Skip to main content

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

Comment Preferences

  •  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.

Subscribe or Donate to support Daily Kos.

Click here for the mobile view of the site