Skip to main content

View Diary: Scientists *Prove* Toxic Assets are Impossible to Regulate (268 comments)

Comment Preferences

  •  Tip Jar (203+ / 0-)
    Recommended by:
    Deep Dark, Angie in WA State, chrississippi, tmo, hannah, Timaeus, fitzov rules, alisonk, johnmorris, lobbygow, tommurphy, tacet, shpilk, hubcap, mrfleas, bara, eyeswideopen, opinionated, skrymir, Euroliberal, Time Waits for no Woman, cosmic debris, shanikka, phild1976, Ignacio Magaloni, ctsteve, Jesterfox, DemocracyLover in NYC, DustyMathom, psnyder, emmasnacker, pat bunny, johnfire, JimWilson, penguins4peace, lcrp, riverlover, alizard, Pohjola, Deward Hastings, jcrit, Daddy Bartholomew, Josiah Bartlett, mm201, Gowrie Gal, Julie Gulden, Fabian, greycat, UncleCharlie, yuriwho, Halcyon, run around, panicbean, Simplify, nytcek, ChemBob, drewfromct, david78209, Dobber, reflectionsv37, Mz Kleen, farmerchuck, where4art, FunkyEntropy, johnrhoffman, deepsouthdoug, daddybunny, troutwaxer, Oye Sancho, xaxnar, Jim P, SSMir, third Party please, New Deal democrat, Milly Watt, buckstop, earwulf, Naniboujou, carolita, NBBooks, tecampbell, global citizen, StrayCat, bubbanomics, agnostic, paul2port, Data Pimp, bleeding heart, Preston S, sceptical observer, ER Doc, rage, profh, Clive all hat no horse Rodeo, Hedwig, OHdog, DBunn, bigchin, One Pissed Off Liberal, old wobbly, tourist305, Boreal Ecologist, Mike McL, dotsright, Loudoun County Dem, linkage, yoduuuh do or do not, FishOutofWater, mommyof3, lurks a lot, eOz, Uncle Cosmo, bnasley, malharden, Drowning Wave, Seneca Doane, letsgetreal, millwood, Moderation, jhop7, uciguy30, willb48, TomP, ShadowSD, ynp junkie, Wes Opinion, Sharon Wraight, Akonitum, jamess, monkeybrainpolitics, Happy Days, Calamity Jean, pickandshovel, Seamus D, kyril, luckylizard, Troubadour, DixieDishrag, binkycat, In her own Voice, HoosierDeb, sydneyluv, shortgirl, Leo in NJ, 4km, LaFeminista, FudgeFighter, prettygirlxoxoxo, Pris from LA, J M F, arendt, Neon Vincent, ARS, snackdoodle, JG in MD, Michael James, be the change you seek, Stranded Wind, Zotz, m4gill4, mrchumchum, Fixed Point Theorem, Mercuriousss, jomi, johngoes, sanglug, allep10, Green Karma, Nonconformist, acromagic, NCrissieB, Amber6541, BasketCase, publicv, amk for obama, TheWesternSun, gulfgal98, pablito, ItsSimpleSimon, Benintn, paradise50, Kristina40, DrFitz, ricardomath, Floande, USHomeopath, rmabelis, heart of a quince, Thassa, Olon, thethinveil, PedalingPete, Wolf10, Claudius Bombarnac, bamabikeguy, Canuck in Ohio, VTCC73, carl offner, Atilla the Honey Bunny, Vexed, Logical Fallacy Contraption, MichaelNY, LakePipes
    •  I to sez: great diary. (20+ / 0-)

      Tipped and rec'd.

      You'll pay me the 8s I won of you a-betting?

      by Boreal Ecologist on Sun Oct 18, 2009 at 07:31:24 AM PDT

      [ Parent ]

      •  The key to sound securities... (17+ / 0-)

        starts with sound underwriting of the underlying mortgages.  Fogging a mirror is not a sound criteria.

        In the old days (Ha, the 80's are the old days now), mortgages had to meet FNMA underwriting standards which were fairly strict back then.  

        I am here to represent the democratic wing of the Democratic Party. Roar louder!

        by Josiah Bartlett on Sun Oct 18, 2009 at 09:48:15 AM PDT

        [ Parent ]

        •  The key to cleaning up the giant pile of shit (6+ / 0-)

          The problem isn't how to stop the trading of complex CDOs/CDSs; if this paper is right, that will stop. The problem is the capital already invested in complex CDOs/CDSs totals several times the world's annual GDP, according to this paper, and all of that capital will be inextricably frozen for the lifetime of these instruments. That is a giant, indissoluble clot in the world's financial arteries.

          Disclaimer: I am not an economist and I don't play one on TV either.

