Wednesday, December 05, 2007

The middle men

To further the cause of Man in a Shed trying to figure out persistence mechanisms with ATL and COM today's post is another blog recommendation - The Daily Reckoning (again), currently MiaS's favourite horseman of the Apocalypse (Financial that it ).

This post contains such wonderful stuff as:

    Before pulling the trigger, the judge was curious… a curiosity shared by millions, no doubt. He wanted to crack open a sophisticated derivative product – a mortgage backed security – and find out what was in it. In the event, he discovered that something was missing; structured finance was not structured quite as well as it pretended to be.

..... go to the post to see how this turns out ...

It also contains the following analysis, which when the politicians get round to trying to understand the credit crunch may yet have serious political implications - think about it:

    "The mortgage companies earned fees by lending money to people who couldn’t pay it back. Then, the lenders shrewdly sold the mortgages on to Wall Street firms who bundled them up and turned them into tradable securities, backed by complex mathematical models that showed what they were supposed to be worth. These were then rated by companies such as Fitch and Moodys – again for fees – and sold on to people who didn’t know what was in them, generating more rich bonuses for the financiers. That was the beauty of securitized debt; the money was made in the middle, while the trouble was pushed out to both ends." (emphasis mine ).

But all tells the story of how Deutsche Bank found out that hard way it had less than it thought on 14 mortgages in the US. (In MiaS brief former career in Drilling this is know as a Oh **** moment).

PS If I was a left wing socialist - I would be making a lot of noise about all this - so why are they so quiet ? Could the answer be the closeness of Gordon Brown to certain parts of the city ?


Tom Paine said...

The lefties are not smart enough to understand the issue, otherwise they would certainly be making a song and dance. You overstate the problem yourself though. Yes, some of the debt packaged and sold on was dicey. However it would be rated as such and investors would make decisions on how much they wanted to take in the various risk categories. The difference between the situation now and in previous property downturns is that the exposure to dicey debt is much more widespread. The theory was that, like prudent bookmakers, the banks had "laid off" the debt with lots of other bookmakers, so that no-one would really get hurt. The theory is about to be tested, but it's not a black and white issue.

Man in a Shed said...

I can't say I fully understand it myself - one reason for reading the Daily Reckoning.

However I also have the uneasy feeling that a lot of people, including many employed in the finance industry, don't fully understand it either.

I have read articles that suggest that a lot of the pricing models that value these products may share common failure conditions. In the engineering world this is know as common mode failure - as an example - a fire in a cable conduit takes out all your control safety systems at the same time.

There is a problem when people make their money by getting other people to take risks that are not fully defined, quantifiable or understandable.

There is a political problem if some people are leveraged to make sufficient from fees that the outcome of their advice is broadly irrelevant to their own welfare. Its the same with the CEO who takes short term discussion for his bonus that will ultimately kill a company, or politicians with short term goals for example fighting two war with under resourced military assets leading to long term degradation of the underlying military capacity.

If you make enough money in 2-3 good years to retire then who cares?

Remember the reaction to Enron in the US. A lot of people may lose out personally in the upcoming credit crunch - and they will be angry and vote for who ever channels that anger.

It would be better if the centre right had an analysis of the problem and a recommendation before all the noise on this starts in the popular media. The demand will be for far stronger regulation.