The black box economy

The Boston Globe ^ | January 27, 2007 | Stephen Mihm

[Clintonfatigued]

If true, this is alarming.

[HangnJudge]

If true, this is alarming.

Gee, yah think?
Where is that FReeper with that long
commentary on the Illusion of
money and Banking?

exerpt...

A handful of financial theorists and thinkers are now saying we shouldn’t. The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling - a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.

That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade - a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.

Unlike the building blocks of the conventional economy - factories and firms, widgets and workers, stocks and bonds - these new financial arrangements are difficult to value, much less analyze. The money caught up in this web is now many times larger than the world’s gross domestic product, and much of it exists outside the purview of regulators.

Some of these new-generation investments have been in the news, such as the securities implicated in the mortgage crisis that is still shaking the housing market. Others, involving auto loans, credit card debt, and corporate debt, are lurking in the shadows.

The scale and complexity of these new investments means that they don’t just defy traditional economic rules, they may change the rules. So much of the world’s capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn - moves that have averted serious disasters in the recent past - may not work as expected.

[steve8714]

This is the true danger of globalization. It’s easier to manipulate markets with one large chunk of capital than it is millions of small ones.

[RightWhale]

a vast, secretive web

Not secretive at all, but not well explained to the ordinary person. Probably there is no theory that would fit well in a textbook for a college course.

[VegasCowboy]

In theory, additional regulation may help with this. The Financial Accounting Standards Board, which establishes corporate accounting procedures and guidelines, took a first step in that direction this past November, ordering investment banks and anyone else holding complicated securities to assign market values to so-called Level 3 assets - a fancy name for assets for which there is no prevailing market price. This meant assigning a market value to all those CDOs.

This is not true. CDOs were always reported at market value, as are all investments. The new rules state you must disclose how you came up with the value. A level 3 valuation is one which is derived from a model.

Banks promptly began writing down tens of billions of dollars of assets, and their investors are still trying to sort through the results. It's still too early to tell whether or not the effort will work, or whether the "market prices" that get reported are anything more than figments of in-house accountants' imaginations. For his part, Das is skeptical. "It will help that people will know the poison they're drinking," he says. "Whether it will help stabilize the system is another question."

More inaccuracy. The write downs were not a result of the new accounting rules. They were because of the lack of liquidity in the markets and the poor performance of many CDOs.

Its apparent the author doesn't understand the subject matter very well, so I wouldn't get too concerned over this fear-mongering article. Basically, he doesn't understand derivatives; therefore they are "scary."

[Cacique]

bump for later

[Donald Rumsfeld Fan]

Its apparent the author doesn't understand the subject matter very well, so I wouldn't get too concerned over this fear-mongering article. Basically, he doesn't understand derivatives; therefore they are "scary."

That's exactly what I was thinking while reading the article.

Be skeptical of anything you read in the Boston Globe.

[tbw2]

I don’t put much faith in something whose value is derived from a model. Models can be manipulated.
This is coming from an engineer, with a strong understanding of math and models.

[Pining_4_TX]

I do think the global economy is so huge and so intertwined that it is beyond the control of any leader or government. That is why it is so laughable to hear all the candidates promise they are going to fix the economy. As if they could.

[VegasCowboy]

No doubt about that. However, many of these CDOs (even those rated AAA) have been marked down to $0.10 on the dollar or lower. If anything, many of the valuations we’re seeing right now in quarterly earnings releases are conservative.

[VegasCowboy]

The only thing a politician can do to impact the economy positively in the long-term is to get out of the way. Gimmicky stimulus packages are nothing but political pandering.

[tcostell]

I don't tknow... to me (a guy who's worked in financial derivatives for 2 decades, and hedge funds for 10) this sounds like the same old complaint. Every time there is an issue with derived risk, some empty headed reporter slithers out to the sunlight and claims that it's all a "secretive world where only a few understand it".

I'm not defending the CDO excesses. I don't work in credit or CDO's but I do understand them. There is no big secret here, just the same old excess and human failings that have always caused problems.

[VRWC For Truth]

No, it’s a black hole caused by too much federal gov’t. Even a blind man can see this.

[cinives]

http://hingefire.blogspot.com/2007/12/derivative-house-of-cards-shadow.html http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/index.htm

You all may want to think again. The danger is the credit creation piled on debt that is near valueless. Some estimate it is on the order of $85 to $1.

