Drifting into Failure: Complexity Theory and the Management of Risk

Abstract

The Gaussian copula, an equation first published by David Li in 2000, was a beautiful thing—in isolation. Its intention was to price collaterized debt obligations, and work out whether they were moving in the same direction. The copula was an enabler of mortgaging the most hopeless of homeowner prospects. Millions of securities could be traded on the back of a single number (a security is something that shows ownership, or right of ownership of stocks or bonds, or the right to ownership connected with derivatives that get their value from some underlying asset). As more and more webs of interactions and relationships and interdependencies and feedback loops started growing around it, however, it became part of a complex system. The copula became the trigger of a recession that swelled the number of homeless families in the US by 30% inside of two years (Associated Press, 2010). It ended up bringing global lending to a virtual standstill, triggering a worldwide financial crisis and a deep recession. How did a once good idea like this drift into failure, and how can such a risk of collapse be managed? That is what this chapter is about.