          How about this:

          If something is frozen, what's the problem? Leave it frozen and let the government print a shit ton of money and spend it on things that actually improve the general welfare of the people - infrastructure, green energy, health care, education, etc. All we have to do is un-privatize the Fed so that taxpayers no longer necessarily have to pay interest (or even pay back principle on newly created money.) New money is created all the time; it's just that our corrupt government has simply given this function (the ability to create money out of thin air) away to our wealthy rulers in the banking industry.

          If Big Shitpile ever begins to thaw out somehow, possibly flooding the economy with too much money and igniting excessive inflation, we just tax the fuck out of the rich bastards and suck some of the money back out of the economy. When or if that point comes, all the productive investments in infrastructure, green energy, health care, education, etc. in the meantime should have the economy in good enough shape to handle sucking back in some of the money. At the same time we could start paying off some of our debt to China.

          The only problem I can see with this solution is that our "democracy" is too corrupt to enact it. Our bankster overlords would never let it happen.

    •  Reminds me of the unpicked over bags of coins, (11+ / 0-)

      and or stamps that used to be sold to children and or neer do wells..These are of course now the same grown up type people who depend upon hitting the lottery in their "Retirement planning" portfolios !

      No CDOs for me, I'm still buying the unsearched coin and stamp bags and I'm really, really overdue for that lottery chisel..?

      And of course there is always Vegas or AC

      "Course I'm respectable. I'm old. Politicians, ugly buildings, and whores all get respectable if they last long enough." Noah Cross - Chinatown

      by LakePipes on Sun Oct 18, 2009 at 08:06:21 AM PDT

      [ Parent ]

    •  The "what to do about it" question ... (41+ / 0-)

      ... is as counter-intuitive as the math. The problem isn't how to stop the trading of complex CDOs/CDSs. The problem is that if this paper is supported by other complexity theorists, no buyer should ever buy another complex CDO/CDS, at any price ...

      ... because not even the most sophisticated buyer with the NSA's computing capacity could calculate the risk of a single complex CDO/CDS within the lifetime of the instrument. That means there's no way to know if you're paying a fair price for that risk, nor even to know whether an instrument failed through bad luck or the seller's cheating.

      If this paper is correct, no one should buy any but the most transparently simple CDOs/CDOs. The rest are value-less - they can't be sold at any price - and the government won't need to do anything to stop them from being traded. No buyer will touch them.

      The problem isn't how to stop the trading of complex CDOs/CDSs; if this paper is right, that will stop. The problem is the capital already invested in complex CDOs/CDSs totals several times the world's annual GDP, according to this paper, and all of that capital will be inextricably frozen for the lifetime of these instruments. That is a giant, indissoluble clot in the world's financial arteries.

      •  This is an interesting, and subversive point. (16+ / 0-)

        Because it may mean that if the proofs of this research paper are digested by investors, they will pull money out of complex CDOs on their own.

      •  Not quite (12+ / 0-)

        The paper does not say that there are no good CDOs or that the risk of CDOs cannot be determined under any circumstances.  What is says is that CDOs are vulnerable to undetectable manipulation -- that you can't tell in computationally tractable time whether the underlying assets were non-randomly distributed among a non-trivial number of CDOs -- whether someone intentionally made some bad CDOs by choosing to concentrate the lemons in them.  If you could be certain a priori that the underlying assets were randomly distributed, then (modulo other considerations, such as mistaken assumptions about the independence of the underlying asset prices) the risk of the CDOs could be computed.

        In other words, the solution to the problem can be seen as providing a trustworthy mechanism that guarantees random distribution of the underlying assets into the pool of CDOs.  Whether that is itself a tractable problem is left as an exercise for the reader.

        •  Were we able to exercise prior control (4+ / 0-)
          Recommended by:
          DBunn, Akonitum, NCrissieB, MichaelNY

          on the construction of CDO/Ss, wouldn't the problem of undetectable manipulation thereafter remain? Your conditional - "If you could be certain a priori" - is so stringent as to be unlikely to be satisfied in the real world by regulatory agencies whose ability to protect the public is limited at best and highly subject to prevailing political winds. Even if your stringent condition were in theory satisfiable, how would buyers be able to reassure themselves that it had been actually implemented? Would potential buyers really be in any better position to know the quality of the CDO/S on offer before them?

          American democracy: One dollar, one vote. See? Equality!

          by psnyder on Sun Oct 18, 2009 at 12:34:11 PM PDT

          [ Parent ]

          •  Sure, guaranteeing randomness isn't easy (5+ / 0-)
            Recommended by:
            barath, psnyder, knocienz, NCrissieB, MichaelNY

            But it may not be computationally hard the way ex post regulation of CDOs is.

