CDOs & Computational Intractability
Readers with backgrounds in derivatives and theoretical computer science may find amusement in the recent working paper from Arora et al.: Computational Complexity and Information Asymmetry in Financial Products.
The article provides delightful juxtaposition of cross-discipline buzzword bingo: computational complexity (theoretical computer science), asymmetric information / lemon costs (information economics), and densest subgraph problem (graph theory).
In short, the authors posit that detecting fraudulent CDOs/CDSs is essentially computationally intractable (p. 12). Needless to say, the press is already having a field day with the article to blame Goldman (arguably rightfully so, to the demise of their counterparties); despite what I wonder may be limited capacity to fully comprehend the subtle theoretical details of the article.
A few more choice words from the authors (p. 3):
What is surprising is that a computationally limited buyer may not have any way to distinguish such a tampered derivative from untampered derivatives…The paper suggests a surprising answer: in many models, even the problem of detecting the tampering ex post may be intractable.
The article is a pleasing practical application of computational complexity theory, which Arora and Barak cover nicely in their recent text, Computational Complexity: A Modern Approach.