Collateralized Debt Obligations
Jan. 18th, 2008 09:05 am![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
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.)
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.)
Re: BANKING AND BUBBLES
Date: 2008-01-21 08:39 pm (UTC)Where did I say that?
Here's an analogy, not necessarily one I'll stick to, but think of "Frank wants to keep the word 'hurricane' for when weather goes bad." But first, I want to reserve "hurricane" for specific events that aren't, for instance, tornadoes or blizzards or droughts. And second, hurricanes are recurring events, even if rare in relation to a particular town. So they're not aberrations. And whether they're "good" or "bad" is a question I'll bracket.
Or think of forests and forest fires and rivers and floods. I can think of any forest as potentially at some point developing into forest-fire conditions, but I'd still reserve the phrase "forest-fire conditions" for particular conditions that make a fire in the near-term a real possibility, rather than saying that "all forests are potential forest fires." You could say the latter, but then you could also say that all forest fires are potentially lush and florid forests, since the forest fire will burn out eventually, leading to the conditions for new growth.
My point here is that if you want to use "forest-fire condition" for any forest in any of its states, then what word would you use for what we're currently calling "forest-fire conditions"?
Another analogy might be electrical grids and blackouts (this maybe being a closer analogy - I'm not sure - since electrical grids were created by humans, just as banking is). If I understand Duncan J. Watts correctly, he is saying that the overload that causes blackouts will keep occurring no matter how well you prepare, since random events at some point will cause a cascade effect where the electrical overwhelms the system. And of course another example Watts gives of a cascade effect is a financial bubble. In this instance, he's not saying that blackouts are an integral feature of electrical grids, but he is saying that they are unavoidable. (Whereas there is a school of thought that says that forest fires are integral to forests, and if we want to manage the fires we've got to give up our zero tolerance policy towards fires, or else we'll end up making them worse.)
Re: BANKING AND BUBBLES
Date: 2008-01-21 09:44 pm (UTC)neither of them seem quite right: not least because a bubble is NOT the actual crash, it's more like the conditions moving towards a crash, and there's some disagreement whether a bubble has to end in a crash to be a bubble --- triffidfarmer, not a banker, but works in the city, read this whole thread and said, "yes, 'bubble is a bit of a my weed is your flower' type word...")
but integrality is i think key to what i'm getting at; so that's helpful