In order to keep this blog from being drier than a popcorn fart in July, I will forgo detailed statistical treatises.
Most modern historical accidents relied on a blind belief in correlation statistics. The belief that the non occurrence of co-incident events in the past surely indicates the un-likely event these events could bump into each other in the future.
Many financial modelers have had the good fortune to replace common sense with a PhD. This has lead them to great salaries and recognition at least temporarily on Wall Street. The recognition will continue for some time in the future but will alas not be conjoined with good cheer and great salaries.
Most of the accidents in finance, the current CDO and CDO squared bubble are due to the dubious belief that past relationships are indicative of future relationships. In a closed physical system this is true. For the rest of the real world it is not. As Warren Buffet has stated if the past was a way to predict the future, then the wealthiest people on the planet would be librarians.
Mathematicians who aren't known for being famous with relationships in the real world are taken far too seriously when it comes to the financial world.
For the mathematicians in the audience please wake up and realize the financial world is not a loosely coupled Hilbert space.
Being a recovering quantitative analyst I can assure you that the faith placed in financial math models is scary. I have worked with 2 of the world's largest global banks albeit in jr. roles and wrote my masters thesis at a top engineering school on quantitative approaches for hedge funds.
The greatest danger in finance is the ever shrinking *. The * (asterisk) starts life in the world as a caveat or warning that a model rests on certain assumptions. As money is made and people want to believe, the asterisk seems to shrink and disappear in importance. After the inevitable accident the stunned financial modeler will bring back up the * in order to save his own asterisk. The current asterisk that should be quoted in regards to CDO's and CDO's Squared is "Assuming the correlations in mortgages debt holder payback etc. holds steady."
Many a flawed Markovitz asset allocation has fallen foul of the correlation error. As products are created that are ever more "Markovitz efficient", such as structured products we will all be at risk of correlations that are larger than they appear in the rear view mirror.
The next big Asterisk to read about will be RMBS (retail mortgage backed securities) and the inevetible failure of a few CDS (Credit default Swap) counter-parties. This will lead to yet more banking problems.
Unfortunately the problems of the credit crisis are still unfolding. Things will most likely be improving by 2009, but the nadir has not been reached. A few banks are going to be caught out when "winning" CDS trades are activated by default events and the counter-parties are found to be troubled banks, iffy hedge funds or suspect trading vehicles. Full disclosure I make a living in the financial markets and trade based on some of the information in this blog.