Sunday, March 1, 2009

Your Economic Crisis

A short reading list:

"It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything."

"Often the banks themselves have no idea if they are making money or not. The regulation of derivatives has been so weak, and the speed of innovation of new products so fast, that it has left a void on the trading floor. Cowboy traders have been taking advantage of a flawed system, knowing there is almost no chance of anything coming back to hurt them. So long as the traders can make it look like they have made a profit, they get their bonuses. This is the financial equivalent of the Wild West, yet only those on the inside realise this."

"“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.

When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam.”"

Hey, one man's scam is another man's religion.

Well at least a higher top-bracket income tax will get a little bit of our money back, eh?


ninquelote said...

The trick to scamming billions of dollars and then eventually getting bailed out is to involve tons of unwitting (and especially stupid), innocent people, and make sure that their very well being depends on government intervention. Just make sure you stash enough of your hard earned profits away in an off-shore account in case you have to make a quick getaway.

yoggoth said...

It's trillions of dollars now. The size of the fraud leads to the necessity of government intervention.

Many of these guys do have an off shore account. Sadly, however, most of them don't really need one aside from tax evasion purposes. This was a legal scam. Why was it legal? Politicians are incredibly bad at taking away the so called punch bowl when people are making money in an unsustainable way. This should have been an area where nonpartisan regulators stepped in. Unfortunately, regulators and the Fed became increasingly politicized starting under Reagan and continuing under every president since.

Herr Zrbo said...

I didn't understand this post at all. I don't understand the financial crisis at all either. Sometimes capitalism baffles me, that people are allowed to trade in theoretical futures. Who invented this system? No wonder it's so messed up.

"Say, I'm going to guess that the price of Gold will go up, want to invest in my prophecy?" Let's do a rain dance while we're at it too.

yoggoth said...

Zrbo - say you buy some gold, but are only 90% sure it will go up in value. What if you could enter a contract with another party in which they would pay you if gold lost value? This would be insurance for your investment. What's the difference between insurance and gambling?

Also - did you read the 3 articles? They're interesting and the quotes make more sense in context. I just thought it made for better blogging to have some teaser quotes.

Herr Zrbo said...

It's not that your post didn't make sense, it's the language used that I never understand. "Ratings arbitrage", "correlation numbers", "cowboy traders".

There's so much financial jargon I just don't understand. This is also why I never want to deal with buying a house. I don't really even understand what a mortgage is for crying out loud, let alone how equity works. I guess I'm fine renting and letting someone else pay for water/garbage/plumbing, etc.

ninquelote said...

I consider mortgages the easiest type of investing in something, so I would suggest you never buy gold either, Zrbo, let alone stocks.

yoggoth said...

Ratings arbitrage and correlation numbers aren't technical financial jargon so much as shorthand used in the respective articles to describe shoddy business practices.

I picked out the part about correlation numbers because it seems absurd on its face that you could figure out a single number that would correlate with the probabilities of disparate events. If you read the article it sounds like they were using the market price of contracts to figure out the probability of conditional triggers(events that would require one party or another to do something) in the contracts.

You and I could enter into a contract under which I pay you $15 if it rains tomorrow and you pay $10 for that contract. (If it rains you can't go to work and won't get paid. You think of this contract as work insurance, not just a random bet.) You're pretty sure it's going to rain tomorrow, so you max out your credit card and buy as many of these contracts as you can afford. Little Earl thens sells you a contract under which he pays you if I don't pay. This second contract only costs you $1 and because you have this second contract you feel secure because no matter what happens you aren't going to lose money now, and you go max out 3 more credit cards buying the rain contracts. You write down in your journal that you now have $50,000 dollars more than you used to because your rain contracts are such a good investment. Someone else could use the price you paid for the original contract and the price LE charged you for the second contract to determine the chance of rain tomorrow. They could then write a million new contracts based on that for everyone in San Jose. Now the weatherperson could even use the price of all those contracts to forecast rain. After all, what are the chances that all of those professionals could be wrong?

yoggoth said...

To add to the confusion, most mortgages in California are actually deeds of trust.

Herr Zrbo said...

Well, after trying to figure out how all this mortgage mess works I can't blame homeowners for buying bad loans. How are they supposed to understand this stuff without a law or business degree and they've got some broker telling them 'everything will be fine!'? They need to teach this stuff in school.

ninquelote said...

That's why we have Yoggoth!

Little Earl said...

I'm with you Zrbo. My college loans are about as complicated as I'm willing to get.