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

[koganbot]

I actually don't remember, but I think the bank run was a random event - not Potter-induced - the role of which in the plot was to prevent Jimmy Stewart from going on his long-dreamed-of vacation/honeymoon to Europe.

I do think that "bubble" has a way narrower definition than you're giving it. People were calling the tech and the housing bubbles "bubbles" before they burst, saying that prices were way overinflated and that the people who were investing expecting the prices to keep rising at the same rate were in for unhappiness. I think a bubble that doesn't burst so spectactularly is called a "fad." But I do think that a bubble will feature people investing on the assumption that a much higher rate of growth than the previous norm is now the new norm. Obviously all lending depends on the expectation of some growth or at least not a major contraction.

Sorry for being impatient above.

[dubdobdee.livejournal.com]

don't be! it's an excellent sign i'm still fuzzy abt things -- i *think* i know what i'm trying to say here, in a jargon-free way (and i suppose at root i regard the whole of capitalism as more of a risky flimflam than say krugman does) but i'm absolutely certain i'm not making it clear, to myself or anyone else

[koganbot]

Actually, what Capra is doing is more subtle than having George Bailey/Jimmy Stewart saying "Trust Me." It's been years and years since I've seen the film, but the way I remembered it, the bank wasn't simply small and family run, it was something of a credit union. And what Capra was having Jimmy say was, in effect, "Trust Us," meaning trust your neighbors, whom you know, who are your fellow depositors and the ones who are building homes on the basis of the money - our deposits, from you! - we lend to them. So he was saying, "Trust us 'cause we are you, and we are the small guys and you know us." (And now I recall for sure that Potter wasn't invested in the Building And Loan, 'cause later, when Jimmy's uncle loses the $8,000, Jimmy goes to Potter to bail him out, and Potter refuses). Whereas the people who are hoarding the money now are large institutions who, if my brother's account is right, are - with reason - not trusting their own assets. They're holding onto their own money because they don't how much money they've got. In the movie you're not assuming that Bailey has suckered Martini into a mortgage at rates that Martini can't afford, whereas in the current subprime mess you have institutions who've (sometimes unknowingly) invested in "assets" that turn out to be based on the solvency of suckered Martinis, many of whom are going to end up insolvent. Even in Bedford Falls (was that the name), a certain number of Martinis are going to fail, but because of the housing bubble and unethical and highly nontrasnparent dealings, you know that way more Martinis are failing, but you can only wait to see how this plays out.

Notice how I'm now writing with great authority about something I was clueless about several hours ago, and may well still be clueless about!

[koganbot]

Oh, and Potter was involved in the Building And Loan. I just checked Wiki:

An avaricious and opportunistic board member of the Building & Loan (and owner of most of the town), Mr. Potter (Lionel Barrymore) seizes this opportunity to gain control of the Board of Directors and end the "nonsense" of home loans for the working poor. George makes a reluctant but impassioned plea to keep the company independent, moving the board members to agree, but only if George remains to run the business.

But Potter has nothing to do with causing the (later) run on the bank, I don't think. But he does try to take advantage of it by offering 50 cents on the dollar to anyone who wants to sell out.