Via HBS, a good introduction.
I thank George McQuistion for the pointer.
The economics of structured finance
Previous post: Assorted links
Next post: Markets in everything, Psycho edition
Our Books
Modern Principles of Economics
Launching The Innovation Renaissance
The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will(Eventually) Feel Better
Create Your Own Economy: The Path to Prosperity in a Disordered World
Discover Your Inner Economist
Good and Plenty: The Creative Successes of American Arts Funding
Judge and Jury: American Tort Law on Trial
Markets and Cultural Voices: Liberty vs. Power in the Lives of Mexican Amate Painters (Economics, Cognition, and Society)
The Voluntary City: Choice, Community, and Civil Society (Economics, Cognition, and Society)
Creative Destruction: How Globalization Is Changing the World's Cultures
Changing the Guard: Private Prisons and the Control of Crime
What Price Fame?
In Praise of Commercial Culture
Entrepreneurial Economics: Bright Ideas from the Dismal Science
Contact Us
Very good paper. Thanks.
The Other Eric, that sentence also struck me as being rather strange since it follows the recollection of someone of a conference call conducted with Fitch:
FPC: “What are the key drivers of your rating model?†
Fitch: “FICO scores and home price appreciation of low single digit or mid single digit,
as home price appreciation has been for the past 50 years.†
FPC: “What if home price appreciation was flat for an extended period of time?†
Fitch: “Our model would start to break down.†
FPC: “What if home prices were to decline 1% to 2% for an extended period of time?†
Fitch: “The models would break down completely.†
FPC: “With 2% depreciation, how far up the rating’s scale would it harm?†
24
Fitch: “It might go as high as the AA or AAA tranches.†
That sounds like someone acutely aware of how fragile the model is. A glass can be fragile but won’t break as long as you don’t drop it. In the same way, Fitch realized their model was fragile but thought there was a very small chance of flat or declining home prices.
Two of this paper’s authors (Coval and Stafford) operated a semester-long class at HBS, where each session of the class revolved around a computer simulation of a financial instrument (such as a CDO). At most sessions, we the students sat in front of our respective laptops with a custom piece of software that modeled a particular virtual marketplace in which we competed against each other in real-time, and issued buys, puts, etc., depending on the nature of the instrument being modeled, and at the end of the class, learned how “well” we had performed in terms of profit or loss compared to everyone else. This may sound like fun — but actually, pretending to be a day-trader with only a tiny armamentarium of trading tools, for hours on end, in an artificially constrained marketplace, turned out to possess limited value for both entertainment and education. But I digress…
The professors sometimes took time out to lecture on the same complex mathematical models that appear in the paper that’s linked by this blog posting. But when I took the HBS class, about 3 years ago, the professors offered no mention of the systemic risks posed by these models. Quite the contrary. I vividly remember Coval at the chalkboard in front of the class, writing out the levels of tranches, with this percent of the securities allocated to that letter rating of risk, and unabashedly praising the ratings mechanisms for their sound mathematical basis. The authors back then were enthusiastic supporters of the same securities which they now describe in their paper as “actually far riskier than originally advertised”.
Which makes me wonder a bit….advertised by whom?
All this discussion is only to implement some ideas and to build the pylons of thinking about the economics of structured finance. In real life, the markets are too dynamic and unpredictable to make any sure affirmations. Blair Rewards
I don’t think that anyone could have predicted the downfall of the real estate market… I wish there could have been something to about it, but the government chose not to help the honest tax payer, but the big corporations…
CPC network
Comments on this entry are closed.