This post was first published in January 2010 on the FiduciaryX website. I am posting it again today on the new Bdellium blog just to have a complete record of my (few) previous posts in one location.

The cover story by Felix Salmon in Wired magazine’s February 2009 issue, Recipe for Disaster: The Formula That Killed Wall Street, provided an engrossing account of how the indiscriminate use of a single mathematical formula contributed to the meltdown in global credit markets.

Heads I Win, Tails You Lose

The risk-reduction benefits of pooling large numbers of individual credit risks depends critically on the probability of multiple defaults happening simultaneously. In a 2000 paper called On Default Correlation: A Copula Function Approach mathematician David Li (pictured above) described a method for calculating default correlations and using them to determine credit risk of collateralized debt obligations.

His approach, called a Gaussian copula function, was considered mathematically elegant but its safety for use depended critically on the accuracy of the input values. The attraction, but also the Achilles heel of the model, was that it derived key inputs from historical market prices of credit default swaps rather than requiring primary due diligence into the individual credits.

To quote the Wired article:

“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. “

In fairness to David Li, he acknowledged the danger of blindly using the model, as quoted in a September 2005 Wall Street Journal article How a Formula Ignited Market That Burned Some Big Investors (subscription required):

“The most dangerous part,” Mr. Li himself says of the model, “is when people believe everything coming out of it.” Investors who put too much trust in it or don’t understand all its subtleties may think they’ve eliminated their risks when they haven’t.”

So Wall Street institutions were faced with a choice – acknowledge that the model was a fine “concept car” but not yet ready for road use or ignore the risks, book billions in spurious profits and pocket millions for themselves. They choose the latter course. Why not, when the personal financial rewards for “winning” were huge and the losses would ultimately be borne by others. Wall Street played its one-sided game and some individuals did indeed walk away with millions of dollars before the house of cards collapsed.

Retirement Industry – Deja Vu All Over Again?

I have scanned the comments that were posted on the Wired article and they fall into two main categories – scorn (“so these so-called rocket scientists were stupid after all”) and disgust (“yet another scheme of evil Wall Street to fleece ordinary investors”). My reaction was somewhat different, probably because I tend to see things through the lens of the challenges facing pension fiduciaries. I was immediately struck by a strong and worrying similarity between this story of the CDO market and the actions of many fiduciaries within the retirement industry.

In summary, I believe that a large portion of the people charged with protecting the retirement security of plan participants are succumbing to exactly the same temptations and pressures faced by participants in the CDO markets. They know (or should know) that many of the methods they use to assess performance, manage risk and make decisions are inadequate or even fundamentally flawed. However, whether due to indifference, inexperience or inertia they are unwilling or perhaps unable to change even, ironically, when clear, simple, proven alternatives are available.

Choose To Do Better

Fiduciaries can wait for increased regulation and litigation to force change but the truth is that lasting change must be voluntary – it cannot be imposed. Alternatively, plan sponsors can use their collective power to ensure that product and service standards meet the real needs of those who ultimately pay the true cost – their plan participants.

During the past ten years I have met a small band of highly dedicated, highly experienced warriors who are fighting the good fight (sometimes at significant personal cost) to encourage and help fiduciaries change for the better. Unfortunately, some fiduciaries just don’t get it and never well. However, thanks in no small part to the efforts of individuals such as the developers of FiduciaryX, there are now many fiduciaries who know that “business as usual” will not get the job done and who are willing to make the effort to learn and apply better solutions.