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Anglo Disease watch (5) - just break the thermometer and all is well

by Jerome a Paris Thu Jul 5th, 2007 at 08:24:14 AM EST

Laurent Guerby pointed me to this story in yesterday's open thread, but this story from a few days ago on Bloomberg news is both scary and fascinating:


S&P, Moody's Mask $200 Billion of Subprime Bond Risk

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

These securities are portfolios of loans to home owners which are put together to create the equivalent of large loans. They are then sliced in different tranches, with some a lot more risky than others (i.e. some will be the first not to be repaid if the underlying loans do not perform, while other will be hit only later).

From the diaries - afew


These securities are sold to all sorts of investors, who rely on two things (i) is that the underlying risk is a highly diversified client base in the largest asset class in the world (real estate in the US) and (ii) these securities are rated by the rating agencies; such rating suppsedly giving a good measure of their riskiness. Many investors are restricted by policy, and siometimes by law, to assets with at least a given rating (thus the distinction between 'investment grade' and 'junk bond' - one bond has the right rating, above the limit, the other does not).

In many cases, the rating is the single most important tool in the decision to invest or not. As Bloomerg notes:


Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

A lot of investors would be forced by policy to sell, in the case of downgrades, thus triggering massive slaes and price collapses.

And...


Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

(...)

S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.

Under the old guidelines, S&P said a bond's ``credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

Credit Support

Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.

The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn't have automatically resulted in a downgrade, he said.

Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.

Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.

There's a lot more data in the article about the scope of the coming problem, but that last line is extraordinarily scary. A ratings are supposed to be high quality stuff already, with default rates below half a percent. Most of these 'A' bonds have this alarm ringing; while this does not imply a default yet, it's a stunning, and deeply worrying number.

Just to give you an idea:


Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.

This will get really, really ugly.

But current policy is to hide the thermometer.

Display:
just a question :

how can we profit from this ? ;-)

by fredouil (fredouil@gmailgmailgmail.com) on Wed Jul 4th, 2007 at 08:24:15 AM EST
The right question is how deep your pockets need to be to profit from this.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 08:30:58 AM EST
[ Parent ]
Borrow dollars: buy energy assets anywhere you can.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 08:40:26 AM EST
[ Parent ]
I have a good chunk of money in oil, if the economy falters, I'll have to dump early.

you are the media you consume.

by MillMan (millguy at gmail) on Thu Jul 5th, 2007 at 12:47:17 PM EST
[ Parent ]
if you're a homeowner, is to sell now to rent.
Otherwise, you can try to short various asset categories - starting with bank shares.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 08:44:24 AM EST
[ Parent ]
Of course, this shouldn't be construed as financial advice ...
by Colman (colman at eurotrib.com) on Wed Jul 4th, 2007 at 08:50:02 AM EST
[ Parent ]
I read about CDO's etc etc in Financial Times yesterday on the train (I usually don't read FT) and got all cold. These things just seems so... foggy, toxic, unpredicatble, financial weapons of mass destruction.

I guess it might be a good idea getting out of that great and stable hedge fund (+6-10 % per annum without exception) which I don't really understand how it works?

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 4th, 2007 at 07:38:50 PM EST
[ Parent ]
No tree grows to heaven.  No cup is bottomless.  No investment is forever profitable.  If you don't understand an investment then you don't know when it's time to take your profits and run.  ;-)  

Skepticism is the first step on the road to truth. -- Denis Diderot
by ATinNM on Wed Jul 4th, 2007 at 08:09:03 PM EST
[ Parent ]
True, true...

Still, the hedge fund in question mainly holds Swedish state bonds... Which feels pretty safe. The entire fund feels like the risk is somewhere in between stocks and bonds, no? A little riskier than bonds, but a better return too.

But who knows if they mix in all kinds of toxic crap which turns it all on its head?

