Mark to Market

I stared at a macro formula embedded in this massive Excel spreadsheet with $32B debt financing portfolio. This was the only piece that had stopped me from understanding the flow through the whole spreadsheet. After I googled for half an hour, I was still not completely sure. Without hesitation, I placed a call to Richie.

"Cubic Spline is a non-linear function with at least two known points on the curve to determine the 3rd one. It is normally used in the yield curve of fixed income..." Richie explained the concept clearly within a minute.

"Now I understand why they built this macro in. Wow, math genius! No wonder you have so many degrees." I exclaimed.

"Yeah, that translates to a half-idiot by your standard!" he retorted.

"I am quite close, quite close." I replied jovially while putting down the headset.

I always believe that the number of degrees and/or professional designations is inversely related to how far you could go in career. High IQ is not necessarily transferrable in the development of excellent soft skills, which are key to advance careers in the corporate world. But I have to admit that there are exceptions. With 5 academic degrees and after teaching at the top university in China and Canada for more than half of his career, Richie has succeeded in moving up the corporate ladder and holds a very senior position in risk management at the largest bank in Canada. Like Richie, there are a handful of senior professionals nicknamed as "the quants" from mainland China active in the risk management field on Bay Street in Toronto, equivalent to Wall Street in New York. Probably and arguably the most famous one is Dr. David X Li, an original Bay Street export to Wall Street.

Educated in China and trained academically and professionally in Canada, Dr. Li pioneered Gaussian Copula model for the pricing of collateralized debt obligations (CDOs) in early 2000s in US. With its simplicity and ease for understanding, the model had since been frequently used to value CDOs for a wide range of investment vehicles previously deemed too complex to price until the collapse of financial services industry in late 2008, after which time the formula has been labelled as "recipe for disaster”. Maybe Dr. Li sensed the danger inherent in the system he had helped establish. By 2005, Dr. Li was among those warning about the limitations of his model. "The most dangerous part is when people believe everything coming out of (the model)," he told The Wall Street Journal once. He also wrote: “The current copula framework gains its popularity owing to its simplicity. However, there is little theoretical justification of the current framework from financial economics. We essentially have a credit portfolio model without solid credit portfolio theory.”

I only came to know Dr. Li's name when Richie, who is Dr. Li's good buddy at the University of Waterloo and ex-coworker at the bank, sent us an article titled "The Formula that Felled Wall St." published at the height of the financial crisis by Financial Times. The article instantly generated heated exchange of emails amongst ourselves. The theme was obviously focused on whether Dr. Li shall be blamed for the crisis. The argument finally came to a pause with a conclusive email from Yong, another Bay Street legend.

“David Li didn't blow up Wall Street, but certainly supplied the matches. 
David had laid a foundation for Copula framework. His original idea was quite innocent. The market has gone way too far after his publication. What a world, a mathematician can be so "dangerous"! The total loss of this financial crisis is over 10 trillions, which has exceeded the total damage of the first and second world war.”

While I was drafting my evaluation report of the debt financing, my mind could not help wandering. In accounting, financial instruments are usually calculated at market (fair) value, which is termed as “mark to market”. Remembering several minor tricks I made in pricing stock options before, I chuckled at the thought of Richie’s famous yet ironic comments:

”Mark to market, I would rather call it mark to model.”

If there is absolutely real objectivity, the world would have become a much less “exciting” place, wouldn’t it?