            My points are two.  First, that the paper does not show that CDOs themselves are inherently evil or the source of evil, but rather that the evil of claiming random distribution of risk in a CDO pool when, in fact, the distribution is non-random passes through and is hidden by the CDOs.  Second, that guaranteeing random distribution defeats the evil, even while leaving the CDO market intact.

            Is guaranteeing a random distribution of the underlying asset risk any more tractable than regulation that depends on ex post detection of CDO manipulation?  There is reason to be hopeful that the answer is yes.  Trustworthy randomness is not just a problem for CDOs, but for many problems in information security.  As such there are already some fairly strong solutions, and there will continue to be improvements.  Guaranteeing that CDOs were built with trustworthy randomness would essentially be a matter of feeding a list of underlying assets into a regulator-audited and regulator-secured black box that would spit out CDOs with a certificate of randomness, a seal of approval.  Trusting the CDO to be free of manipulation then becomes a matter of trusting the certificate and the black box process.  Establishing and maintaining that trustworthiness is certainly non-trivial, but at least in concept it is more tractable than is ex post regulation of CDOs.

            •  Maybe... (2+ / 0-)
              Recommended by:
              Foodle, NCrissieB

              Though there are plenty of protocols to do joint randomness generation and to do secure multiparty computation (and lots of work on joint-shuffling for voting mixes and the like), it would be adding complexity to the situation, which we've found is perhaps not the direction we want to go in.

              It could work, but maybe that's looking at the solution from too CS centric a viewpoint...I wonder if we could really expect regulators to understand the processes for randomness generation, etc.

              •  It would be adding steps to the process (3+ / 0-)
                Recommended by:
                barath, NCrissieB, MichaelNY

                but it would actually be reducing complexity in the sense that information would be destroyed -- it wouldn't be possible for the CDO creator to retain privileged information about the distribution of lemons.

                •  Turning the CDO market into a mutual fund? (3+ / 0-)
                  Recommended by:
                  Foodle, NCrissieB, MichaelNY

                  Given an accredited random distributer, what is the distinction between the different resulting CDOs? In theory, with sufficiently large input, the different groups should have a gain/loss distribution that would be determined by entropy equations.

                  In that case, why even distribute them into different CDOs? Your payoff distribution would be entirely based upon the criteria for entering the pool prior to the randomization and breaking them into different groups after randomization would be worthless.

                  Effectively, you would be investing in a subsection of the mortgage market that was used to create the pre-randomization pool.

                  •  Yup (3+ / 0-)
                    Recommended by:
                    barath, knocienz, NCrissieB

                    I agree as far as I can see, and I must confess to not really understanding the utility of the practice of dividing the pool up into multiple CDOs instead of just selling shares in one big CDO created from the entire pool.  Of course, the random function for distributing all of the pool assets into a single CDO is also satisfyingly simple, easily audited, and very trustworthy.

                    •  Different investers want different things (1+ / 0-)
                      Recommended by:
                      NCrissieB

                      Some want high risk/higher return. Others want low risk/lower return. Without this function, they become pointless.

                      CDO's were not used much until David Li came up with his Gaussian copula models for pricing.

                      Investment banks jumped on them since they assumed the formula was valid and would reduce risk. This diary shows that they are not and, more importantly, can never be.

                      •  Tranches (1+ / 0-)
                        Recommended by:
                        Claudius Bombarnac

                        Risk/return can be differentiated by tranches within a single CDO.  The risk/return needs and desires of different investors don't demand dividing the asset pool into multiple CDOs.

                        •  You are right to a point... (0+ / 0-)

                          But not all CDOs are created equal and this is my point.

                          A senior tranche in one CDO can be quite different from that in another CDO depending on the overall quality of the underlying assets, cash flow, yield, management, and a plethora of other factors.

                          This gives a much greater range of risk/return options/features.

                          I can't picture having a single CDO created from one gigantic pool and simply divided into 4 tranches. It is not the way the free market works.

        •  Another possibility (1+ / 0-)
          Recommended by:
          NCrissieB

          is simply to require that all tapes describing the assets underlying these derivatives are encoded in a standard and machine-readable form.  If you can get all of the information into a database, you can check for yourself on a variety of properties such as the geographic, demographic, and property attributes of each mortgage.  If they are well-distributed, then congratulations, you have a chance of losing your shirt honestly.  If they turn out to all be two-year old 3,000 sq. footers made by a fraudulent builder in Detroit ... good luck.

          But, I think the end message is the same - always require the fundamentals to be as exposed as possible.  That way there is at least the chance to read the fine print.

