During that time, investors want to have more compensation on their investment, so in order to earn more; they usually take additional risk, which called the pricing of risk. The incremental compensation might be measured by interest rates or fees. However, being a market participant, they must calculate accurately the risk with the financial situation. Unfortunately, they did not really accurately measure the risk with the financial innovation such as mortgage backed securities (MBS) and collateralized debt obligations (CDO). Besides, they also did not understand the effects that may caused on the overall stability of the financial system. There are two examples that related to the above statement in the followings:
Pricing model for CDO
During that time, the pricing model for CDOs did not accurately reflect the level of risk they introduced into the system. In this case, the bank estimated that they can sell $450bn of CDO between the late of 2005 to the middle of 2007. Among the $120bn of CDOs, it had been liquidated. For the high quality of CDOs, JPMorgan estimated that the average recovery rate was almost thirty two cents on the dollar. However, the recovery rate for mezzanine CDO was only approximately five cents for every dollar.
AIG used the usage of credit default swaps to insure the obligation of various financial institutions. In this case, AIG normally received a premium in exchange for a promise to pay money to one party in the event another party defaulted, which was the basic CDS transaction. In fact, when AIG faces many CDS commitments, it actually did not have the financial strength to support its. Unfortunately, it had taken over by the government in September 2008.During 2008 and early 2009, over $180 billion have been provided by the U.S. taxpayer in government support to AIG. That amounts has flowed to various counterparties to CDS transactions. It had included many large global financial institutions.
However, the financial model was hard to understood and was not properly understood due to the limitations on its. In the financial model, due to the high tractable which further means that it rapidly came to be used by a huge percentage of CDO and CDS investor, issuers, and rating agencies, so the formula assumed that the prices of the CDS was correlated with and it can predict the prices of mortgage backed securities correctly.
Finally, the nightmare had begun. When financial markets started behaving in ways that users of Li's formula had not expected, the cracks began appearing early on.
About Li's formula
Before we started to discuss about the cracks in year 2008, let us introduce some concept about the Li's formula. There is a guy who called David X.Li, is the person who applied Li's formula in year 2000. Li's not only work on price up the CDOs, but also measure the risk that had more impacts and quickly then others previous economists who won the Nobel-Prize. However since the Great Depression, he started to determine correlation and cracked it wide open in a very simple and elegant mathematical formula, it started to become a formula that normal in the finance worldwide area.
Li's formula also known as a Gaussian copula functions for five years. It looked like more clearly, more accurate and more ease than before that allowed hugely complex risks to be modeled with by a piece of financial technology. From his brilliant mind-set about the mathematical way, Li has made it possible for the trader to sell vast quantities of new securities. In this way, the financial markets have been expanded to the higher levels that unimaginable.
In the bond market, which further mean that the multitrillion-dollar system that allowed to lend trillions of dollars to companies, countries and home buyers through pension funds, insurance companies, and hedge fund. A bond is just like an IOU that promise to pay back money with interest by a certain dates. During that time, bond investors, Wall Street banks, ratings agencies and regulators were adopted Li's method and deeply involved in it. This method has lead many people to make much money in the bond market. However, there are lots of warnings about the limitations of the method but ignored by largely people. And lastly, the cracks seriously occurred in the year 2008 and lead the Li's Gaussian copula formula downturn in the history. It had caused lots of losses and brought the world financial system become worst.
Both the international bond rating agencies and bank regulators started to rely on the investors. The investors is now who wanted to reassure the fact as the financial assets is now become more complexity and harder to value on its. So, the international bond rating agencies and bank regulators had accepted some complex mathematical models that showed the risks were smaller than they actually proved it.
George Soros who is a Hungarian-American currency speculator, and popular in stock investor stated that when the new products had become so complicated and hard to calculate the risks, the super-boom got out of hand. The risks are now started relying on the risk management of the bank themselves. At the same time, the rating agencies also relied on the information not itself but provided by the originators of synthetic products. It can be considered as irresponsibility.
http://finance.blogs.ie.edu/archives/2009/03/li-a-revolution-after-black-scholes-formula.php
