Via the beady-eyed Browser, a fascinating piece over at Marginal Revolution about the way small errors in calculating debt risks can have cascading systemic bad consequences down the road:

Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06. 

 In terms of our original mortgages the true default rate is 20 percent higher than we thought–not good but not deadly either. 

However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase.  Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase! 

The dark magic of structured finance conjured many low-risk securities out of many risky securities.  Like all dark magic, however, the conjuring came at a price because if you didn’t get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined.

Scroll down through some very smart comments, not all of which agree with the piece itself.

As someone sagely says, garbage in, garbage out.