Recipe for Disaster: The Formula That Killed Wall Street

"Recipe for Disaster: The Formula That Killed Wall Street," (Feb. 23, 2009, wired.com) was the first article published by any widely read news organization that postulated the mathematical origin of the Financial crisis of 2007-2009. Written by Felix Salmon, the article explains that David X Li invented the Gaussian copula function, which was used by banks, lenders, insurance companies, and others to rapidly and cheaply price Collateralized debt obligations. Although the formula was designed to help calculate and price risk, the article exposed how the underlying assumptions built into the formula actually magnified and sytematized the risk, rather than reduced it.
The largest and most fundamental assumption underlying the formula was that the price of credit default swaps were correlated to and could predict the value of Collateralized debt obligations.
According to the article, "In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled 'On Default Correlation: A Copula Function Approach.' (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps."
Shortly after its publication, the article was widely read, receiving a large amount of attention in the blogosphere, on digg, and resulting in a number of other articles about the formula.

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