          •  Sure, but (2+ / 0-)
            Recommended by:
            OdinsEye2k, NCrissieB

            if you are going to force that level of information awareness on potential CDO buyers, then those buyers may as well become direct lenders.  The whole point of a CDO is to be able to extract low-risk investment opportunities that don't require the level of knowledge of risk in the underlying asset that direct lending does.

          •  wrong conclusion (0+ / 0-)

            The issue described here persists even if all information is available, and the root or the issue is how the liabilities and payoffs to different tranches are defined.

            However, I am not sure if the paper describes the "real" problem.  In my opinion, the real problem is the following: well designed derivatives allow to trade "risk" with correct prices if the participants in the market exercise due dilligence.  However, the attention of the participants is diverted from the analysis of the underlying facts (e.g. how long one can keep selling mortgages in markets where buyers cannot afford them without those markets crashing) to the analysis of the model.

            For example, suppose that a car is worth 1000 when it functions and 0 when it does not (so-called lemon) and ca. 20% or cars in a pool of used cars are those that will pretty soon stop functioning.  To sell the cars we issue warranty contracts.  Warranty contracts are pooled and securitized.  Now we have pay someone 250k to provide financial guarantee for  1000 cars -- giving that someone a profit of 50k and removing the risk from our books.  So far so good.

            But suppose that the problem with cars is not that some have hidden defects, but that most of them are insufficiently resistant to corrosion.  More precisely, the problem emerges when salt is applied to roads for to long period of time in a single winter.  Cars survive first and second winter with few defects.  The fee to guarantee 1000 cars drops to 100k.  Then comes a harsh winter and someone who pocketed 100k has 500k liabilities.

            Which would be a "personal problem", except that that "someone" did it 1000 times over, and  most banks gave risk-free loans with cars on warranty as collaterals etc.

        •  I agree with your analysis. (1+ / 0-)
          Recommended by:
          barath

          However, the problem then becomes how to regulate a private market such that sellers have no choices in what underlyings (of a given type) that they bundle into CDOs/CDSs. As you note in comments below, that is a non-trivial problem because in a private market clever people can usually find ways to cheat.

          The problem here is that if this paper is correct, buyers can't use statistical analysis of CDO/CDS performance to identify fraudulent sellers. The computation required to detect lemon-loading fraud will take longer than the lifetime of the instrument and the statute of limitations. Why would any buyer take that risk?

      •  NP complete isn't _exactly_ "unsolveable" (12+ / 0-)
        First, some very loose definitions, just to establish whether I understand NP-completeness. (Feel free to skip this.)

        P: The class of problems which can be solved in polynomial time, i.e., for an input of N items, the running time is less than N^k for some constant k.

        NP: The class of problems where we can check a proposed solution in polynomial time.

        NP-complete: The hardest problems in NP. If you can solve these, you can solve anything in NP.

        There are some important wrinkles here: Some NP-complete problems are easily solved almost all of the time, and only become hard for obscure special cases. Other NP-complete problems can be solved approximately (e.g., "I can guarantee that this solution is at least half as good as the ideal solution, whatever that might be.").

        In real-life, lots of optimization software needs to deal with NP-complete problems. For example, efficiently drilling holes in circuit boards is equivalent to the "traveling salesman problem", which is NP-complete. But there are techniques for getting a good answer to this problem, just not the best answer.

        So this paper doesn't actually prove it's impossible to do an adequate job of analyzing CDOs/CDSs. It does, however, strongly suggest that it's a difficult, ugly problem.

        My gut feeling: Anybody shopping for CDOs/CDSs would be better off trying to beat the house in Las Vegas.

        •  But, you have to slam your (2+ / 0-)
          Recommended by:
          drewfromct, NCrissieB

          crazy graph-searching, genetic algorithm, random searcher, or whatever algorithm against every CDO share you have is what it sounds like.  That may start getting us to talk about grains of sand in the universe.

        •  Indeed (2+ / 0-)
          Recommended by:
          scotths, NCrissieB

          Let's not be guilty here of twisting the facts to suit our purposes: the other side does that often enough. You're right that we're likely to be able to solve this problem in many cases, and to get a good approximation in others. In our minds, we can separate CDOs into "obviously good", "obviously bad", and "I don't know" classes, and because the brain is no more powerful than a Turing machine, computer programs can do the same thing.

          •  Remember, there's a nasty asymmetry here (0+ / 0-)
            (Turing machines aren't really relevant in this case, because we're talking about NP-complete problems and not the halting problem.)

            Before I could have an informed opinion on how bad the problem really is, I'd have to read the paper carefully and study a cross-section of real-world CDOs and CDSs.

