In one of the acrobatic high points of 2009, the global financial industry has almost magically landed on its feet. Bankers were in spectacular trouble around a year ago, with entire portfolios going up in flames and banks tottering on the edge of bankruptcy. All is not yet well, but lifelines from taxpayers and costless money from central banks have saved banks and perhaps resurrected some of that old arrogance of the masters of the universe.
It is well known that the toxic waste conjured and sold in the bubble years contributed to the collapse. A new paper by four economists —Sanjeev Arora, Boaz Barak, Markus Brunnermeier, Rong Ge—sheds some new light on the issue. They show that there was just not enough computing power in the world to run the mathematical models that were supposedly used to price CDOs, one of the more toxic derivatives.
The usual critique of financial engineering is that some of the underlying math is plain wrong. What these four economists have shown is that CDOs simply could not have been priced. Interesting!