Well, it feels prudent to slowly move over into bonds... Can't hurt that much.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 4th, 2007 at 08:23:43 PM EST
[ Parent ]
This is an example of actions designed to prevent a moderate cascading failure just bottling things up and creating the conditions for an even bigger failure in the future.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 08:57:36 AM EST
Don't some credit derivatives have paiement upon a rate change? i.e., a downrating itself would create a shockwave...

P.S. and there should be a limit of 46 characters to Diary title lengths. So that Re: Title is less than 50 chars.

Un roi sans divertissement est un homme plein de misères

by linca (antonin POINT lucas AROBASE gmail.com) on Wed Jul 4th, 2007 at 09:14:35 AM EST
That is the problem. The credit rating agencies realise this and decide that breaking the rating system is a lesser evil compared to the adjustment that would occur were they to doengrade all these bonds.

To be honest, I hope the SEC takes notice of what the Bloomberg piece is saying, and investigates S&P and Moody's for "alleged distortion of the credit market".

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 09:27:34 AM EST
[ Parent ]
But the SEC might just agree that breaking the ratings is a lesser evil than breaking Wall Street. After all, it's their turf, too...

Pierre
by Pierre on Wed Jul 4th, 2007 at 09:40:29 AM EST
[ Parent ]
The question is how bad is it?. Is this just a moderate adjustment that is being prevented, or a big crash?

Maybe they're just trying to hold out until January 2009, so the crash doesn't happen under Bush's watch?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 09:48:18 AM EST
[ Parent ]
There is no way they can postpone it so far. On the contrary, I think a 29-like crash before the election is what bushco wants: chaos, state of emergency, raise of the charismatic leader, etc, etc...

Pierre
by Pierre on Wed Jul 4th, 2007 at 09:57:43 AM EST
[ Parent ]
Standard CDS (credit default swap) contracts have a lump paiement upon a default (and the loan with eventual recoveries are transfered to the provider of the derivative security).

But the rate plays a role: as long as the product remains "Marked to Model" (theoretical pricing and not actual quote from a market, which is only available for the most liquid ones, like iTraxx basket and the like, see www.markit.com - nothing is free there).

The "Model" price is a math model of the probability of a default by the time the CDS expires. This gives you a value "averaged over all possible futures weighted by their respective probabilities".

Most of those math models try to extract "implicit" information from the market: notably, when a borrower has issued bond, they have a yield (coupon set a issue divided by price set by market), which has a spread (how many % more than Fed rate is it ??). Risky borrowers have high spreads, which means they must pay exorbitant rates to borrow, thus increasing their riskiness ("on ne prête qu'aux riches")

So the math models computes the risk of default of company ACME in years 1,2,3... based on the spreads of its quoted bonds of maturities 1,2,3 years: actually, you are making a poll of the opinion of traders about if/when ACME will default, except (market quotes + untested math + historical default events to calibrate) replace a lot of phone calls... (+ tricky poll maths)

And the problem is that in the past years, markets have been so in love with risk that the spread range between "sovereign debt" and "total junk" is only a few percentage points.

So basically when the auction at BearStearns & Merril Lynch says that securities traded for 30 to 80 cents on the dollar, it means their spreads are up by 1-20 percentage points. Which means that the new market opinion, according to the models, should now read as: 100% guaranteed total default across the board for all MBS within the next 6 months. Either that, or the calibration is out the window and bankers are now shit scared about risky loans like they haven't been in decades (= total credit crunch)

Most institutions with MBS marked to models should now be basically writing them off, which would require a gov'nmt bail out...

Pierre

by Pierre on Wed Jul 4th, 2007 at 09:55:31 AM EST
[ Parent ]
Just look at how often the topic is mentioned in the business press now. The FT has a major article on the topic almost daily these days.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 10:35:14 AM EST
[ Parent ]
The Fed stopped lowering interest rates and started charging for borrowing - strange notion, eh?  And the Yen carry trade seems to be ending as well.  The US consumer has dutifully consumed and have so many 'assets' that they are bankrupt (Cash Statement.) Investors in the 1,000,000,0000 person Chinese market have discovered - Gadzooks! - 999,000,000 don't have any money and of those that do, a Gucchi rip-off is just as good as a Gucchi.

