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Showing posts from May, 2010

The Goldman Case – 2: CDOs

The Goldman case revolves around the CDOs. So, we must begin with these vehicles.

A CDO, or collateralized debt obligation, is a security, only more complex than traditional securities such as stocks and bonds. The complexity is not conceptual, as in, say, quantum mechanics, but procedural and functional. It can be measured by the words that are needed, as per requirement of the law, to describe the structure, pay off pattern and risks of the CDOs in the offering memoranda. These documents can run into hundreds of pages of legalese and still not cover all the material facts. The SEC’s charge against Goldman is precisely this “failure to disclose”, which constitutes fraud under the securities law.

A procedural/functional complexity can best be shown via an an example.

Take a bank which has lent the following amounts to 5 home buyers. The monthly payment for each loan is shown in brackets.

1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]

Th…

Was the Top Kill "Chance of Success" a Made-for-TV Number?

I'm always curious about how people use and abuse the tools of probability and statistics. In structured finance, slices of CDOs failed at a rate completely inconsistent with their high-level ratings. Okay, that's bad. But even worse is that when strips of CDOs started being packaged in other CDOs, not only did the level of complexity rise in the new products (the "CDOs squared"), but sensitivity to initial misrating -- and the implied low probability of default -- exploded. (The explanation of why this is so is a bit technical, but is worth checking out at Marginal Revolution's The Dark Magic of Structured Finance.)

Now Top Kill has failed.

Failed to plug the spewing oil pipe a mile below the water's surface in the Gulf of Mexico.

Failed to stop the environmental carnage taking place in the ocean and along Louisiana's shores.

Top Kill came with its own simple, straightforward probability: a 60 to 70 percent chance of success. The number gave us comfort -- BP…

Reading Between the Lines: Europeans Will Be Europeans No More

Last week, Greece became the byword for the European “fiscal crisis”. The mainstream press and media pulled out all the stops in hyping an impending doom if the severest austerity measure were not put in place – and soon. The Financial Times had little else in its opinion pages except warnings by its regular and guest columnists about the eurozone’s “race to the bottom”, Europe’s “lack of preparedness for austerity”, Britain’s “lack of preparedness for austerity” and the view in “Germany” – based on interviews with a few Germans – that the trillion dollar aid package was doomed because it did not address the fundamentals, which could only be corrected with more austerity.

The New York Times got into the act, too. It dispatched Tom Friedman to Greece for an interview with Papandreou. Friedman is an idiot, though of the useful kind. Because he never understands what the “shot” is, to show his importance, he reveals whatever he picks up in conversations. He paraphrased the prime minister …

So Why Did the Stock Markets Do a Bungee Jump on May 6?

What I find interesting about this story (and if you think bungee jump is hyperbole, you haven't looked at the intraday Dow chart) is there's a decent analogy: Imagine that murder victims start turning up in some small, idyllic U.S. city. Throats slashed, bodies mangled. Residents grow fearful. They start locking their doors all the time, glancing over their shoulders, going out less. The pressure mounts for police to find the killer, to calm a jittery city.

Now imagine a hit-and-run of sorts in the financial markets. Stocks make a sudden, vertiginous plunge, only to rapidly recover. Billions of dollars of wealth evaporate, then reappear. But how did this happen? Who caused it? Who profited from it? Could they do it again, and what if the next time the markets don't bounce back? And so investors grow fearful. They wonder: Should I continue to put more funds into volatile stock markets? Can they be trusted?

And the search begins, among the financial forensic teams, to find a …

Weekend Musings: Why Bother With Mosquitoes?

James Cayne, the ex-CEO of Bear Stearns, and his lieutenants were called before the Financial Crisis Inquiry Commission I know not for what.

Even when everyone feigned surprise, it was a tired show. Surprise! Cayne did not curse. The Wall Street Journal:
At times, it seemed like the panel was caught off-guard by the matter-of-fact manner, beginning when Mr. Cayne kicked off his testimony by admitting that Bear's leverage was too high.
The New York Times:He [Cayne] showed little emotion at the hearing, giving no hint of his reputation for outbursts during his nearly 15 years at the helm of the company before stepping down in January 2008.Sa’di:What could an old whore do but repent from debauchery and a sacked sheriff from hectoring?The goon turned walking gentleman offered this gem about the cause of the collapse of his firm. The firm’s collapse, he said, “was due to overwhelming market forces”.

Since the creation and continued operations of Bear Stearns was also the result of market f…

Epilogue: The Meaning of “System” in Systemic Risk

I was reading about tomorrow’s elections in England, when I thought of Tony Blair which reminded me of the two-part series, The Meaning of “System” in Systemic Risk. I had meant to end the series with an epilogue, but I forgot. So, if you were following it, my apologies for what surely seemed like an abrupt end.

Yet, as Rumi would say, we never really left the subject; all posts on this blog are about systemic risk. Such is the nature of the "relations" about which I have been philosophizing of late. When you get the main relation, the whole, right, the parts, in the forms of individual developments, will confirm, accentuate and strengthen it.

Yesterday, for example, I read that Chancellor Angela Merkel had quoted Swabian housewives to give a lesson to German and European “overspenders”: “One should simply have asked a Swabian housewife. She would have told us her worldly wisdom: in the long run, you can’t live beyond your means.”

I had written about this very topic the day bef…

Those Overspending Americans

Data released by the Commerce Department today showed that, once again, American consumers are spending more and saving less. As reported in The Financial Times, a JPMorgan analyst interpreted the numbers thus in a note to his clients:
Speculation that consumers are reforming, repenting and rebalancing now looks premature or overstated.So, we are back to the narrative of irresponsible consumers bringing the U.S. economy to its knees by spending beyond their means. The fault, dear Brutus, is not in stars.

In several places on this blog, I have explained the material basis of this seemingly moral weakness. This time, I will let the vice president of the U.S. explain, as quoted in the same paper (April 21, p. 3)
Mr Biden, who is in charge of Barack Obama’s “middle class task force” said the last US economic cycle, which began in 2001 and ended in 2007, was the first in history that left median incomes where they were at the start.

Yet, over the same period, the growth in productivity, whic…

The Goldman Case – 1: Introduction

You must know about the “freak shows” that were popular up until the middle of the last century. These macabre circuses traveled from place to place and exhibited their “freaks”: the elephant man, the snake woman, the scorpion girl and such.

The rabble went and paid to look at the freaks and count their blessings. Imagine being the parents of the “scorpion girl”!

Such naked exploitation of physical deformities is no longer acceptable. But the practice continues under a different guise. The freaks are now the child prodigies. The 5-year old Korean who plays Appassionata. The 4-year old Iranian who has memorized Qur’an –without knowing Arabic, no less! And the usually home-schooled, always awkward 8-year old who can correctly pronounce and spell onomatopoeia, hippocastanaceae and cwm.

These are mechanical performances, of course, like a bear dancing or a dog shaking hands. What these children know of music, religion and language is barely above what a space-traveling “astronaut” chimpan…