imagination,’ financial mathematician Emanuel Derman once noted,
‘so that, inevitably, a model will be used in ways its creator never
intended.’[6]
Unfortunately, the mortgage models had some major flaws.
Perhaps the biggest problem was that they were based on historical
house prices, which had risen for the best part of two decades. This
period of history suggested that the mortgage market wasn’t
particularly correlated: if someone in Florida missed a payment, for
example, it didn’t mean someone in California would too. Although
some had speculated that housing was a bubble set to burst, many
remained optimistic. In July 2005, CNBC interviewed Ben Bernanke,
who chaired President Bush’s Council of Economic Advisers and
would shortly become Chairman of the US Federal Reserve. What
did Bernanke think the worst-case scenario was? What would happen
if house prices dropped across the country? ‘It’s a pretty unlikely
possibility,’ Bernanke said.[7] ‘We’ve never had a decline in house
prices on a nationwide basis.’
In February 2007, a year before Bear Stearns collapsed, credit
specialist Janet Tavakoli wrote about the rise of investment products
like CDOs. She was particularly unimpressed with the models used to
estimate correlations between mortgages. By making assumptions
that were so far removed from reality, these models had in effect
created a mathematical illusion, a way of making high-risk loans look
like low-risk investments.[8] ‘Correlation trading has spread through
the psyche of the financial markets like a highly infectious thought
virus,’ Tavakoli noted. ‘So far, there have been few fatalities, but
several victims have fallen ill, and the disease is rapidly spreading.’[9]
Others shared her skepticism, viewing popular correlation methods
as an overly simplistic way of analysing mortgage products. One
leading hedge fund reportedly kept an abacus in one of its
conference rooms; there was a label next to it that read ‘correlation
model’.[10]
Despite the problems with these models, mortgage products
remained popular. Then reality caught up, as house prices started to
fall. During that 2008 summer, I came to the opinion that many had
been aware of the potential implications. The investments were