And on and on and on and on.

The monkeys are no longer in charge of the banana plantation.

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Wed Jul 4th, 2007 at 01:11:58 PM EST
[ Parent ]
What you're saying is regardless of what the credit rating agencies do, isn't it?

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 10:37:26 AM EST
[ Parent ]
Absolutely. It only depends on having a quote for the bond, or bond basket. The more you have, the more it becomes difficult to hide it (one auction with a dozen baskets, 10 bidders, and one quote data point at a single date could still be dismissed as an "outlier"). But as the evidence will pile up, the ratings will become irrelevant to the write off.

Where the ratings matter, is that derating those securities would force a sale by those institutions with a "risk mandate" (e.g. pension funds are not allowed by statutes to detain bonds below a certain quality). Basically, they would have to liquidate their position by the end of the financial quarter, when their reporting is due. And this would provide lots of datapoints regarding the crash...

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:05:30 AM EST
[ Parent ]
Mandated selling because of downgrades will provide "panic mode" data points (i.e. lots of sellers and few buyers), which will feed on themselves in a vicious circle. The unwinding can only be painful, precisely because of these trigger mechanisms, which force transactions to take place and 'shine light' on the whole sorry mess, whose sudden visibility in turn makes the crisis real and feeds it.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 11:11:26 AM EST
[ Parent ]
Can any of you Bears of Financial Brain tell me what the key differences are between a CDS and a Guarantee?

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 11:28:14 AM EST
[ Parent ]
It's pretty similar, from the point of view of the purpose it serves for "hedging" customers. It's an insurance against default by the borrower, which repays you of the nominal remaining at the time of default (forgoing expected trailing interests, but you can reinvest the premium at the rates available at the time).

And the cost is regular payments, so it really works a lot like those "unpaid lease" insurances that individuals can get for property they let.

But it is different from an asset-backing, in that it is hassle free: you get cash, full stop. No legal action to take to seize the backing asset, no doubt about its future value and liquidity at the time of default, no delays...

The two can coexist: there are CDS on asset-backed loans. But you can't have your cake and eat too. In such cases, the CDS contract says that all you initial entitlements as lenders are transfered to the CDS issuer (that is, they try to recoup the loss they made on a default, by snatching the assets and getting whatever recovery they can - in short, with the CDS, you transfer the hassle to a bank)

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:41:25 AM EST
[ Parent ]
But if, as Pierre suggests, the banks are beginning to get worrying signals from their models even without the credit ratings being downgraded, they will try to quietly reduce their exposure by selling any high-risk debt instruments they do hold. In addition, if they start writing things off, this is bound to show up in their quarterly financial statements. Which will provide more data points.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:40:50 AM EST
[ Parent ]
Exactly. The only way they could conceal this much longer, is if the SEC is complicit and also validates "updates to the in-house models" to shift the baseline as the crash goes.

Note that this will not be easy: I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed. These hedge funds have officially demanded that the SEC applies regulation swifly and strictly to the big street names (in short: they will not let their preys escape). So there is big money pushing for a crash too, and lobbying power on both sides.

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:48:05 AM EST
[ Parent ]
I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed.

In other words, fredoiul cannot profit from this any longer, as people with deeper pockets than him and earlier access to information already have ;-)

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:50:12 AM EST
[ Parent ]
Fredouille can still give it a try, I just gave the recipe. But it is risky: as always, timing is critical, as if you short too early and wait you pay a lot for margin calls, and some stocks could benefit from (heresy !) ... a bailout !!

Pierre
by Pierre on Wed Jul 4th, 2007 at 11:59:23 AM EST
[ Parent ]

FSA sounds alarm on subprime lending (4 July)

The Financial Services Authority has started disciplinary action against five mortgage brokers for weak "responsible lending" practices in the subprime mortgage market.

