime bubble, from the viewpoint of some people who not only predicted the collapse but managed to profit from it by shorting subprime derivatives. (via Tim Bray.)

Some of Lewis’s observations:

• He mentions the central role played by the bond rating agencies, who screwed up in a big way. Amoung other things Standard & Poors apparently relied on a computer model that did not take into account the possibilty that home prices might fall. Most of the institutional safeguards intended to keep something like this from happening relied on these agencies to give reliable ratings. Some sort of reform is probably needed to address the conflicts of interest that they face.
• He thinks the problem really started when investment banks first switched from partnerships to public corporations. A partner is personally liable for the firm’s debts and thus has strong incentives to make sure that it doesn’t take on insane levels of risk. A corporate executive knows that it’s the stockholders who bear the risk, and thus will be tempted to take big risks in order to earn big bonuses.