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View Diary: Our Economy: MASSIVE FRAUD By Mortgage Industry. (269 comments)

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  •  Not fraud - just criminal ignorance... (11+ / 0-)

    And it may, IMHO, be subject to civil suits.

    I have read and emailed this article to many friends and colleagues around the world.

    This is truly a super article - worthy of at least one diary here at Daily Kos.   While David X. Li's mathematical model (the Gaussian copula function) itself may be quite overwhelming to someone not trained in Math, Statistics and Actuarial modeling, some of the very interesting portions of this article are:

    His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

    Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation
    swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

    How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion-dollar system that allows pension funds, insurance companies,and hedge funds to lend trillions of dollars to companies, countries, and home buyers.

    The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

    and finally without compromising the site's copyright rules and acknowledging that David Li had also warned about the models unpredictability  

    "Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, becausethe sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price depreciation scenario? Because if they had, they would have never rated a single
    mortgage-backed CDO."

    A must read.......

    •  the brass ring (6+ / 0-)

      all that has occurred was neither crime nor incompetence

      the bush / cheney regime provided an opportunity for everyone
      from billionaire to janitor to have a final grasp at the brass ring

      the easy widespead material affluence that made america the
      envy of the world is over

      forever

    •  Can't blame David X. Li completely (6+ / 0-)
      I went and hunted down Li's original paper and came to the conclusion that he was doing his best to actually take into account the risk of dependent events.  It just turned out that the math he invoked gave some simple metrics which people flocked to because it boiled down to a single number.  His Gaussian copula function transforms a  pair of independent probabilities to something that has a dependency, thus raising the risk of default from a multiplicative probability of small numbers to something orders of magnitude higher. This is actually a proper move. Somebody was going to discover this heuristic sooner or later, and Li happened to be one of the first.

      However, the underlying math of invoking hazard functions for deducing the default risk has even more severe implications, and that concept was there before Li even tried to apply his own set of heuristics. Anyone that understands stationary processes knows that economics is not time-independent and that huge risks are waiting in the wings since hazard rates are not static or stationary in the financial markets.  

      So what we are seeing with the Wired article and some other articles that preceded this, is an attempt to lay the blame on a single person, where we know that the actual blame needs to be placed on all the stooges that thought that they could get away with squirelling away and deferring the possibilities of ultimately risky strategies. We are seeing the annointment of Li as the "O-ring" failure mode of the financial sector. (The infamous O-ring of the first space shuttle disaster provided the convenient scapegoat to that whole affair, even though probably more endemic problems were at the root of the explosion)

      Predicting failures on physical processes and actuarial types of things is much more refined than applying the same concepts to financial instruments.  

      This is scapegoating to the highest order, but the wheels are in motion.  All I can say is that it is probably better to put the blame here than on the Community Reinvestment Act. :) The seemingly well-educated do indeed deserce most of the blame, not some working stiffs or low-income people trying to make ends meet.

      (As a disclaimer, I am not overwhelmed by the math even though I have no particular expertise in finances or actuarial science.)

      •  After the failure of Long Term Capitol Management (2+ / 0-)
        Recommended by:
        Orj ozeppi, Taunger

        in 1999 or so, the limitations of this type of VAR model was apparent.

        It was just that anyone who tried to point out the dropping affordability index coupled with loan products with resets and balloons was a recipe for greatly increasing defaults got their jobs outsourced to someone who "understood the risk statistics better".

        In other words they did not want to hear it.

        The thing that makes me suspicious that there is not as much willful ignorance as intent is that there are 10 or 15 times as many side bets that the mortgages would fail (Credit Default Swaps) as there are underlying mortgage backed securities (Collateralized Debt Obligations). So if a CDO CDS package were bundled and rated as low risk because the CDS insured the CDO against risk, that would be a one to one ratio. The fact that there are 15 TIMES as many CDSs as CDOs means that an awful lot more money stood to the made by some counterparties if the loans default than if they are preforming for term.  
        That looks like perverse incentive to make variants of balloon loans which are known to have a high risk of default and possible big time conflict of interest to me.  

      •  Wall Street is littered (0+ / 0-)

        With corpses of the disbelievers of the Li formula...

        :)

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