Super Senior

Maybe "idiots" is too generous.

Do we know that the "idiots" didn't try to sell the risky stuff, but nobody would touch it?

And how many people would get a whiff of the stuff if they tried to sell it too widely? Someone with offended nostrils might have shut down the casino.

Better to retain the stuff in house, bank the complete income stream bonuses, and if it goes South, plead "idiocy" to shareholders. Then go to Treasury for a bailout.

I could be wrong about this, but my impression was that many institutions didn't only make these bets, but they put them in off-balance sheet entities, while insisting to shareholders (and regulators) that their exposure was minimal. This would be bad enough, but these entities had lines of credit with the institutions in case the excrement hit the air conditioning (how, precisely, this is legal is beyond me, it must be what they mean by 'innovation'). All in all, it sounds a lot like what Vice President* Cheney claimed to have liked about the work of Arthur Anderson.

I don't know how these instruments evolved, but a Darwinist could have predicted ever more complicated devices, ever more fancy footwork flights from reality.

Thank you, Kevin, for finding explanations of these various instruments, none of which I understand, really. But then isn't that the point Warren Buffett made a while back?

So as an investment, its the kind of thing only the govenment would buy.

Lounsbury you said "as for synthetics, there is nothing wrong with the process as such"-I am not sure what that means. What exactly is accomplished by sythetics apart from creating a fake market for securities? I mean, is there more capitalization? (It does appear that IBM gets a dime) More "spreading the risk"? Why are they necessary? In the example given, could a company pursue similar returns with other bonds; if not, why not? Had market conditions changed that one had to piggy back on an old bond rating? And if so, would not that ipso facto create a false value? The bundling issue I certainly understand and I definitely see some value in them (but how does a 100% Aaa rating can be graded the same as 80% Aaa does strain the mind considering these models were not market tested). The problem there was an over reliance on new and unproven (and probably fatuous) algorithms.

I can't believe I am agreeing with the Lounsbury, but I think I am.

Looked at from an engineering perspective these guys were not conservative enough. They took too big a risk with unproven technology.

Is it fair to say that economists fail to use the same rigor and caution that engineers have been forced to use? The science of engineering has had to take its lumps and learn how to assess and manage risk. Engineers still make mistakes, sure, but the practice has been improving by learning from the mistakes.

Will the school of economics do the same? I dunno. They seem to be unable to learn certain lessons.

It is a pity their foolishness has to harm the rest of us.

Tripp: Looked at from an engineering perspective these guys were not conservative enough.

You're too kind. I'd change "not conservative enough" to "grossly incompetent". And that's still being kind - the less charitable view is that they were pushing a scam. See Ponzi, Charles. Crimes of intent being difficult to prove though, I'll settle for grossly incompetent.

What do synthetics do? Read Felix's article. They provide a tool for hedging, a means of potentially distributing risk and a financial tool. There is no such thing as False Value. Value is in the eye of the beholder. If I create a financial instrument that tracks emerging markets bond risk, wherein I pay the buyer if some condition X is achieved, and they pay me a stream of premiums, there is no 'false value' - we've contracted a means of exchanging risk. Of course the person paying the premiums should bloody well be sure about counter party risk, I might go belly up which makes my insurance nonsense. But that's hardly a unique problem.

All financial instruments are abstractions and thus "fake."

And of course it is easy to call incompetence in hindsight or if one has never actually worked with any of these things, however for a rather long stretch these tools worked quite well for what they were designed to. Then in a rather short period of time, since 2000 or 2005, they were stretched beyond the point of breaking. The risk models actually performed well, as Felix notes, on the classical products, and these financial innovations lower cost of borrowing. For firms, for ordinary people etc. This has nothing to do with "Ponzi" schemes, however much the raving Left and know-nothing populist Right wishes to engage in ignorant moralising.

Of course one can take the Moralising Luddite position all Debt is bad, etc. etc., but historical experience rather shows that lower cost, easier to access financing for both investment and consumption is an overall good.

But then, just like anything, too much of a good thing can be bad. Just like you can die from drinking too much water.

Returning to the issue of risk and the engineer example, this is actually a good one. Much of the sub prime lending was done off of models and assumptions on mortgage lending that was based on decent and fairly robust historical data and tested modeling. Even synthetics. Success in those applications (as Felix's article notes, although in reference to Corporate) saw this extended. But... the financial engineers tried to assume same inputs and behaviours, when the post 2000 lending market had seen serious pollution of lending standards. Bang goes a core assumption in the models.

Rather similar to the engineer used to working with familiar steel in say a dry Mediterranean climate, and tries to import same assumptions without prior experience into a wet sub-artic one.

Financial engineers did a fine job in an environment they understood. Classic mortgage securities and derivatives off of them have performed fine. They did not properly understand that the new environment made the models bollocks.

BTW, CDS were designed not to circumvent regulatory rules, but to address the risk distrubtion aims. You may wish to familiarise yourself with Basel II Advanced standards before blowing on about Regulation and these issues.

Lounsbury,

Thank you for a concise explanation. What you say seems to make sense.

The tricky part that I am not clear on is why it seems no one noticed that a basic assumption, as you put it, became incorrect.

Isn't "always question your assumptions" a standard rule of thumb in financial circles, or at least when dealing with massive sums of money?

I think the phrase "GIGO," or "Garbage in, garbage out" was fairly common even at the beginning of computer modeling in the sixties, and that was forty years ago.

