This is also not true. Bond math is extremely complicated, and mortgages even moreso. There are a lot of inputs to model and a lot of sources of variance.
It is not “impossible” to accurately gauge the risk of default. If that were true, than banks would not extend mortgages and credit cards would not exist. This modeling works very well most of the time.
The problem is that when it is wrong and everyone uses it, the cost of being wrong is extremely high.
The impossible to gage part comes from the sheer amount of mortgages being packaged together and sliced apart.
Thank you very much. Very informative.
Correct me if I’m wrong - of course, some of this debt is “bad” in the traditional “house in foreclosure” meaning of bad. One of the issues at play is no one really knows what proportion of the debt that is held will not be made good over the term of the bond. And the more uncertainty there is, the higher the likelihood that risk occurs, and the less attractive those bonds are to buyers - which is the reason for the urgency - prop up the market now (and maybe put in foreclosure protection), money starts moving, jobs are retained, people make house payments. Let the people who made dumb decisions take their knocks, that Delorian looks less and less attractive by the minute a the risk on the “good debt” - in the traditional sense, increases.
There are highly specialized people whose jobs are to do just that.
And now a lot of them are either unemployed or are getting ready to box up their personal effects.
At the same time, the government might be purchasing mountains of hybridized CDOs, each with a fat prospectus. Someone with the right skills needs to be able to analyze these instruments.
I wonder…
Don’t you think Bernanke/Paulsen/Cox (hah! Like Cox has actually ever done anything!) pretty much screwed the pooch with the initial “No oversight, what I say is law” 3 page wonder? Don’t you think that is why the bill is facing such difficulty right now is because nobody trusts them?
Along the same lines, why the rush? Shouldn’t we prefer this get done the right way, and not shoved down our throats like items in the recent past? I know the mere fact that there is a bailout discussion freezes the market because they are seeking a better offer from the gov’t than they would in a private sale, but isn’t okay to tell the petulant pukes that caused this problem to sit down and shut the hell up?
Once the credit crisis is averted, don’t you think Bernanke will then have no reason to keep interest rates artificially low? He has been trying to strike a balance in stagflation, but the bailout will lop off half of that equation, so what’s to prevent him from jacking the rate up to 11 (if he is a fan of Spinal Tap)
The crisis will not be averted. We will have a bad economy for years while this mess gets worked out. The group on Rose agreed that we will be downsizing and have problems with the credit industry for at least 3 or 4 years. They may be optimistic. Bad times are ahead.
Yeah, and they did a crappy job of doing it.
No, not really. The business decisions were crappy. The math was fine.
Unfortunately, they’ve already taken whatever knocks they’re going to take. The question know is whether ordinary chump taxpayers around the world stump up a trillion or more bucks now in order to try to avoid a risk that the world economy transitions to a model where everything is paid cash in advance and the only people who can borrow money are the ones so rich they don’t need to.
Once again, thanks Scylla for a great thread.
And am I the only one who LOL’d at the title? 
I can hear the CEOs shouting “don’t tell me the odds!”
I’ve heard of people using models of consumer credit that allow the adjustment of credit lines to just barely safe - in other words, affordable. Clearly there is incentive for credit card companies to adjust this to find the optimal tradeoff between interest payments and the chance of default or even falling behind significantly. I believe some of the inputs to this model involve payment and purchase records.
Do you have any insight on this?
This is my objection to the current bill. Looks like Paulson’s trying to do some favors & arrange some kickbacks before he leaves office, rather than look out for the interests of the government or taxpayers after he leaves.
I think this was aluded to earlier, but can you elaborate the role mark to market played in all this, if any? I’ve seen that some people claim that removing that accounting requirement would make this whole thing go away. My understanding is basic, so I really can’t tell if they are full of it or not. I think this is also in the Senate revision of the bailout.
The models behind the theoretical value of the CDO’s are esoteric and maybe accurate. there are plenty of examples where the models fail - most notably AIG Financial Products. AIG FP guaranteed/wrote insurance for a lot of the CDO’s, and they got it so wrong the very conservatively run AIG parent need a $80B bailout. (I used to create and sell esoteric derivatives to institutional investors based on models.)
Assume that the models are correct, the problem still resides with the underlying assets, primarily the sub prime loans. Sub prime loans were made under rosy bull market conditions that assumed a ‘manageable’ default rate. Now with housing prices in a freefall, reset rates kicking in to raise the payments, and no way to sell the homes at breakeven prices, the CDO’s underlying ‘assets’ are being devalued every day. Even if one holds the bonds to maturity and assume housing prices will bust and recover before then, the percentage of bonds that will be worth zero is going to be considerably higher than it is now. In other words, CDO prices as an asset class have to fall to reflect the much greater risk.
Look, it’s real simple. if a homeowner can’t afford payments on a 30 year mortgage at 5%, then they wiill lose ‘ther’ homes. (these people are renters not homeowners).
Until housing prices fall enough to be ‘affordable’ eg when all theses foreclosed and should be foreclosed homes finally all find buyers, then and only then will the recovery begin. Then and only then will one be able to accurately price CDO’s to maturity.
Sure. We’re not really talking about a couple of firms losing money, anymore though. It’s cascaded.
You can make 100K and still buy a house for 300k, if you finance it. The size of the market, particularly the credit default swap market isn’t an issue.
Credit default swaps are bets. Let’s say you have 10k of bonds from issuer X. You make a bet, or take out insurance with me. For a small fee, I agree to make good on Xs bonds that you hold if X defaults.
There are credit default swaps on Treasuries. The treasury market is huge, hence the big numbers for the size of the market. The chance of a default though is perceived to be very small though, so you can insure a lot of treasuries for a small amount of cash.
Corporate and Governments desk, Lehman Bros, late 80s early 90s. Feel free to join in, I could use the help.
It’s just a degree of complexity problem. All the individual components can be valued, and a value can be determined as Bill Gross suggests. More likely, what one man puts together, another can take apart.
I disagree. Did you read Bill’s article? What exactly is the technical issue that prevents such a valuation.
That’s been happening for the last several quarters.
Yup. Liquidity risk becomes systemic and creates credit risk.
Just keep below FDIC limits and you should have no worries.
Scylla, you’e obviously in the markets. i strongly urge you to find a bear market rabbi. don’t make the mistake of using a bull market glasses to judge a bear.
Fact is the underlying can not be accurately priced at this time. eg, any derivative of the underlying can not be acurately priced. One can make estimates and then build in a fat risk premium.
Some people I know, complain that the government needs to do more “stimulus” packages–tax rebates, lowered tax rates, lowered interest rates, government-funded infrastructure projects, etc. They think that these things will help us recover from the economic downturn we’re in.
I think that’s pointless. We’re not in a typical recession, where production has outstripped demand and industry has to scale back until things have caught up. This is a liquidity crisis where the money and trust that let the economy actually work are not functioning properly. Stimulus is not at all helpful.
At least, that’s my opinion. What do you guys think?
shibboleth:
Looks like your question’s been answered.
Gary Kumqat:
Nice to see you again. Would you care for a beverage with your cite?
(Sorry, I said S&L crisis, I meant depression. The RTC lost money on paper because it paid back with interest the REFCORP bonds that funded it.