There was something missing from last night’s premiere of Too Big To Fail, a made for HBO movie which portrayed the inner workings of the U.S. Treasury during the financial crisis on Wall Street back in 2008. By the time the movie was over, I was still having trouble putting my finger on it. It occurred to me while the credits rolled that I had written quite a bit about the crisis while it was going on, so I headed back to the archives of Brown Man Thinking Hard to see what I’d said.
It didn’t take long for me to figure out what felt wrong about the HBO dramatization after I typed the words “Wall Street” into the box marked “search” on my original blog. The buzzwords were all there – “CDO’s”, “toxic assets”, “sliced up mortgage securities” – and the cast of heroes and villains was complete, with everybody from Richard Fuld to Warren Buffet getting mentioned, but the writers didn’t go for the jugular because they didn’t bring up the Gaussian copula formula David X. Li came up with, the formula that allowed everybody on the Street to justify putting so much of their client’s money into mortgage backed securities.
When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market.
Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly). It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool.
What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.
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.
Despite leaving this fatal formula out of the script, the writers did a credible job with the story, building a fast paced narrative around the fear on Wall Street and in the government that led to such quick congressional approval of bailout funds. There was so little verbiage in Treasury Secretary Henry Paulson’s original legislative proposal for a Wall Street bailout, a fact lampooned in the HBO dramatization, that I created an illustrated version for my blog back in 2008 when the proposal was presented to Congress. The scene where Paulson assembled all of the CEO’s of the nation’s leading banks in one room at the New York Fed was reminiscent of the meeting at J.P. Morgan’s library during the Banking Panic of 1907, where old J.P. Morgan himself demanded that the stronger banks put up cash to bailout their weaker counterparts.
Actor William Hurt did a fantastic job of bringing complexity to the role of Treasury Secretary Henry Paulson, whose real life public persona was fairly bland. But the script ascribed almost all of the blame on the banking side to Richard Fuld, chairman of Lehman Brothers, and not enough to his fellow counterparts at Wall Street’s other big banks.
Dr. Jekyll is the bailout banker you've been seeing on TV lately. They are pale, with eyes that seem to blink too much, but that’s because they aren't used to the glare of so many flashbulbs and spotlights. The voices are soothing, convivial even, which is no mean feat, given the circumstances. These Dr. Jekyll's all seem to be clear eyed, sober men who have worked hard at their chosen professions, like most of the rest of the country does, looking for breakthrough new financial products and services the way a research physician searches for a cure for cancer. By the time the designated Dr. Jekyll of the week finishes his somber statement to the news media about how much these "toxic assets" have hurt his company's business, you are almost ready to pull out an envelope and a stamp to mail the poor fellow a check.
But when these munificent Dr. Jekylls are ensconced in the burl wood and leather confines of the company's corporate jet, or while they are pacing back and forth in their lairs atop the glass walled towers that houses their companies headquarters, it is the Mr. Hydes who often appear, their eyes bulging, their lips snarling, their breath hot and raspy as they fume about how terribly they are being treated by a finger pointing press and a raging public. These sinister alter egos reserve the brunt of their indignation, though, for the "toxic assets" on their balance sheets, those nonperforming mortgage loans that they have paid good money to have relabeled as something poisonous and alien to their corporate culture.