I was taught these things as a boy, or at least as a sophomore in college. I don't want to be too judgmental but it seems to me they really are pretty basic ideas.

But I'll tell you, I've been criticized for being too simplistic, so I'm not trying to claim great knowledge outside my area of expertise.

The Lounsbury: for a rather long stretch these tools worked quite well for what they were designed to

Yes, they were applied competently (past tense).

Then in a rather short period of time, since 2000 or 2005, they were stretched beyond the point of breaking.

In other words, they were applied incompetently.

The risk models actually performed well, as Felix notes, on the classical products

What, you mean a mathematical model only works within a finite domain? Sound the alarm! Oh no, wait, that's the first thing you learn about mathematical models, and that understanding the extent of the domain for a given model is the most important thing in using it competently.

Spare me the technical difficulties and 20-20 hindsight snow job. I work with mathematical models all the time. These clowns broke the first rule.

This has nothing to do with "Ponzi" schemes

Pardon my simplistic analogy. No two "getting rich now even though any idiot can see it's a house of cards" schemes are the same. We must dwell on the subtle distinctions lest the great unwashed masses notice the emperor's nakedness.

Of course one can take the Moralising Luddite position all Debt is bad, etc. etc.

Which no one here has done. Find a more convincing strawman.

But then, just like anything, too much of a good thing can be bad.

Keen insight. I'll add that to my accumulated store of wisdom.

Rather similar to the engineer used to working with familiar steel in say a dry Mediterranean climate, and tries to import same assumptions without prior experience into a wet sub-artic one.

Yes, and in the world of real engineering we call that incompetent. The financial equivalent wasn't some subtlety of imperfect extrapolation, but analogous to saying "who knew that steel rusts faster in wet places".

You mean loans whose payment require a larger share of a person's income are riskier? That people with poor credit ratings and/or who have no skin in the game from down payments are at greater risk of default? That prices unexplainable by any fundamentals might be bubbles and that their collapse could reduce the value of the collateral? Who could have known.

They did not properly understand that the new environment made the models bollocks.

Ah, so you agree that they were incompetent.

CDS were designed not to circumvent regulatory rules

Of course not. I'm sure that it was just a coincidence that they had that effect.

Ah Alex the Snide Whanker:

Well clever boy as you think you it, fine, no need to reflect.

However, What, you mean a mathematical model only works within a finite domain? Sound the alarm! Oh no, wait, that's the first thing you learn about mathematical models

Indeed. However in the real world, as opposed to in school, one has to work in circumstances where it is not evident one is not in the same domain. Fine for some whanker of a blog commentator to run by, oh first lessons and all that. Well, whatever, these aren;t even my mates, however idiotic your snide whankery is.

As for blithering on about Ponzi schemes, well, since it is not clear what you're on about, all I can say is there is nothing Ponzi as such about synthetics. Sub prime market, well that is another matter, but that's not synthetics. (and the Moralising Luddite strikes me as rather approp. for you, but I was rather thinking of past Drum threads, whanker).

In any event, to correct your distortion my offhand analogy, I was rather making a reference to more subtle changes in stress rates, but as I am not a steel engineer and I am conversing with a juvenile whanker I am sure you'll come up with some asinine trying to be snotty clever remark.

Finally: Of course not. I'm sure that it was just a coincidence that they had that effect. No, they did not. They responded to regulatory rules and guidance on hedging risk. There is absolutely nothing wrong or "circumventing" in using hedging tools under risk weighted regulatory capital regimes. In fact it is encouraged. Of course you may prefer banks return to 19th century practise.

The Lounsbury: However in the real world, as opposed to in school, one has to work in circumstances where it is not evident one is not in the same domain.

If you change the credit underwriting standards it's not evident that you change the risk of default? Ok, I'll believe it if you'll believe that I'm the Queen of England. And for a change of pace, we are amused.

to correct your distortion my offhand analogy, I was rather making a reference to more subtle changes in stress rates

Stress rates? Are you referring to Truesdell, Green-Naghdi or Jaumann rate? Doesn't matter, as I don't understand continuum mechanics any more than you do. Please limit yourself to offhand analogies that you have at least some vague understanding of.

"Rust" is much better understood and appreciated by the layperson, and hence a better analogy for just how obvious a mistake these financial geniuses made.

I am sure you'll come up with some asinine trying to be snotty clever remark.

You can count on me!

[CDS's] responded to regulatory rules

Which regulatory rules were those? The ones explicitly prohibited by the Commodity Futures Modernization Act of 2000?

There is absolutely nothing wrong or "circumventing" in using hedging tools under risk weighted regulatory capital regimes.

Uh, Loon, the circumventing was in using CDS's instead of regulated hedging tools. And if you buy hedging tools on something you otherwise have no financial interest in (a key characteristic of CDS's), it's not hedging, it's gambling. See Panic of 1907.

In fact it is encouraged.

Prudent financial management is encouraged? Wow, they gotta work harder on getting the word out.

Of course you may prefer banks return to 19th century practise.

Panic of 1819, Panic of 1837, Panic of 1857, Panic of 1873, Panic of 1893. Uh, maybe not.

I'm kind of nostalgic for the mid to late 20th century when the US had its longest ever period without a banking crisis. Clueless Luddites seem to think it may have had something to do with old fogies reminiscing about the Great Depression and asserting their Socialist ideals by regulating the banks enough to keep them from getting too clever.