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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
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.
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.
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.
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
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.
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
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.
Um.
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.
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