Harvard Cooks its Wall St. Goose (and everyone else's)

After serving time at Enron, Iris M. Mack signed on to be a quantitative analyst for the Harvard Management Company which manages the university's humongous $38 billion! endowment. She had hoped her new job would not only prove secure but far from the questionable trading and accounting practices that forced Enron into bankruptcy.

Mack was fired a few months later. Why? It seems that Mack sent an e-mail to the chief of staff for then-Harvard President Lawrence H. Summers, in which she detailed her concerns regarding HMC’s “frightening” usage of derivatives and statistical modeling techniques, the Company’s lack of a portfolio-wide risk management system, high employee turnover rate, and low level of productivity, specifically among its managers.

You would think the institution that serves as a virtual freeway to Wall Street would be more solicitous of its homage-driven treasure. Sadly, it seems, despite its staggering resources and sparkling prestige, ever since it began churning out tongue-lolling MBAs instead of philosophers and anthropologists that esteemed cathedral of learning has been minting numskulls and suckers. In fact the correlation can be made the more Harvard grads on Wall St. the worse for the markets. As one pithy analyst notes:"Despite their reputation as future business leaders, Harvard grads are perpetually behind the curve."

How else to explain that not one of the Clinton administration's Yard-trained wizards caught the lethal fallacy lurking in the formula concocted by a Chinese mathematician that has sent the entire U.S. economy into the dumpster? Well at least partly we can blame it on greed.

The conundrum of "liberalizing" capital is that to achieve those exponential returns for the rich who've demanded more and more of the pie there needs to be more and more "profitable" investments--but those constant returns depend on two opposing conditions: lower wages and higher consumption. Enter Mr. Li.

In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps.

(If you're an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream—interest payments or insurance payments—and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.)

It was a brilliant simplification-- Li didn't just dumb down the thorny workings of correlations; he decided the only thing that mattered was the final simple, all-sufficient figure that sums up everything. And not a single Harvard whiz-kid said "whoa..."

Instead Li's magic formula inspired every Wall Street quant with dreams of Vanderbilitian riches. Of course, there were the usual contrarians who warned about such magical thinking, but the bankers were too busy making money out of thin air and none of their critics had apparently studied at Harvard-- or were named Summers, Rubin or Geithner.

As for Mr. Li, he now works for a hedge fund in China.