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Due diligence cannot protect you from shit happens.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 04:56:07 PM EST
[ Parent ]
shit happens

The preferred term, used by all the Serious People©, is "Black Swan Event."

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Mon Mar 12th, 2012 at 05:12:58 PM EST
[ Parent ]
That's not what I'm talking about. Suppose you know that the True Probability™ of someone being unable to repay you is 5%. Then what? Did due diligence protect you form credit risk?

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 05:20:34 PM EST
[ Parent ]
If you know that the True ProbabilityTM of non-payment is 5 %, you can discount those five per cent when making the loan.

If that renders the effective interest incompatible with the customer's business plan, then you can not make the loan. If the loan represents a large fraction of your equity, then you can not make the loan.

This is why you need to do it before making the loan.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 09:54:18 AM EST
[ Parent ]
Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

But this is tangential to CDOs, where you can sell the same worthless non-coverage to multiple buyers over and over, with the certainty that if any of them try to claim on their 'coverage' you can shrug and say it's not your problem.

Oh - and the government will probably bail them out anyway.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Tue Mar 13th, 2012 at 10:12:42 AM EST
[ Parent ]
But as long a you have the capital to issue a lot of independent 5 % non-payment risk loans, you can get away with simply discounting it 5 %.

The salient point here is that you only get to do that with idiosyncratic risk, because systemic risk is, by its nature, not independent. This is why properly run industrial societies use government back-stops to ensure that not everyone is unemployed and broke at the same time. Because the government, as the only entity which is definitionally solvent, is the only entity which can serve as a backstop against systemic risk.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:17:36 AM EST
[ Parent ]
I think the key thing we should have learned from LTCM is that it's difficult to determine which risks are independent, which are not, and what sort of feedback the dependent ones will create for one another.
by rifek on Tue Mar 13th, 2012 at 03:00:20 PM EST
[ Parent ]
No, the key take-home points from the Long Term Capital Management fiasco are:

  • The market can remain irrational longer than you can remain solvent.
  • Don't bet your entire business that you're the smartest guy on the block.
  • Don't bet your entire business on any single transaction, particularly when that transaction does not keep the two first bullets firmly in mind.

Of course, none of this should have been in any way novel or surprising, and the fact that humanity regularly has to re-learn such simple matters of common prudence does not auger well for our collective cognitive prowess.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 03:18:59 PM EST
[ Parent ]
We knew those before.  LTCM thought that, if some risk spreading is good, more is better, but they never took into account that if you spread risk far enough, it becomes recursive.
by rifek on Wed Mar 14th, 2012 at 02:41:54 PM EST
[ Parent ]
They drank their own cool-aid.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 14th, 2012 at 04:34:04 PM EST
[ Parent ]
Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

Precisely! The problem with credit is that the risks are all "in the wrong direction". You get a small income stream at a rpofit in exchange for the risk of a large loss. And risk-aversion magnifies the perception of losses.

Also, diversification doesn't quite work. If you have 20 bonds with a default probability of 5% you're virtually guaranteed a loss of 5% no matter what so it's all pain, no gain. You're maybe better off gambling on just one bond where at least you have a sizeable probability of making a profit.

Naked CDS are much "better" - you pay a small fee in exchange for the chance of a big payout.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 10:20:34 AM EST
[ Parent ]
No, you can diversify it away as long as it is idiosyncratic risk. The fact that you are virtually guaranteed to suffer on the order of 100 defaults out of 2 thousand loans just means you have to charge 5 % extra on all the loans.

Where this breaks down is when everybody goes broke at the same time, because some right-wing idiot (but I repeat myself) was allowed to play with levers of government that he has neither the understanding nor the inclination to handle safely.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:29:05 AM EST
[ Parent ]
The fact that you are virtually guaranteed to suffer on the order of 100 defaults out of 2 thousand loans just means you have to charge 5 % extra on all the loans.

It means you're virtually guaranteed no upside and all downside. Logarithmic utility can be really nasty on the downside.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 10:30:42 AM EST
[ Parent ]
No, it means I'm virtually guaranteed a payment stream of 95 % of the nominal payment stream, assuming the defaults are uncorrelated.

You need to look at the discounted value of the expected cash flow rather than the nominal principal, for the same reason you need to look at MWh produced rather than nameplate capacity when evaluating the required price of volatile energy sources.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:36:35 AM EST
[ Parent ]
I agree fully with Jake's side of the argument here.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 10:46:09 AM EST
[ Parent ]
"assuming the defaults are uncorrelated."

Um.

by Colman (colman at eurotrib.com) on Tue Mar 13th, 2012 at 10:54:33 AM EST
[ Parent ]
In a properly run economy, they are. Because the sovereign employer and investor of last resort makes sure that the macroeconomy does not go boom.

If you hand the keys to the sovereign over to right-wingers, then of course they break it. But that is not dependent on the particulars of finance theory - right-wingers break your economy because breaking countries for fun and profit is what right-wingers do.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 11:05:36 AM EST
[ Parent ]
Analytical simplicity. The general argument still holds even with correlated defaults.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 12:33:23 PM EST
[ Parent ]
because due diligence forces you to have prepared a plan B for lots of different things, and to demonstrate your general ability to deal with the unexpected.

Wind power
by Jerome a Paris (etg@eurotrib.com) on Mon Mar 12th, 2012 at 05:57:26 PM EST
[ Parent ]
In other words, due diligence is at least as much about "Know thyself" as "Know thy counterparty".
by rifek on Mon Mar 12th, 2012 at 06:53:32 PM EST
[ Parent ]
Sun Tzu and the Art of Finance.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 07:18:11 PM EST
[ Parent ]
And Lao Tzu and Musashi.
by rifek on Tue Mar 13th, 2012 at 01:49:01 AM EST
[ Parent ]
Due diligence cannot protect you from shit happens.

Define "protect."

Part of doing your due diligence is to make sure that the contract you are entering into will not cause your firm to cease to exist if shit happens. Unless said shit is so bad that your firm has a meaningful risk of ceasing to exist anyway. Part of doing your due diligence is to ask "what could possibly go wrong?" come up with a reasonably comprehensive answer, and then make contingency plans for all of those situations. Even if the contingency plan is just "in case of nuclear war, roll over and die."

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 09:52:59 AM EST
[ Parent ]

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