            But in general, if side A and side B are trying to outsmart each other, and side A gets to dream up NP-complete problems to trick side B, I really don't want to be on side B. Side A gets to throw together some fairly simple problems, and then side B has to put in a huge amount of skull sweat to find approximate solutions. Even if you can somehow remove the NP-complete problem from the table, there may be other serious asymmetries between side A and side B. Nasty technical problems, like many other sorts of misfortune, tend to come in clumps.[1]

            Plus, there are many other ways to build a deceptive CDO or CDS. You can, for example, feed all the underlying loans through ultra-complex software that nobody really understands, and have it spit out carefully-tuned CDOs that look good on paper but which conceal all sorts of dubious assumptions. ("Well, of course those variables are all independent and they all have nice Gaussian distributions. And what could possibly be wrong with basing all our math on a 5-year historical model based on a single economic boom? And of course variables that are uncorrelated during an economic boom will remain uncorrelated during a one-in-a-lifetime crash.") If you need an advanced degree in statistics just to explain how the math should work, very few people will be smart enough to find the mistakes. And nobody will listen to them, because they sound depressing, and the optimists are making money hand over fist in the short term.

            [1] Who, me? Superstitious?

            •  Hrm (0+ / 0-)

              (Turing machines aren't really relevant in this case, because we're talking about NP-complete problems and not the halting problem.)

              Are there NP-complete problems that can solved at all with a device less powerful than a turing machine, even in exponential time?

              Plus, there are many other ways to build a deceptive CDO or CDS.

              Absolutely right, which is why this result doesn't matter all that much. The problem is extremely complex regardless, which is why we need to deal with it through legislation.

              As the old adage goes, never try to address a social problem with a technological solution.

              •  Turing machines (0+ / 0-)
                Are there NP-complete problems that can solved at all with a device less powerful than a turing machine, even in exponential time?

                A Turing machine, in more intuitive terminology, is just a general-purpose computer[1]. Even some very simple and easily solved problems require a Turing machine.

                And if a problem can be solved at all, it can almost always be solved by a Turing machine.[2]

                Because the easiest problem requiring a Turing machine is much easier than an NP-complete problem, and the hardest problem solvable by a Turing machine (given enough time) is much harder than an NP-complete problem, you can just sort of take Turing machines as a given in this discussion. :-)

                As the old adage goes, never try to address a social problem with a technological solution.

                Now, that's taking all the fun out life, right there. :-) If your social problem boils down to communication, it can occasionally be fixed by sufficiently clever application of technology.

                [1] With an infinite amount of memory.

                [2] We certainly can't build anything more powerful than a Turing machine. But if you're interested, there are some rather useless theoretical proposals based on very dubious physical theories.

        •  remember that it's also a game (0+ / 0-)

          The seller is deliberately trying to find the "obscure" cases that are intractable to solve, so knowing that you can usually find a good solution for randomly chosen inputs might not help at all (I haven't read the underlying article yet, but I can intuitively see how to game such a system as the diarist suggests).

          And the difference between a 95% and 105% return on investment is the difference between going broke and getting rich if you are highly leveraged.

      •  This Knowledge Won't Stop Trading In Them (5+ / 0-)

        If this paper is correct, no one should buy any but the most transparently simple CDOs/CDOs. The rest are value-less - they can't be sold at any price

        There's a big difference between "should" and "will".

        The people buying the CDOs that got us into this mess didn't make bad financial decisions. They bought a bet the seller was foolish to make. The buyer bet the underlying assets, like mortgages, would fail to pay their obligations, in which case the seller would then pay the buyer more than the buyer paid the seller to set up the bet. It's the sellers who made bad financial decisions, which this paper shows can't be distinguished from good ones.

        But that's totally irrelevant. The sellers knew they were making bad financial decisions, bad bets they were doomed to lose - big bad bets. They just didn't care.

        Because the specific people selling those bets got paid that year a bonus based on how much they sold, regardless of how badly the bet would lose a few years down the road. By the time the bets came due, they'd been paid, and often left for some other bank. And if losing the bet crashed their bank, they'd just look for another bank to go to, or retire on all those years of bonuses.

        Or, if Goldman Sachs had Hank Poulson and then Tim Geithner and Larry Summers running the show, they'd just get even more bonuses for losing so badly, buy low in the stock market they'd crashed, and sell high once it grew back up financed by vast new government debt.

        Why wouldn't they just do all that again? They most certainly would. And they most certainly will, even if they "should" not, because there's no more credit left in the Treasury. They will anyway, and roll the dice with everyone else's money.

        Which is why we must have laws prohibiting any public backing of any bank or person who buys or sells any instrument whose risk cannot be accurately quantified and proven.