The UK financial regulator on Wednesday issued a damning report on the sector, which lends to borrowers with spotty credit histories. Arrears among subprime borrowers are currently running at 20 times those of mainstream mortgage holders, sparking concerns firms have taken on excessive risk in ramping up their lending in this area.


SEC examines subprime market (27 June)

The Securities and Exchange Commission yesterday said it had initiated a broad-based investigation into the troubled subprime mortgage market.

Christopher Cox, chairman of the SEC, told a congressional panel that the regulator was investigating a dozen subprime mortgage issues, including collaterallised debt obligations (CDOs), which are repackaged pools of debt sold to investors.

The SEC is also looking into the secondary market for these instruments.

Asked what had prompted the scrutiny, Mr Cox said "the climate and the environment". He added: "The attention that is being paid generally to problems in this area causes us to be alert to the potential for violations of the laws and regulations that we enforce."



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 12:24:48 PM EST
[ Parent ]
Funny.  CCox naming the problem "the climate and the environment" and then admitting the SEC is way behind the industry he is in charge of regulating.

Our knowledge has surpassed our wisdom. -Charu Saxena.
by metavision on Fri Jul 6th, 2007 at 07:24:53 PM EST
[ Parent ]
By the way, why would anyone want to enter a marked-to-model swap with the institution that maintains the (proprietary) model? That's naïve in the extreme.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:53:08 AM EST
[ Parent ]
you mean a credit default swap or a regular swap ? I assume it's a CDS you are talking about.

Actually, it is not relevant to the "subscriber of the insurance": most of the time, he wants a hedge. If the rate of payments for the hedge doesn't chew up a too big proportion of the coupons, he'll be happy. He only wants a big name to sell the protection (you don't want your insurance to go belly up, do you ?)

The model is only pertinent to the book value of the contingent claim in the bank's account. Pretty much like the valuation of a portfolio of drivers at an insurer. The problem is that driver insurers have models based on big old historical records where Gauss works very well.

The banks do have a problem: they sold lots of protections for too cheap fees, valuing them a derisory price coming from a fancy model (ACME will default in a credit crunch ? nononon, that can't be). And they thought they were faster than Insurance companies, because models enabled them to roll out new products faster and without waiting for the accumulation of long historical records, etc...

Now the models will either be tweaked or they will make it apparent that lots of cash will be due shortly, and that the hedges of the banks are grossly inadequate. Note that it is only because the swing in the inputs is terrible (from bubble to crunch) that the model can do nothing but confirm the disaster (that common sense could have predicted). We do not know for real how these models would perform in a non-bubble, non-crunch period, because they have never been back tested on such a period.

I take it they are rather poor in that they did not incorporate more indicators that would have raised alarms as early as two years ago in the real estate market.

Also, I think the theoricians will soon discover such realities as "friction" and "inefficiency" in the market. There's plenty of this in an illiquid real estate market (legal costs, janitor costs, realtor fees...)

Pierre

by Pierre on Wed Jul 4th, 2007 at 12:22:06 PM EST
[ Parent ]
The "Model" price is a math model of the probability of a default by the time the CDS expires. This gives you a value "averaged over all possible futures weighted by their respective probabilities".

Most of those math models try to extract "implicit" information from the market...

Implicit information of a model flows from the decision-making structures (schemata) of the model based on the valuation and privileging of the total input stream from what is being modeled.  Baldly, you only see what you're looking for.  

In a mathematical model the problem is compounded¹ by the assumptions of Set Theory as applied in Probability and Statistics.  In the former, a pre-model decision is made to toss all 'unlikely' or low probability occurances into one variable if they are included in the model; in my experience these 'unlikely' occurances are ignored.  

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Wed Jul 4th, 2007 at 12:53:01 PM EST
[ Parent ]
Baldly, you only see what you're looking for.  

It's not that bad. When you have a model (produced by scratching you head), and you miss a few calibration parameters, extracting them from the market is like asking around a closed question (answer: yes/no or a single digit, or which box gets checked). In many cases, this actually works very well, pretty safe, and anyway there's no other way you can cope with the volume dealt everyday (I'm thinking of plain vanilla put/call options here, on stocks or currencies).

