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Part II - The Blow UP From Technology Review
Derivatives allow banks to trade their mortgages like bubble-gum cards, and the separation of the holder of a loan from the writer of a loan tended to create an overgenerous breed of loan officer. The banks, in turn, were attracted by the enormous market for derivatives like CDOs. That market was fueled by hedge funds' appetite for products that were a little riskier and would thus produce a higher return. And the quants who specialized in risk assessment abetted the decision to buy CDOs, because they assumed that the credit market would enjoy nine or so years of relatively benign volatility.
It was a perfectly rational assumption; it just happened to be wrong. Matthew Rothman, a senior analyst in quantitative strategies at Lehman Brothers, called the summer a time of "significant abnormal performance"; according to his calculations, it was the strangest in 45 years. James Simons's Renaissance Technologies fund slid 8.7 percent in the first week of August, and in a letter to his investors, he called it a "most unusual period." As Andrew Lo put it, "Unfortunately, life has gotten very interesting." The Wall Street Journal called it an "August ambush."
The damage quickly spread beyond the market for low-quality debt instruments. It was almost as if the financial world had become a market for nothing so much as standard deviations, the mathematical term for the spread of values straying from a mean. In fact, the summer might be described as a time when too many investors had purchased standard deviations that were too high for their means.
It was a perfectly rational assumption; it just happened to be wrong. Matthew Rothman, a senior analyst in quantitative strategies at Lehman Brothers, called the summer a time of "significant abnormal performance"; according to his calculations, it was the strangest in 45 years. James Simons's Renaissance Technologies fund slid 8.7 percent in the first week of August, and in a letter to his investors, he called it a "most unusual period." As Andrew Lo put it, "Unfortunately, life has gotten very interesting." The Wall Street Journal called it an "August ambush."
The damage quickly spread beyond the market for low-quality debt instruments. It was almost as if the financial world had become a market for nothing so much as standard deviations, the mathematical term for the spread of values straying from a mean. In fact, the summer might be described as a time when too many investors had purchased standard deviations that were too high for their means.
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