        "When the going gets weird, the weird turn pro." - HST

        by DocGonzo on Sun Oct 18, 2009 at 03:30:25 PM PDT

        [ Parent ]

        •  Why would buyers take the risk? (0+ / 0-)

          Most of these were AAA-rated securities, so buyers felt they were making safe investments. Partly that was because the ratings houses were paid by the same banks that were creating the securities, but partly it was because the ratings houses thought they knew how to evaluate the securities well, and partly it was the (apparently false) assumption that buyers could by due diligence identify fraudulent sellers.

          If this paper is correct, the last two assumptions are both not true and not resolvable by statistical analysis. The paper says you can't use statistical analysis of a seller's CDO/CDS performance to detect lemon-loading fraud, as the calculations require longer than the lifetime of the instrument and the statute of limitations.

          Given that knowledge, if the paper is correct, why would any ratings firm give a good rating to such an instrument? And because the buyers of CDOs/CDSs were mostly sophisticated, institutional investors ... given that knowledge, why would any of them take that risk again?

          I don't doubt that sellers would want to sell these instruments. But a transaction also needs a buyer, and if this paper is correct - the authors admit their analysis is preliminary - the sophisticated buyers who invested in CDOs/CDSs wouldn't go near that risk again.

          •  Because It Pays Off (0+ / 0-)

            The buyers and sellers treat the instruments like a black box, regardless of their actual risk, because of the payoffs I just described. It didn't matter to the buyer that the CDO they bought failed to yield more than they paid (or yield anything, for that matter), because they hedged that bet with a CDS which cost less than the CDO would yield if it paid off, but which would pay off a lot more if the CDO failed. That's one reason the pools of money buying and selling these instruments are called "hedge funds".

            The "irrational" player is the CDS seller, because they knew they were left holding the risk on unquantified risks - which are always assumable only to be bad risks. But, as I described, the risks were not held by those paid to trade in them. Held instead by their employer, whose losses wouldn't affect the person selling the CDS (or the bonus they got in the selling year). And since the biggest sellers were "too big to fail", that meant that they, their lobbyists and the legislators they bought were not holding the risk, but rather the taxpayers (and US Treasury bondholders and buyers) were taking the risk. Taking the risk without receiving the reward, just the business end of the whipping stick.

            The problem is the interest conflicts. Both the corrupt ratings agency and the unaccountable CDS seller. The "let nature take its course" solution, like what you recommend now that the treacherous risk lurking beneath inscrutable "AAA" profiles is known, would have been to just let the banks that sold those bad bets fail. But we didn't do that. So the buyers and sellers each have some kind of rigged game that keeps them doing what they were, for the promise of money.

            The old game was enabled on the risk analysis level by corrupt ratings agencies. But the, in the 1980s junk bonds were known to be even more risky, guaranteed losses across their class of bond, but banks bought them up fast then, too. And this decade was exactly the same, except the bonds were bundled instead of individual corporations. They knew the risks were bad, but they did it anyway because they knew the game was rigged so they can't fail, except upwards.

            And they will again. "Too big to (be allowed to) fail" hasn't changed, so nothing will be different. These big banks and investor corps will continue to take risks they can't handle, as long as they're not required to handle them when the chips are down. Which is why legislation is required. They're so used to being invulnerable that they will continue to act that way - just like they did after Poulson told them the sky was falling, and they had to take a $TRILLION crash helmet, but they refused. The system doesn't feed back negatively to them. Until it does, they will let it all ride. And it can be made to feed back negatively to them only though legislation. The market is already too deeply structured to protect and reward them for the market to correct them.

            "When the going gets weird, the weird turn pro." - HST

            by DocGonzo on Sun Oct 18, 2009 at 06:56:30 PM PDT

            [ Parent ]

            •  We're reading the situation differently. (0+ / 0-)

              It may be that you're reading it better than I am. I'm not a financier, economist, or mathematician, and you may be one or more of the above or just know more about it than I do.

              From what I've read, this is not a case of sellers setting up doomed-to-fail bets that their firms then foisted onto the taxpayers. (Well, the last part is true; we have been stuck with the bill.) Rather the major banks had bought up the mortgages, many of them undocumented, and to control their (the banks') risk they sold off pieces of that risk in the form of derivatives. The ratings firms, paid by the banks and thinking they knew how to evaluate the underlying assets, gave those derivatives AAA ratings. Pension funds and other institutions saw the AAA rating and thought these derivatives were safe investments, akin to the long-term, modest-yield, modest-risk bonds they usually bought.

              The derivatives' risk was much higher than the buyers (and maybe the sellers) knew, because the Li Cupola Equation treated home mortgage defaults as purely independent events. It didn't consider that home prices are systemic and defaults could trigger a feedback loop. The banks who bought those mortgages and offered the derivatives, and the ratings houses who graded the derivatives, were all using Li's equation to evaluate their risk. The buyers were relying on those AAA ratings and the sellers' past performance to evaluate the risk.