Like every closed question, it has a preconception of the world. The answer will not tell you that may be you should take a broader perspective and rethink your model because times are changing. You only realize when the results become unstable with time, or you lose money... And then you make the model smarter (like Local Volatility vs. Black-Scholes after the 1987 crash)

The problem is credit derivatives have had no prior "model testing, low volume phase". The bubble brought the volumes to the top tier of the banking business in 5 years.

Pierre

by Pierre on Wed Jul 4th, 2007 at 01:08:38 PM EST
[ Parent ]
The use of "Bad" is a value judgement which you, not I, applied.  As you said, "...there's no other way you can cope with the volume dealt everyday ..."  That doesn't imply, however, what is not covered in the model can't hurt you.  (For a given value of hurt.)

This is (1) a subject I'm greatly interested in; (2) can bore people for days discussing; (3) getting way off topic.  


Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Wed Jul 4th, 2007 at 01:49:18 PM EST
[ Parent ]

A game of bluff and bluster for extravagant reward

Gambler's Ruin is quickly explained: let us imagine some Buddhists started a casino. Unwilling to take unfair advantage of anyone, the management offers a game at completely fair odds: flip a coin against the bank and win a dollar on heads, lose a dollar on tails.

What will happen over time? Intuition suggests, and strict calculation confirms, two grim facts: the game is bound to end with the ruin of one party, and that party will be the one who started with less capital. Your chances in this world are proportional to the size of your bankroll: the house wins by virtue of being the house.

When you are up against other gamblers, therefore, relative depth of pocket becomes the overwhelming issue.

(...) that is where Gambler's Swank comes in.

John Law, the 18th-century Scottish inventor of modern state finance, began his life as a gambler. Travelling throughout Europe, he would arrive in a new city and take the best rooms. Splendidly dressed, tall and handsome, he would choose as his mistress the most exquisite local lady. He would then set up the game, at which he acted as banker, and win all the money of anyone who cared to play.

The card games of Law's time were much like the Buddhist coin-toss: based more on chance than on skill, they actually gave the banker only a modest advantage. How, then, did Law win so much and so often? Swank. His "front" - the clothes, the rooms, the mistress, the icy calm - made him appear supremely rich and thus indifferent to failure. His success stemmed mainly from the seeming limitlessness of his funds (...)

In finance, where capital - its size, its sources - is mysterious, gambler's swank reigns supreme. That, not the yardstick of fair remuneration, is the reason investors tolerate these gigantic salaries. Why should you smile when your fund manager tootles down the highway in his Bugatti Veyron? Why should you stake him to a marble-and-glass office and two weeks in Gstaad? Because he is playing a risky game on your behalf: a game of bluff as well as calculation.

Bluff can win... until.

I can only refer again to Nassim Taieb's books, discussed not long ago on ET.


In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 12:19:56 PM EST
Sorry if this question has already been asked and answered.

Are Financial derivatives actual derivatives (rate of change of the rate of change) or differences (how to put this ... rate of/actual separation distance?)

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Wed Jul 4th, 2007 at 12:22:27 PM EST
They are instruments that work off the back of the behavior of other financial instruments (derive from them). You could call them meta-securities, in a way.

For instance, the simplest derivatives are puts or calls, i.e. the right to buy or sell a share (or bond, or whatever) at a given price at a given date.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 12:27:10 PM EST
[ Parent ]
And if you borrow to invest in them you get second level gearing, presumably?

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 12:52:01 PM EST
[ Parent ]
Usually you don't borrow so much to buy them: they are cheap if they are "out of the money" (little probability of turning true but you buy it to hedge against a market change disastrous for your other investments). And simple options are mostly traded for arbitrage (you buy and sell at the same time, some two stuffs of very close value because you found someone ready to secure the deals with you at a price spread that will make you a little money whatever the outcome).

