Can someone show me, and explain, the math formula that was responsible for the subprime mortgage scandal?

http://www.theguardian.com/science/2012/feb/12/black-scholes-equation-credit-crunch

Garbage In = Garbage Out

@Rarebear Good article, explaining to what @talljasperman is referring.

That main theme of that puts the blame in the wrong place, the equation did exactly what it’s supposed to.
There is a portion of it related to the value of the underlying (spot price)
And another portion related to cash flows that can be expected.

If those are overestimated, especially in terms of their long-term probability of delivery/default, then when the market corrects the spot price and/or it’s expectations of future cashflows, the equation will tell you the price of the securitized asset should drop.
And it’s right, those assets were worth less than they had seemed to be.

Some people like to customize their Black-Scholes pricing model with a twist that considers the ratings of the securitized asset. If those people relied on publicly available ratings from the big guys like S&P, Moody’s, Fitch then they were additionally screwed at purchase time because a lot of junk when wrapped up in a bundle miraculously rated AA and AAA status – which was totally ludicrous.
Some weren’t even put together with enough good information compiled about the underlying mortgage quality to be properly rated if due diligence were observed.
But a great rating makes it look like an investment rather than a crap shoot.

If you put garbage into the equation at initial offering time (overvalued assets, overestimated cash flows, underestimated stability, underestimated risk, those pesky fantasy ratings) then you get out of it a garbage, over-valued price.

Loved this video to explain the whole thing in plain terms

http://vimeo.com/3261363

Doesn’t touch on the equation directly that I remember, but explains the variables and terms used and how they were either misrepresented or misread.

There isn’t the ONE formula. There are many of them, such as Value At Risk (VAR). And there are multiple factors responsible for subprime mortgage scandal.

I am a little late to this question. Anyways, to give a bit of background, the Black-Scholes equation allowed traders to “bet on bets.” It’s like a new can of worms opened up.

Level 1: buying and selling stocks
Level 2: futures contracts, “betting” on the future prices of the stocks
Level 3: “betting” on the future values of the “bets” made in level 2, now possible using the math

To be more specific, the equation allows investors to hedge their bets. They can place a bet on a price gain, and place a bet on a price drop, in a way that gives profit will minimal risk.

The math equation was not “incorrect” as much as it was people using it incorrectly. On Wikipedia, it states the following underlying assumptions behind the math:

“There is no arbitrage opportunity (i.e., there is no way to make a riskless profit).
It is possible to borrow and lend cash at a known constant risk-free interest rate.
It is possible to buy and sell any amount, even fractional, of stock (this includes short selling).
The above transactions do not incur any fees or costs (i.e., frictionless market).
The stock price follows a geometric Brownian motion with constant drift and volatility.
The underlying security does not pay a dividend.[Notes 1]”

The problem is that people used the equation in situations which violated these assumptions. The equation is meant to reduce risk, but if you use it incorrectly, there will be huge amounts of hidden risk.