Spero Consulting

(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.