              As I read the paper cited in the diary, the buyers could not evaluate the risks well enough within the lifetime of the derivatives based on the sellers' past performance, and the ratings houses probably couldn't either. Whether the banks/sellers could is a different question and not addressed in the paper.

              That's the story I've pieced together from what I've read. The story you're telling is different, and it may be that your story is more accurate. I don't know enough to evaluate that.

              •  Different (1+ / 0-)
                Recommended by:
                Claudius Bombarnac

                I developed software for brokerages, then insurance corps, in the late 1990s, while they all transformed into "integrated financials" (bank + brokerage + insurance) after CitiGroup formed in violation of the Glass-Steagall "firewall" (sector exclusion) act, which was finally deregulated in 1998 so the entire industry could follow Citi into the last Depression's leverage/risk hole. I worked closely with these bankers to model their business, so we could automate as much of it as possible so it could be scaled up as quickly and cheaply as possible, the Internet Boom way. All of our projects were defined by, and in terms of, risk management. Every single person, whether banker, developer or generic manager, was a risk manager. Especially in the insurance departments, where risk was the only product they traded in.

                Credit Default Swaps are risk products. That's why AIG, the biggest insurance corp, sold the most of them. AIG, among others, had over century of experience in trading risk - and these offices are governed by tradition and custom, even when a new generation of punks targets those as vulnerable to new ways to game the system. These bankers knew the risks they were selling were bad bets. Because every one of them knows that an unquantified risk must be treated as an unlimited risk.

                That's why they rigged the system, despite the terrible odds. Of course selling mortgages to people with no income/job/assets (known as a "NINJA" loan), on first homes at dizzyingly inflated prices (because of the excess of loans) was sure to go terribly wrong in very many cases. But still they sold them, because each of them allowed the bankers to sell many bad bets on them succeeding. Those bets counted as sales in calculating those bankers' bonuses. They knew it would all come home to roost, but it was all structured as someone else's problem. And in banking, whenever there's a race, everyone runs the same way, even when they all know it's to the bottom. They knew, but they took pains to hide it. That's why some complex and absurd formula like the Copula is useful: it's the cover story, that no one in banking believed, but it would make them look less guilty (and get less prosecuted) when the shit finally hit the fan. The ratings agencies rating high to keep their "separate" consulting divisions getting big business from those same banks in "other" operations was the biggest fig leaf that every bank and agency knew was a scam where security needed to be.

                And it hit the fan for 3 solid years. ARMs started raising rates in 2006, immediately raising the default rate. That went on through 2007 and 2008, until the small actual assets these banks leveraged to borrow from the Fed (and ultimately the Treasury, which is taxpayers) actually ran out. So for those 3 years, it was blatantly obvious every day that the CDOs were failing, and the multiplied CDS obligations to pay on them anyway were coming due. There was no way not to know. But still they sold these instruments. They even refused to accept the bailout at first, because that would have allowed the White House to order them to stop selling those booby traps without waiting years for Congress to reregulate (still just another pile of papers on Barney Franks' desk, over a year since deregulation destroyed the world). And then they got bailed out anyway, in ways that have earned the most politically connected (Goldman Sachs) some more record profits, and seen all the bankers themselves golden parachuted to enjoy all the bonuses they socked away through their Bubble years. Not a scratch on them, strolling among billions of maimed and dead bodies across the global landscape.

                So in short, they knew their game was doomed to fail, but also knew it was rigged to be someone else's problem. And that's exactly what happened. Your version matches the facts except for where you've been spun on what the bankers knew and expected. Your version is just an advanced step down the same path as the original story: "it's all too complicated for anyone to understand". Which, to a banker, means they either reject it, or wrap it in some risk handoff so they don't have to understand it, if they do understand that shell game will still make them money while minimizing their own risk. And that's exactly what happened.

                "When the going gets weird, the weird turn pro." - HST

                by DocGonzo on Mon Oct 19, 2009 at 06:06:29 AM PDT

                [ Parent ]

                •  Ahh, thanks for the explanation. (1+ / 0-)
                  Recommended by:
                  DocGonzo

                  I agree that an unquantifiable risk must be treated as an unlimited risk. The paper referenced in the diary doesn't comment on whether the seller knows the actual risk. It simply and explores whether the buyer can use statistical analysis to detect a seller's lemon-loading fraud.

                  As for the balance of your post, I usually keep my take on it to myself because it's beyond cynical and well into ugly: the banks and megacorporations have set up the system to ensure that almost none of us can ever be more than one bad life event away from losing our life's accumulated assets ... to them.

