The Real—and Simple—Equation That Killed Wall Street

Chris Arnade in Scientific American:

“If it weren’t for those meddling kids!” That was the punch line for every Scooby Doo episode. It also is the overly simple narrative that many in the media have spun about the last financial crisis. Smart meddling kids armed with math hoodwinked us all.

One article, from the March 2009 Wired magazine, even pinpointed an equation and a mathematician. The article “Recipe for Disaster: The Formula That Killed Wall Street,” accused the Gaussian Copula Function.

It was not the first piece that made this type of argument, but it was the most aggressive. Since then it has been a common theme in the media that mathematics, especially obscure advanced mathematics, is largely responsible for the catastrophe that doomed the world to the last five years of recession and slow growth.

This theme plays on the fallacy that danger always comes from complexity. It’s a fabrication that obscures the real causes, that makes it easier to say, “Hey, it wasn’t my fault, I was blinded by science.”

The reality is much simpler and less sexy. Wall Street killed itself in a time-honored fashion: Cheap money, excessive borrowing, and greed. And yes, there is an equation one can point to and blame. This equation, however, requires nothing more than middle school algebra to understand and is taught to every new Wall Street employee. It is leveraged return.

What is leveraged return?  It’s the return on assets using borrowed money.

The equation for the leveraged return, L, is:

Where Y is the return of the asset, R is the cost to borrow money, and N is the “haircut,” or the percentage of money the investor must put down to secure the loan (the down payment).

More here.