(And a long aside about the nature of CDOs.)
The Wall Street Journal has an incredibly inane article in today’s (September 25) edition. It is entitled Crisis Stirs Critics of Free Markets. Actually, the crisis has stirred advocates of free markets, including the entire senior management at Spero Consulting.
The three writers of article don’t seem to understand that the US is hardly a pure free market economy, and many of the current financial problems were either caused or exacerbated by governmental regulations or authorities or politics. In fact, it almost seems that the troika doesn’t read its own paper.[1. As we've written a few times over the past couple of days, it is quite possible that the government's proposed bailout will exacerbate the problem, especially if it attempts to stretch-out the term of the bailout. That's one of the reasons that we're against it.]
For example, in Tuesday’s journal, Blame Fannie Mae and Congress For the Credit Mess Congress the authors of that column explain that Fannie Mae and Freddie Mac are government sponsored enterprises–not quite free enterprise startups–and their recent, hard push into sub-prime and Alt-A mortgages was clearly politically motivated. It is right there in the journal (and probably 10,000 other places) that the writers could not find.
In addition, regulations and laws permitting only investment-grade purchases–e.g., for pension plans etc.–created a demand to “highly-rated” credit products, and that was a major impetus for the creation of CDOs (or securitizations of securitizations). Those ratings were mandated by federal law and the provision of such ratings is highly-regulated, including entry into the industry. The journal has had any number of articles and op-ed columns on those topics, too.
Moreover, most CDOs were designed to meet particular ratings guidelines, i.e., the objective was to segment the cash flows from the mortgages (or mortgage-backed securities or CDOs) into different tranches with different probabilities of default and losses given default. The idea was to take bunch of relatively average things (mortgages or MBS) and synergistically create a lot of really good, investment grade, stuff and a little bit of bad stuff, known as the equity tranche. The ratio of these good-to-bad tranches depends crucially on assumptions about collateral’s interrelationships and dependencies. So, optimistic assumptions–meaning independent or uncorrelated collateral values–generated more good stuff than bad stuff, and unfortunately, more good stuff than recent history shown to be the case.
Aside: these estimations are performed via some type of Monte Carlo simulation and as mentioned above require making assumptions about those relationships, i.e., the joint distributions of randomly-distributed cash flows. That’s very hard to do without making many, many simplifying theoretical assumptions, and because so many of those assumptions were violated in practice, no one honestly knows how to value those securities today.
It’s that interrelationship that is particularly tricky to know: look up “copulas.” Folks generally define them in ways that they can solve them, regardless of whether the solvable copulas represent reality or not, and that empirical validity is difficult to determine because there isn’t as much data and history as one would think, and recent history hasn’t been that favorable or representative. There’s a file in On Nedges and Sledges and Paving the Road to Hell that illustrates how to relate three independent variables to create to correlated ones.
So, a demand for investment grade securities combined with some clever–but ultimately inaccurate math and statistics–permitted the manufacture of more investment grade CDOS. Kind of reminds us of Chinese baby formula, and in that respect makes in seem less like bad luck and more like the lax management and excessive risk-taking that we criticize.
Our criticisms are fair and justified. Complaining that the US is too much of a free economy is not, and falling for international political rhetoric is just plain stupid. We don’t expect much from three reporters–were they Moe, Larry, and Curly?–but editors of The Wall Street Journal should know better. Shame on them.