Subprime just got the implosion started. Next to be downgraded will be all the exotic mortgages to creditworthy buyers, the LBOs, the bond insurers, the commercial paper, credit card debt, and so on.

This problem is real, it's bubbling behind the scenes as the Fed and other Central Banks try to inject liquidity into a situation where confidence has collapsed, and it will hurt all of us.

[jwparkerjr]

I have virtually no understanding of the world of high finance at all. In my very limited view of what’s happening it looks to me like when there started to be lots of money around with no place to go banks started issuing credit cards like there was no tomorrow. They were sending them out to anyone and everyone, whether they asked for one not. After a while all of those cards became used to their limit. Then the excess money started chasing after the real estate market and all those ARM’s and sub-prime mortgages started to be used to pay off the credit cards which were then used again and once again were at their limits. Now people have 30, 40 or 50 thousand dollars in unsecured credit card debt with payments totaling so much they can’t make them and pay for the necessities of life AND this time they can’t borrow on their homes because the value of real estate stopped going up. Now they have huge credit card bills they can’t pay and the rates on their ARM’s have climbed steadily as the Fed raised interest rates to slow the economy. And the credit card debt just goes up every month. If they are at their limit and get socked with a late fee then they go over their limit and now they add more to the balance. The miss a payment and the balance goes up again when the late fee is attached, which only puts their balance still higher and they yet another over balance charge. This is happening with several of their cards, not to mention their mortgage is getting farther and father behind. I know this is a bit of hyperbole, but it’s happening to an extent to more and more people every month. And now, along comes our government, already in debt up to their ears, and decides to borrow more money to send everyone up to $1200, five months or so from now. And because the Congress couldn’t get its act together enough to do something about the AMT in a timely manner IRS says refund checks will be much later than usual this year. A lot of families depend on this check every year to pay big one-time items like homeowner’s insurance or taxes and for some of these people it won’t be there in time this year. I could go on, but I’m sure most of you are asleep by now.

[cinives]

You are so right.

Then take all that debt, package it up, sell it as AAA debt, do it multiple times, and carry it as assets on your books. Then, when the value of the underlying debt goes in the sh!#er, devalue it at pennies on the dollar, write it off, and get a bailout in the form of Treasury Funds from the Fed.

The world is drowning in debt, and there’s no bottom in sight yet. 2008 will be a very interesting year, and I hope everybody has some spare cash just in case.

[VegasCowboy]

I couldn’t access your first link. As to the second, I see it was written in November 2007. Gross was right and we are seeing the consequences of all the leveraged debt in almost every large financial institutions earnings releases. The question, though, is this: how much more is to come? Most CDOs that have any exposure to sub-prime have already been written down substantially, even those that have maintained their ratings and are still performing. The point is this: if something cost a bank $1 million, and it has been written down to $100,000, there isn’t much left to write off. It can’t go negative.

The big question is how will the large, unsecuritized portfolios do in the coming months and years. Its not the derivatives that scare me, because they are already being marked to market, and many of the very conservatively. Its the other stuff that may be performing today but tomorrow could be virtually worthless (e.g., home-equity line portfolios).

The good news about this stuff is that is unleveraged, and it won’t all go bad. Its going to be an interesting year, that’s for sure, but we can get through it with lessons learned. That is, at least until the next batch of young hotshots who will have no memory of this period gets to Wall Street. Then we’ll go through this again, much as we are now repeating many of the same mistakes made by prior generations.

[VegasCowboy]

Then take all that debt, package it up, sell it as AAA debt, do it multiple times, and carry it as assets on your books.

Here's is how this worked. A bank issued a pool of sub-prime mortgages yielding 10%. They then securitized these mortgages and sold the "risk" to different parties in the form of CDOs. Some of these were indeed AAA, and for there to be losses in the AAA stuff losses on the mortgages would have to exceed 20%. The AAA holders would earn around 6%. The remaining 4% went to the holders of the bottom 20%. Their risk was much higher, though, as they would take the first 20% of losses on a dollar for dollar basis. Today, much of this stuff is worthless.

I've heard that single mortgage pools were sold multiple times. I'm not sure why one would do this, though, so I'm a little skeptical. Look at this from the selling Bank's perspective. They have a pool earning 10%. They sell the risk and distribute the entire 10% of earnings. Why would they then sell the risk again and have to pay another 10% to another group of people, especially when they could just borrow money at a much lower rate? Maybe I'm missing something, so feel free to enlighten me.