Collateralized Debt Obligations

[koganbot]

"Repackaging dubious loans into collateralized debt obligations creates a lot of perfectly safe, AAA assets that will never go bad."

The sentence is from Paul Krugman's column in today's NY Times. He's using it as an example of sophistry (which his dictionary defines as "a deliberately invalid argument displaying ingenuity in reasoning in the hope of deceiving someone"), though I'd think that putting the word "dubious" into the sentence makes it not sophistic. (The first half of Krugman's sentence describes what investment funds actually did, not what they said they were doing, right? So no one ever actually made the argument. Or did someone?)

But anyway, if I understood that sentence I'd understand how we got into the current financial situation (recession believed to be looming, is possibly here already), but I don't know enough about either economics or Wall Street to understand that sentence.

I know what "collateral" means (a car, house, etc. that backs up a debt, so that if the debtor can't pay, the lender gets to take possession of the car, house, etc.). And I know that AAA means that the asset is rated highly (considered "reliable and stable" by a credit rating company such as Standard & Poor's). But I don't know how you get from "dubious loans" - i.e., mortgages at onerous terms given to unwary home buyers whom one could not reasonably assume would be able to pay off the mortgages or understand what they were getting into - to "collateralized debt obligations" and then to "AAA assets." Which is to say I don't know what happened, or what the assets were. I gather that the cautious responsible investors who purchased (?) the "AAA assets" were, in effect, investing in the risky subprime mortgages without being told that this was what they were investing in. (Is that right?) So it's not just the homeowners who took out the subprime mortgages who are struggling for cash and therefore not spending, but also a bunch of solid citizen investors, hence a lot of people and firms are scrapping for money rather than spending or investing it. (Right?) This tends to depress an economy.

So, anyway, what happened?

(By the way, Krugman's really good, even if he doesn't always have the space to explain everything. I read his blog whenever I get the chance.)

Comments

[dubdobdee.livejournal.com]

but all banks are "bubbles" -- they lend more money than they "have right now", because money in advance (capital in fact) makes all kinds of activity possible; paper money is in fact itself a "promise to pay"

the current situation is more flawed in the sense that, thanks to bad investments, there's far more exposure -- partly because lack of transparency means that the holes in the pile remain largely invisible -- and hence far greater risk; but it's not "fundamentally" differently flawed than ANY mortgage set-up: there's always SOME risk of non-payment (illness, loss of job, giant meteor lands on house, apparently great business idea is unexpected flop) and as soon as the risk becomes big enough, the institutions which manage the movement of holes in ordinary times become vulnerable themselves

the problem is the revelation of lack of value (and concomitant effects), not so much the actual lack of value -- what's frightened the market is not that they realised there are lots of scoundrels around (though there are) but they realised that the designated grown-ups who are capable of spotting the scoundrels have created systems which so rigorously obscure the scams that they literally don't know till they open the box if it's going to be full or empty

in fat times, you can get round this -- just don't open the box and sell it on -- its continued circulation keeps itself aloft (by which time the "bad investment" mortgagee may have got a new job and be paying his way again, the the hole is disappearing)

[koganbot]

I'd thought that "bubble" meant that things were valued far more than they were worth, with speculators jumping in on the assumption that things are rising quickly enough for them to make a quick killing, and their jumping in helping to inflate the bubble. "Everything is a bubble" is like saying "every sound is loud" and "every climate is hot"; is true if you define "bubble" as "anything that is 100% risk-free" and "loud" as any sound that could possibly be detected by the most sensitive instruments imaginable and "hot" as anything that isn't absolute zero. But that simply takes "bubble" and "loud" and "hot" out of the language. (Didn't yr bud Hegel say differences in degree can be differences in kind? I wouldn't know, not yet having figured out how to penetrate his prose.)

[koganbot]

"anything that ISN'T 100% risk-free"

[dubdobdee.livejournal.com]

yes this is certainly a good example of quantity becoming quality -- that at a certain point value-inflation becomes unsustainable

you're kind of saying it can only have been a bubble after we know it's burst: i think i'm saying that bubbleness should be taken to include those situations which turned out after the fact to have smoothly deflated without catastrophe, and that's there's actually a continuity across the catastrophe point, and that banks do basically work in this general area, because if you count the worth of a bank as "all the cash it could actually give out right now", this is hugely less than worth defined as "all the cash it has promised it is holding for you the depositor" -- but that in routine times of good information (which is to say trust) people are prepared to say, "ok i won't take my money out now if that will help"

the point i'm making about risk isn't that there aren't different levels or kinds of risk, which need to be handled differently -- it's that a system has been set up which (rather deliberately) obscures this fact: it WAS (i would argue) pretty much sold the way krugman says it was, tho probably the pitch wasn't collapsed into such a brutally contradictory sentence: large numbers of the buyers wanted to believe that this circle had been squared (because they were making comfy money now and didn't want to imagine they were borrowing against the future -- but of course they were...)