Wired has an article called Recipe for Disaster: The Formula That Killed Wall Street. It's about how a mathematician came up with an idea of how to easily quantify the coupling of risks in individual cases that investors want to know so they can make better decisions. For exmaple, you know that one investment has a given chance of going into default, and that one debt arrangement is bundled with others to make a bigger financial instrument in which you could put money. If one starts going badly, are others also more likely to head south, or are the individual risks really independent of each other? You need to know the answer if you're going to intelligently understand the risk.

The solution was a formula using a technique called a Gaussian copula function. All of Wall Street rejoiced because suddenly it was easy to calculate risk without waiting for historic data:

The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

And then, eventually, the market imploded. But when you look at the approach the mathematician took - examining the historic prices of credit default swaps - you start to see just how stupidly so many in finance acted:

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. 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.

The article focuses on how you cannot count on the correlation of financial securities, because risks that seem out of sync one day can suddenly all manifest at the same time.

I'll put it a little differently than stated in the article becuase I think there's an even more fundamental point that financiers missed. Like any market, CDO purchases largely move on emotion - it's one of those indisputably human activities. When people think they are safe, they will do the most astoundingly stupid things because they simply don't perceive danger.

CDO prices are an accurate historic measurement of what people thought risk was, not of the actual inherent risk of the underlying investment on which the CDO was taken. So all of these investment decisions were made based on looking at people's perception of risk, whether right or wrong, and not the actual risk. No wonder everything blew up. It was like betting on the results of a card game when you weren't one of the players, didn't know their history of success, and couldn't see any of the cards. Here's the scary part: the people who didn't notice the difference are the ones still in charge.

The Disease That Was Subprime Lending

Those who think that the subprime mess was an unfortunate accident that could not be anticipated by management should read a BusinessWeek story called Sex, Lies, and Subprime Mortgages. Fraud and trading of sexual favors for mortagages that could be bundled into hot securities were supposedly common, and whistle blowers were shut down by managers who didn't want the good times to end. What went on was literally criminal, and I suspect that the major Wall Street institutions simply turned blind eyes to everything in their quest of deals that could yield profits and a quick exit before the players got caught. Unfortunately, the collective moral depravity set off a chain reaction that we will be facing for years. It does make me wonder what similar may have gone on in credit default swaps, credit card-based CDOs, and other such debacles.

Credit Card Derivatives: Facing Reality, One Step at a Time

The amount of single-minded focus that the media has placed on the mortgage market and the collateralized debt obligations surrounding it is nothing more than a fad. I don't mean that the problem is a fad - far from it. This is part of something bigger that is here to stay for many years. But the media pays attention like an industry with ADD. Journalists have grabbed on this because it was big and bright, essentially as it latches onto a story about a celebrity or the murder of a pretty coed.

But the financial crisis is much more than mortgage-based CDOs and the London inter-bank rates. According to whom you ask, the derivatives market has hit between 1 and 1.25 quadrillion dollars. Yes, a thousand trillions. That is so massively beyond the size of the 50 trillion GDP of the entire world as to be stunning and scary.

We've seen two shoes drop in mortgages and credit default swaps (which is continuing to evolve as more defaults happen and more institutions become liable for the "insurance" they offered). Chances are strong for future rounds of stock market plummets as companies continue to need cash to cover their positions and sell securities to get it.

The next one is likely credit card derivatives. As I've mentioned before, there's an entire bond market created in the bundling of credit card and auto loan debt. I have yet to find a good estimate of the total market size. But consider this: a large part of the quarterly $5.29 billion write-off that AIG took in the last quarter of 2007 was for credit card derivatives exposure, possibly through credit default swaps. And around the end of September, Citi said that it "faced up to $10 billion in credit losses, partly because of rising credit card defaults."

Subprime mortgages got into enormous trouble with, what, a ten percent default rate? Last quarter, U.S. banks charged off 5.47 percent of all credit card loans, or about $50 billion. That was up from 3.85 percent in 2007.

To be sure, credit cards don’t represent a huge portion of assets for most banks. For example, they comprise about 14 percent of all consumer loans and leases at Bank of America, the country’s largest credit card issuer. The main problem, Nishikawa said, is that “everyone is so weak after what happened with mortgages that another blow to a consumer product would be hard to handle.”

Consumer groups have long complained that credit card issuers push cards onto people who don’t need them or can’t afford them. They say rising credit card defaults —- just like mortgage defaults —- are largely the fault of banks who lent to risky borrowers.

Innovest estimates about 30 percent of Bank of America’s credit card loans are to subprime borrowers —- second only to the failed Washington Mutual Inc., which had almost half of its credit card loans held by subprime borrowers.

What that story doesn't say is that in the event of a mortgage default, the bank still owns the property -- probably not longer at the value the bank had assumed when writing the mortgage, but still something. Credit cards? Totally unsecured. And when auto loans go bad, the car has lost enormous value once driven off the lot.

Even if the credit card and auto CDOs are smaller than CDOs based at least in part on subprime mortgages, the impact they'll have has the potential to be far larger.