How Stupidity on Wall Street Violated the Most Basic Laws of Physics

by Darwin on September 29, 2009

As a physical sciences and astrophysics buff, I was struck by the irony in some of man’s greatest and most enigmatic physical laws in contrast to some of the dumbest behavior imaginable by Wall street, politicians and main street for that matter.  I couldn’t help but compare some of the most famous physical laws we’ve come to know and love to what we’ve seen transpire in recent years in the investment and banking world.  You’ll surely recognize some of these venerable laws and theorems and surely the people rooted in the midst of frenzied wheeling and dealing on Wall Street and in the mortgage industry should have known that what they were doing was unsustainable, but in retrospect, there’s a tinge of irony in these laws in comparison to how things played out:

1 – The Law of Gravity

What comes up must come down

law-of-gravityphoto credit

Housing Market anyone? For years, the best and brightest minds in the world (physicists and math whizzes from the likes of MIT in fact) developed complex securitization models and derivatives products which quite foolishly assumed that US home prices would continue to appreciate at 6-8% per year when over 100 years of history dictates that home prices appreciate roughly in line with inflation – currently running at 2-3% per year.  Already way above the trend due to a secular bull trend with no actual change to fundamentals, these instruments of mass destruction brought the financial industry and the global economy to its knees during a reversion to the mean – during the fall back to earth.

2 – Conservation of Energy

Energy can neither be created nor destroyed

flame-image-matchphoto credit

Somehow, Wall Street and the frenzied home buying public created value out of nothing.  No down-payment loans and a blind eye to income verification turned home prices loose.  There was real estate flip speculation whereby someone with literally no income and no assets could purchase a condo in Miami for $400K and flip it for $460K the same week.  This went on for years, until the music stopped playing.  You can’t continue to extract value (cash-out refis and flips) from an asset in which it doesn’t exist.

3 – The third law of thermodynamics

It is impossible to create a thermodynamic process which is perfectly efficient.

green light bulb

We saw a massive increase in the number of hedge fund, mutual fund and ETF offerings, many of which had complex expense ratios and tracking errors – only to see many of them fail. You can never get a perfect index match without tracking error and fees/commissions and most actively managed mutual funds can’t beat their index – but you can get pretty darn close in low-fee Vanguard mutual funds or various ETFs.


4 – Theory of Relativity

Transformation between a moving object and an observer in another frame of reference


photo credit

Classical relativity involves a transformation between a moving object and an observer in another inertial frame of reference.
To main street, the Wall Street bonuses seemed outrageous, unwarranted, unsustainable and flat-out insulting.  To those in the ivory tower, it was get while the gettin’s good and do what everyone else is doing.  If any one firm didn’t jump on the mortgage securitization bandwagon, their earnings wouldn’t look as good as their peers, and hence, the house of cards was constructed.


5 – The Grand Unified Theory

This is the holy grail of physics, if you will – trying to reconcile and consolidate all major theories like Einstein’s theory of relativity with the fundamental forces of physics.

physics-picturephoto credit

The Quants – The whizzes on Wall Street thought they had it all figured out – they found the coveted holy grail.  They would take on massive leverage, take inordinate risks on securitized debt and then hedge it with credit default swaps.  This was thought to be the perfect investment model – high alpha returns with fully hedged risk.  With the potential bankruptcy of AIG (which was involved in Hundreds of Billions in credit default swaps), many of the largest investment banks and sovereign wealth funds would have realized tremendous losses – but they were spared by a US taxpayer bailout.  How convenient?  AIG made good on payments to the likes of Goldman Sachs which is approaching $200 per share again.  Meanwhile, our generation is passing on generational debt the likes of which the world has never seen.

Do any Ironic Parallels Come to Mind After Reading?

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1 Retirement Savior September 30, 2009 at 1:21 am

Great article. I think it is funny how the most complex formulas can come down to the most simple assumptions. For instance, the wonderful Gaussian Copula formula that helped become the basis for the mortgage securitization and AAA CDO ratings hinged in the end on the assumption that house prices would not fall. So intricate, and yet at its very heart laid the fatal flaw.
.-= Retirement Savior´s last blog ..Optimism Wins in Investing =-.

2 Evan September 30, 2009 at 9:15 am

I bet you could apply this list to every bubble! You should try rocking out this list to the Tech Bubble
.-= Evan´s last blog ..Finding Help with Unemployment Benefits =-.

3 Miranda October 1, 2009 at 9:44 am

You forgot Newton’s 3rd Law of Motion! Every action has an equal and opposite reaction…
.-= Miranda´s last blog ..Book Review: Welcome to the Poorhouse =-.

4 Credit Card Chaser October 5, 2009 at 3:07 pm

Great points from a general standpoint but it is close to impossible to apply these points in any kind of specific way without the benefit of hindsight’s perfect vision. Very nicely done post though and it illustrates a lot of the general problems that took place.
.-= Credit Card Chaser´s last blog ..Stop Paying Full Price! (Use Your 1% – 5% Cash Back Credit Card) =-.

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