                  •  Cynicism (0+ / 0-)

                    I've never met a banker who could be trusted further than you could spit them. And I've met hundreds of bankers, most of them trying as best they could to describe to me exactly how their job (and the jobs of everyone with whom they work) is done, so I could model and automate it.

                    I don't think the banks "and" the megacorporations (mostly overlap) have set it up for the rest of us to live at the very edge. I think they've set it up to suck as much money and power from the whole system as possible without forcing enough of us into poverty or catastrophe that we stop producing that money (or, maybe, somehow, some day, rebel). They just exercise their money and power to get the most possible money and power for themselves, backing off only when the rest of us are sucked so dry we might threaten the mostly smooth operation of that money and power machine. Because it requires our cooperation to work, even if ultimately that cooperation is both/either unwitting and/or forced.

                    In the US, it's mostly greed that keeps it going, underwritten by ignorance - much of it willing ignorance, and a lot of it herculean denial. "What's the matter with Kansas" is what's the matter with all of us. And that's what bankers and the corporations they love depend on to stay fat as bloody ticks.

                    "When the going gets weird, the weird turn pro." - HST

                    by DocGonzo on Mon Oct 19, 2009 at 03:49:35 PM PDT

                    [ Parent ]

    •  interesting paper; let's not leap too fast (7+ / 0-)

      Thanks for posting the paper. Just a caveat that we're better off not overselling this. It's a draft, early paper, simple model, and the authors make lots of caveats (they themselves would not say they prove anything). E.g.:

      This raises the question whether some other way of CDO design is less susceptible to this manipulation. This section contains a positive result, showing more exotic derivatives that are not susceptible to the same kind of manipulation.

      Our results can be seen as some cause of concern, even though they are clearly only a first step (simple model, asymptotic analysis, etc.).

      (Our few positive results in Section 5 raise the hope that it may be possible to circumvent at least the tampering problem with better design.)

      Does your paper imply that CDOs and related products should be banned?
      For now, that would be a hasty conclusion. The credo in the derivatives market has always been "caveat emptor." The paper shows more reasons for buyers to be careful, and for everybody (buyers and sellers) to take computational complexity into account. Hitherto this aspect has been ignored.

      I suggest following the economics literature on this for a bit (reading the original authors, more than secondary sources), and not over-reacting. Yet... ;-)

      •  Good points. Here's one more: (6+ / 0-)

        While NP-complete problems such as this (and the famous Traveling Salesman Problem) are intractable to an analytic solution in finite time, there are generally "acceptable" solutions that work "well enough" in a large fraction of cases. [Disclosure: IANACS, just an interested observer.] So even if the premise of the article is shown to be rigorously correct, I doubt very much whether that in itself will put much of a damper on this marketing device. As long as there is a way to dump the risk onto hapless victims (i.e. taxpayers) or other suckers by promises of get-rich-quick, the game will continue.

        •  IAACS (5+ / 0-)

          Or at least I was as an undergraduate.  Every problem with a finite problem-space is solvable in finite time by a brute force method.  Therefore, it is not technically correct to say that NP-complete problems are unsolvable in finite time, but rather that there is no known way to solve them in polynomial time.

          Problems that take longer than polynomial time to solve are intractable for large problem spaces, but not for small ones (the traveling salesman problem for a handful of cities can be solved on your computer in very little time).

          ...that's my drive-by pedantry for today  :)

        •  but the seller is choosing the cases (0+ / 0-)

          The seller could be crafting situations outside the realm of those for which acceptable solutions can be found.

          Intuitively, just think of the seller as an agent that is encrypting the risk, and as the buyer you need to decrypt it.   That's a losing proposition if the seller is aggressive enough.

      •  Agreed. (1+ / 0-)
        Recommended by:
        NCrissieB

        I don't want to jump to a conclusion on what should be done - but it does seem clear that the results indicate that there at least exist a number of bundling schemes that are computationally infeasible to analyze or regulate.  So in that sense they did prove the effective impossibility of regulating such toxic assets.

        (Plus I had to give it a catchy title otherwise nobody would even look :)

    •  $589 Trillion fiat currency & credit derivatives (1+ / 0-)
      Recommended by:
      cheerio2

      with packaged toxic assets;)
      http://www.usdebtclock.org/

      US debt will be over $20Trillion in less than 10 yrs

      Look at money creation by Fed and that $589 Trillion currency and credit derivatives.....now that's F I A T !

      The Obama administration may say they want a strong dollar butthey haven’t got the means to support it. The Federal Reserve can’t raise rates, and the White House can’t cut the budget deficit anytime soon.

      Yikes !

Subscribe or Donate to support Daily Kos.

Click here for the mobile view of the site