Pierre
by Pierre on Wed Jul 4th, 2007 at 01:13:06 PM EST
[ Parent ]
I'm familiar with futures and options - I used to be a Director of the IPE - but I am unfamiliar with the effect of borrowing to buy CDS's and similar "toxic waste" which it appears to me essentially loads one level of gearing on another.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 01:20:27 PM EST
[ Parent ]
OK, then why the ** do they call them derivatives?

Oh, I see ... "bullshit" was already taken.  ;-)

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Wed Jul 4th, 2007 at 12:56:25 PM EST
[ Parent ]
They are called "derivative securitues" in the same fashion as "derivative work" is used in IP law. The value of a derivative security is derived from the value of something else.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 01:28:31 PM EST
[ Parent ]
Model-making of Finance is no longer my concern (Hurrah!  Hurrah!) so I'm not up on the lastest nonsense.  So time spent idly wandering through Wikipedia looking for the derivatives in Dervatives and not finding them has been puzzlement making.  Tho' my experience should have informed me that's the sort of thing Finance people do.

Skepticism is the first step on the road to truth. -- Denis Diderot
by ATinNM on Wed Jul 4th, 2007 at 01:58:39 PM EST
[ Parent ]
The "mathematical" derivatives of the "derivatives price function" are called the "greeks" in our jargon, because they're designated by greek letters: delta for the derivative against a share price, vega for the derivative against a share volatility, etc...

More here:

http://en.wikipedia.org/wiki/The_Greeks

by Laurent GUERBY on Thu Jul 5th, 2007 at 01:41:27 PM EST
[ Parent ]
Never mind that "vega" is not the name of a greek letter.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Thu Jul 5th, 2007 at 05:47:13 PM EST
[ Parent ]
This is getting sillier by the moment.

Poor old δ.  It was sitting there, happy, minding its own business when

WHAM

Finance happened.

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Thu Jul 5th, 2007 at 07:46:43 PM EST
[ Parent ]
neither are volga, vanna, velta, zorg...
finance just ran out of greek letters, so they had to invent new ones

Pierre
by Pierre on Fri Jul 6th, 2007 at 03:57:31 AM EST
[ Parent ]
http://www.safehaven.com/article-7893.htm

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 06:56:20 PM EST
The investment bankers slice the MBS into several "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing up the MBS into what are called equity (high risk), mezzanine (middle risk) and the much sought-after investment grade bonds (low risk).

Higher risk equals higher returns, of course, so the equity tranche of the MBS will earn the highest profits if things go well. But if things start to go wrong, the equity is lost first, and then the mezzanine. Even then, the investment-grade bonds could still get fully paid out. This persuades the credit ratings agencies to give the lowest-risk tranche a high enough credit rating to qualify for the critical investment grade rating.

In this way the investment bank has created a decent proportion of highly marketable bonds out of a package of low-quality mortgages. Fairly standard, for example, is to convert a large package of MBS into perhaps 80% investment-grade bonds, 10% mezzanine, and 10% equity.


Wow. This is clever. It's like the financial version of reprocessing nuclear fuel, selling the uranium and plutonium and then dumping all the nasty fission products in the sea without telling anyone.

The investment bank can have still more fun with this. Because what the underwriting institution would see is just a stream of income payments. And just like the boring mortgage streams that we started with, these CDS streams can be aggregated into a pool...then divided into tranches with different risk profiles...producing the magic of higher credit ratings for lower-risk tranches...plus concentrated risk in new toxic waste.

These people are far too clever!

Now they do not take all the nasty and useless waste and throw it in the sea, instead they concentrate it further and dump it into the freshwater reserve!

Maybe not the best allegory, but anyway. On top of that, have a look at this awful graph. It seems you don't get payed for risk anymore, which means that if you take on risks and everything goes down the drain, you are in far deeper trouble than you used to be when things went down the drain back in the olden days.

Off course, the people at SafeHaven are a bit biased and into gold. Such people are usually a bit weird. But so is all this CDO stuff.

Another reason to stay in oil, anyone?


Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Wed Jul 4th, 2007 at 08:12:09 PM EST
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