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

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  •  One of the results (5+ / 0-)

    is that tranching doesn't protect the buyer from manipulation by the seller.

    "Dream for just a second and then do it!" -- Kolmogorov

    by theran on Sun Oct 18, 2009 at 08:03:09 AM PDT

    [ Parent ]

    •  I don't see how such manipulation would benefit (2+ / 0-)
      Recommended by:
      burrow owl, NCrissieB

      the seller unless they wanted to take a loss.  In what I'm suggesting, say the seller stacks a CDO with a bunch of bad debt, such that the value in reality is reduced by 50%.  Both then lose 25%, rather than the seller losing 50%, it's true.  But I can't believe that it's worth it to issue the loans in the first place, if you know you're going to have to eat that 25% loss.  You make/save more money simply by never having issued the loans.

      So yeah, you could choose to screw somebody else along side of you, but wouldn't rational self-interest simply dictate not screwing yourself by issuing bad debt loans?

      Those who labour in the earth are the chosen people of God. - Thomas Jefferson

      by Ezekial 23 20 on Sun Oct 18, 2009 at 08:09:29 AM PDT

      [ Parent ]

      •  Seems plain to me (3+ / 0-)
        Recommended by:
        Mz Kleen, In her own Voice, NCrissieB

        How can a buyer know that the seller has not totally stacked the deck and labeled the best stuff as the worst stuff then keep the “bad stuff” as part of the supposed deal.

        They can set themselves up to be the winner if the stuff they hold is least likely to default but it’s labeled otherwise.

      •  There are M instruments from the same issue (2+ / 0-)
        Recommended by:
        Mz Kleen, In her own Voice

        some are junk, some are gold.  If the seller and his cronies can tell the difference, it gives them a huge edge.  (Say the junky ones tank and the price of the whole issue goes to 20 cents.  You make a killing off the good ones, when everybody else is scared away.)

        "Dream for just a second and then do it!" -- Kolmogorov

        by theran on Sun Oct 18, 2009 at 08:39:16 AM PDT

        [ Parent ]

      •  That is what tranching tries to do (4+ / 0-)
        Recommended by:
        theran, Mz Kleen, gulfgal98, cheerio2

        but it doesn't work in practice because of the asymmetry of information. Time becomes the issue. There is not enough time in the life of the CDO to adequately assess the equality of risk. Therefore, the presumption has to be that the seller is manipulating the risk to off-load the highest-risk assets.

        In the above example, since each of the 1000 mortgages in the theoretical CDO is due at a different time, with different parameters and different risks, the only way to ensure equal distribution of risk is to not split the CDO. In your scenario, the "buyer" and "seller" would have to jointly hold the CDO for the entire life of the instrument, until the final win/loss is accounted. In other words, they become partners, and it is no longer a buyer/seller relationship.

        That is a whole lot like insurance -- the "seller" is asking the "buyer" to indemnify half of the risk for some potential profit. Which is how AIG lost its collective shirt.

        Those who are too smart to engage in politics are punished by being governed by those who are dumber. ---Plato

        by carolita on Sun Oct 18, 2009 at 08:45:37 AM PDT

        [ Parent ]

        •  Exactly. (1+ / 0-)
          Recommended by:
          Mz Kleen

          They do become partners for the life of the product, since the seller wouldn't be allowed to sell off the 50% they hold.

          But in this case, the original 'seller' has to do their homework, and not issue junk, or they KNOW they'll lose money.

          Now admittedly, you could get people who are just idiots selling, but as the 'buyer', it would be up to you to vet your 'partner' if you're not going to vet the individual products.

          There's always going to be some risk, and as any 'buyer' you need to do some homework somewhere, not just blindly accept either partners or products.

          Those who labour in the earth are the chosen people of God. - Thomas Jefferson

          by Ezekial 23 20 on Sun Oct 18, 2009 at 08:56:14 AM PDT

          [ Parent ]

        •  Can you explain how they can off load (0+ / 0-)

          the highest risk assets of a CDO through tranching?  My understanding is that CDOs are essentially a stream of payments collateralized by the underlying MBS, and that the most senior tranche's principal has to be paid off first from the money the CDO receives, and that tranches don't imply that the tranches' investors "own" a certain portion of the actual CDO's assets, just a certain stream and structure of payments in whatever priority the tranch designates.  

          If you're talking about seller manipulation as far as the misrepresentation of riskiness of the ENTIRE CDO, I understand that.  If you're talking about manipulation of certain tranches of the CDO, could you explain further what you mean?    

      •  Those aren't equal outcomes. (3+ / 0-)
        Recommended by:
        theran, alizard, Mz Kleen

        The seller knows or should know how much risk each derivative instrument represents. What this paper shows is that the buyer can't calculate that risk within the lifetime of the instrument, or even within the statute of limitations if the instrument fails. Maybe you got unlucky. Maybe you were defrauded. The calculations needed to know which of these is true are so complex that you can't possibly compute the answer until long after that answer is moot.

        Assuming this paper is supported by other scientists, what that means is ...

        ... no one should buy any but the very simplest CDO/CDS period, for any price, because you can't know whether you're paying a fair price. All but the very simplest CDOs/CDSs become valueless, because no buyer should touch them.

        Problem is, the total of those assets is several times the world's annual GDP. Gone.

        •  the actual advise is almost opposite (0+ / 0-)

          namely, that one could create a MORE complex derivatives so that it would be much harder to hide a manipulation.

          I personally think that the paper is discussing a wrong problem.  To a degree, why should anyone care about correct prices in transactions between private parties?  If A pays B x dollars to get C, then at that moment C is worth x.  Later C can be worth more or less, and it is up to B to worry about.  If the contract says that B will give C to A LATER, then A has a reason to worry: can B deliver?  But still, this is between A and B.

          As far as I can tell, the modern economy is not functioning properly without a certain "velocity of money".  Therefore we want to endow certain financial intermediaries with "safety": you can deposit money in their hands today and you will get what they promise you in the future.  No caveat emptor.

          The financial intermediaries that receive this boon have to be regulated.  And they have to borrow money (accept deposits) at some interest rates, and lend money at another interest rate, with some complex mix of rates and durations.  When you lend you have a trade-off between profit and risk.  So we need to show the regulators that you do not take more risks than you can afford -- I think it is called "capital requirement".  At this point we need to regulate how much risk such an entity takes.

          Risk can be taken, but using derivative contracts, it can also be passed to other hands, for a fee.  Here the pricing of derivatives moves from the realm of purely private transactions to the realm that has to be regulated.  If regulated banks reduce their risk, good.  If they do it cheaply, kudos to them.  But what if they do it cheaply but INEFFECTIVELY?  

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