In 2007, the total value of an exotic form of financial insurance called Credit Default Swap (CDS) reached $67 trillion. This number exceeded the global GDP in that year by about fifteen percent. In other words – someone in the financial markets made a bet greater than the value of everything produced in the world that year.
What were the guys on Wall Street betting on? If certain boxes of financial pyrotechnics called Collateralized Debt Obligations (CDOs) are going to explode. Betting an amount larger than the world requires a significant degree of certainty on the part of the insurance provider.
What was this certainty supported by?
A magic formula called the Gaussian Copula Model. The CDO boxes contained the mortgages of millions of Americans, and the funny-named model estimated the joint probability that holders of any two randomly selected mortgages would both default on the mortgage.
The key ingredient in this magic formula was the gamma coefficient, which used historical data to estimate the correlation between mortgage default rates in different parts of the United States. This correlation was quite small for most of the 20th century because there was little reason why mortgages in Florida should be somehow connected to mortgages in California or Washington.
But in the summer of 2006, real estate prices across the United States began to fall, and millions of people found themselves owing more for their homes than they were currently worth. In this situation, many Americans rationally decided to default on their mortgage. So, the number of delinquent mortgages increased dramatically, all at once, across the country.
The gamma coefficient in the magic formula jumped from negligible values towards one and the boxes of CDOs exploded all at once. The financiers – who bet the entire planet’s GDP on this not happening – all lost.
Hellbound and Down 