Thursday, December 4, 2008

After Ten Years of "Innovation", What More Do We Know About How to Price (or Trade) Credit Risk?


If you want a qausi-seminal piece that will challenge you in every direction, have a look, maybe, at the Sam Jones bit in the Alpahville about Synthetic CDOs and, by incorporation, the pieces by Felix Salmon and Alan Kohler.

It doesn't aspire to be "seminal", but it juxtaposes market structure with technological understanding, for example,

For the monolines and insurers, this wouldn’t have been such a dreadful problem had they not also invested in the underlying notes of many CDO structures: a move that led to the rating agencies downgrading them, and thus exposing them to collateral calls on their billions of leveraged super-senior swaps.

and an explanation how a perceived need drove design, alongside an historical bit of what went wrong when those designs proved insufficient:

Citi’s dalliance with LSS conduits and the commercial paper markets was equally catastrophic. In the summer of 2007, it caused the collapse of several large conduits in Canada. That in turn precipitated a global buyers strike in asset-backed CP. Which spread, in turn, to a buyers strike of all financial CP. Thus ratcheting up the threat of banking collapses, and indeed, leading directly to them, in Germany, and in the UK (Northern Rock).
This goes well beyond the ongoing talky-talk about originate-to-distribute market structure.

If you are very late to the game of understanding today's structured products (like me), their role in the crisis, and trying to separate dysfunction from abuse, you probably could count yourself close to it if you grasped this piece, in detail, not just gravamen.

And that understanding is not easy to come by, not the least of which is that there are so many moving parts to these structures and little commentary on how they were used and by whom in what proportions. So, for instance, if you wanted to make a judgment about whether and how these securities should be regulated, you'll just be left asking for more data, most likely.


Economists are quick to laud the benefits of financial innovation. Perhaps they should consider the "start-up" costs of it, the context in which it occurs.

If "innovation" in the medical sciences is marked by a caution sufficient to protecting the credibility of the science itself, then the hallmark of financial innovation seems to be the reverse, on average - at least when it is applied to "investments".

Case in point: read through the prospectus for a synthetic CDO contraption (kindly provided by one of Felix's readers). Do you think you could make an adequate assessment of the risk-characteristics of any one of the notes (tranches) to be sold? Would you "invest" a billion dollars based on 'Moody's model input #2', even if you had no fear of models and modelling in general? Is it any wonder that Steve Eisman is a rich man today, for having noticed this?


Commentators talk about the massive mis-pricing of credit risk, at the heart of the current crisis. But, that cannot be the whole of it.


Well, ask yourself, how could trillions of dollars be written on sub-prime mortgage risks, either cash or synthetic (!), with such a short history by which to judge their risk characteristics? Wouldn't prudence dictate that you make the most radically conservative assumptions (about joint transition and default probabilities), before betting so much money? I mean that to apply to both seller and buyer, one interested in preserving (and building) their marketplace overtime, the other interested in managing known unkowns, the downside risks.

How much were the risks simply hidden and not just in rational self-deception? Hard to say. Were the assumptions that launched the era certifiably blue-sky? Were people perfectly right to be so wrong? Does financial innovation somehow require a non-simulated crisis or catastrophe, in order to complete its own cycle, to calibrate itself? That's like saying, "until these things are liquidated, no one really knows what the value of them will be." Is that true?

Whatever leads buyers and sellers to kid themselves ex ante, doing so creates what I like to call "opaque potential", which is the spawning ground for almost all financial manias.

That all financial innovation is fertile ground for a financial mania is probably untrue, but being able to spot which ones are is probably not as much of an art as some may think.

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