To help shine a bright light, I think it would be helpful to write about 2 items.
1) How much of the toxic assets on bank balance sheets are CDO’s? CDO squared? How many had to be written down because of rating downgrades?
2) How much did the banks rely of CDS to protect them from rating failures?

While you’re at it, try and explain to John Q public why he should allow banks to buy this stuff? You could also talk about credit ratings. I am hoping that somewhere along the line we will find a Richard Feynman (Challenger O ring disaster explained in simple terms by Nobel prize winning physicist who was also renowned as a teacher) who will explain “how” to regulate these markets. Probably by outlawing many of the instruments (naked CDS?) currently being used.

My second thought is that people’s choice of models was affected by their incentives – either to rate the securities or to sell them. I don’t know how many end investors – the people with the incentive to be skeptical – were really re-analyzing all of the underlying mortgages.

Dear James,

Sorry to bother you with this.

Unfortunately, I have seen your “Where did all the money go?” (Financial crisis for beginners) only few weeks ago. I started then to write (off and on) this comment, but now found the subject closed.

Anyway, I hope you will read this comment. And… many thanks for your most instructive exposition.

Apart from the fact (pointed out most aptly by Justin, November 13, 2008) that you have physically destroyed, by a stroke of a pen, the $200,000 bills paid by Danny to some landowner (call him Rusty), I am afraid that you detrimentally mixed money with financial assets. To my mind, money is a claim on what you call ‘stuff’ (e.g., bread or a… house), whereas financial asset is a claim on money. In more than one way, money and financial assets are worlds apart.

Thus, if we don’t forget the 200,000 paid by Developer Danny to Landowner Rusty, the total amount of money ‘in the world’ after the initial transaction is the same $600,000 (200,000 with Rusty and 400,000 with Danny).

In fact, this answers, literally, also the question “where did all the money go?”: money that was Danny’s (200,000) went to Rusty; money that was Homebuyer Harry’s (40,000) went to Danny and money that was Banker Bonnie’s (360,000) went to Harry and then to Danny. Total: 600,000 dollars – in time one as well as time two.
[By the way, you do not inform us what, if anything, Rusty and Danny did with their money, but I shall come to that later.]

However, consequent upon the house transaction, a newly created financial asset came into being, with face value of $360,000, owned by Banker Bonnie and being, in fact, a promise-to-pay made by Harry on the basis of his future income, backed by the market value of the house [cash transferred on the basis of future-income is the heart of the economic action, but out of context here].

Now, according to your perception, the total amount of money in time one would be $1,000,000 (or your $800,000 plus Rusty’s 200,000), i.e., a total purchasing power of one million dollars. But this is totally wrong.

Assume, for example, that immediately after Harry’s house deal, a new player, John, asked Bonnie for a loan. Given John’s excellent record, steady income and solid collateral, this would have been the ideal business for Bonnie who has, according to you, $360,000. But, alas, Bonnie cannot make the deal – not because of regulations, but, simply, because she does not have a cent (at least at the beginning of time one). What she does have is a ‘promise-to-pay’, plus an access to Harry’s house.
Therefore, the financial holdings in your time one is as follows:
Rusty: $200,000 cash (i.e., money);
Danny: $ 400,000 cash (i.e., money);
Bonnie: promise-to-pay $360,000 (i.e., financial asset);
(Harry’s ownership of 10% of the house is neither money nor financial asset).

However, Bonnie could still make the desired deal with John, if she issued a bond backed by Harry’s promise, but even then, she would have to find someone with money to purchase her bond if she wanted to accommodate John.

In short, if purchasing power is the main attribute and ultimate measure of money, financial asset is the opposite of money. You can convert a ‘promise-to-pay’ into money, provided that someone would be willing to part with cash [in fact, you hold the 'promise' because, in the first place, money that was yours was transferred, by yourself, to others].

Comes the crash.
The only possible ‘endogenous’ cause of the crash in your $600,000 economy (or $800,000 if you insist), is that Danny and Rusty (the only people with money at the beginning of time one!) reduced, for whatever reason, their spending level, so that part of their $600,000 was hoarded. [If we were allowed to assume ‘other banks’, then part of the boys’ cash would have ended up as idle balances in those other banks, because the guys with good record would not want to increase their obligations, and, on the other hand, the banks won’t lend, anymore, to sub-prime guys).

Now, following your narrative, Harry stopped paying, and Bonnie found out that the value of the house dropped to $300,000. How did she find out about the value? Most probably, someone with cash made her an offer.
However, looking back at the financial account we made for time one, what transpired in time two was that Bonnie’s financial asset of $360,000 was obliterated and, instead, she (plus her own creditors) owned now a house for which people with money offered 300,000.

In other words, nothing ‘bad’ happened to the money (600,000) in those periods (if anything, its value in term of ‘stuff’ went up!). What has changed was the volume of the claims on money. In your economy, all such claims were annihilated, because Harry’s income could not fulfill his obligation. The vital mechanism of transferring cash against promises, without which no economic action can take place, collapsed.

what if, say, AIDS had killed the same proportion of the young to middle aged, educated, professional class in the US as it did in, say, Botswana? every insurance company would have gone bankrupt without a bailout. there’s really no way you can tell me that this is a fanciful story and it couldn’t have happened that way. it didn’t, but it certainly could have.

my point is that tail events happen, and you can’t prepare for every contingency.

your logic is that if tail events can blow up cdos then you shouldn’t use cdos. my point is that you can’t avoid tail events; you are stuck with tail events. you can do a much better job of estimating their probability and the damage they will cause. you should try to limit the scale. but you shouldn’t just throw out structured finance because of this very bad cycle.

Unfortunately, what you say is what people believed going into the crisis and is partly responsible for the mess we’re in.

There are a couple different aspects. One that the paper does not address (it is a good paper, but clearly coming from the “Ivory Tower”) is the fact that many investors lost their shirts due to liquidation clauses. That is, once the principal in the pool drops to a certain level, the entire structure is forced to dissolve.

I haven’t seen the detailed mathematical formulation James et al used, but I’m pretty sure (based on the use of the word “correlation”) they assumed normal distributions. So a second aspect to the crisis is RISK MANAGEMENT. Trading desks at the big banks are allocated capital according to some risk model that calculates value at risk (VaR). VaR defines a “boundary” of losses whereby any loss greater than “VaR” is considered a “tail event”. VaR does not tell you anything about how much you may lose if a tail event happens, it merely gives a number specifying the boundary where beyond “there be dragons”. So it would be MAGICAL if traders could somehow find a security where all the risk was in the tails because risk models based on VaR would be blind to such a security. Enter CDOs. CDOs represent a blind spot to risk management systems. As such, CDO desks were allocated capital way beyond anything that was sensible because the risk models were insensitive to the tail events that would cause a CDO to lose money.

I haven’t spent enough time de-constructing these CDO models because I saw how ridiculous they were and moved on to other things. Maybe it is time I did. Any CDO model that does not properly model the tails, e.g. anything that assumes normal distributions, is pretty much a bogus model that should be disregarded. A CDO is a “tail event” security and if the model does not properly handle tail events, it is not a proper model of a CDO. How do you model tail events? Some would say you can’t, in which case, you cannot model CDOs. Hence CDOs should stay out of any responsible asset manager’s portfolio.

The expected payoff of Senior tranches is relatively *insensitive* to changes in parameters, even though parameter variation can create a large change in the rating of the Senior tranche. This holds true even for CDO^2. This bodes very well for the Geithner plan, because it indicates that at least some of these CDOs really are seriously undervalued, and that they really aren’t just worthless paper.