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Replace "stock market" with "MBS/CDO type derivatives" and "computer trading algorithms" with "risk models" and you will see the similarities. I probably should

Replace "stock market" with "MBS/CDO type derivatives" and "computer trading algorithms" with "risk models" and you will see the similarities. I probably should have been more clear but the idea is that all of the financial markets work basically the same way: find a trend, abstract it with algorithms/risk models, exploit that trend and then walk away when the trend inevitably breaks. Every 10 years we keep having "10,000 year floods" according to the latest whiz-bang model/algorithm. It's all the same thing in a different variety.

murbard2 12y ago
There was no trend in MBS. What you had was - a regulatory environment encouraging subprime loans - high yielding securities which were rated as AAA (by a legal oligopoly of bond rating agencies) and thus could be used for bank reserves - a short term interest rate that did not respond to market pressure (because determined by the fed) and thus created a gigantic carry trade Mistakes in risk models always happen, and they can be caused by many things, including an over-reliance on mathematical model. However, for a real catastrophe, you need to remove all the feedback mechanisms such as - a free market that would allow the short rate to rise with increased demand - a free market that would allow bond rating agencies to compete - a free market that would allow bank to compete for balance sheet quality rather than having a government insurance scheme creating a race to the bottom
- bsdpython 12y ago
  How did the rating agencies come up with their AAA ratings on CDOs comprised of mostly subprime debt? They used historical models aka trends that basically assumed that housing prices never went down on a national basis. Throw a bunch of subprime MBS from different regions together into a CDO and bam our model spits out a AAA rating. It was based on a historical model aka trend. I don't dispute any of your other details.
  - murbard2 12y ago
    Actually no, that assumption did not go in the pricing models. The key assumption that people got wrong, was the correlation between the risk of default of different borrowers. A single value was used for the middle of the distribution and for the tails, even though the correlation was actually much higher in the tails.

murbard2 12y ago

There was no trend in MBS. What you had was - a regulatory environment encouraging subprime loans - high yielding securities which were rated as AAA (by a legal oligopoly of bond rating agencies) and thus could be used for bank reserves - a short term interest rate that did not respond to market pressure (because determined by the fed) and thus created a gigantic carry trade Mistakes in risk models always happen, and they can be caused by many things, including an over-reliance on mathematical model. However, for a real catastrophe, you need to remove all the feedback mechanisms such as - a free market that would allow the short rate to rise with increased demand - a free market that would allow bond rating agencies to compete - a free market that would allow bank to compete for balance sheet quality rather than having a government insurance scheme creating a race to the bottom

bsdpython 12y ago
How did the rating agencies come up with their AAA ratings on CDOs comprised of mostly subprime debt? They used historical models aka trends that basically assumed that housing prices never went down on a national basis. Throw a bunch of subprime MBS from different regions together into a CDO and bam our model spits out a AAA rating. It was based on a historical model aka trend. I don't dispute any of your other details.
- murbard2 12y ago
  Actually no, that assumption did not go in the pricing models. The key assumption that people got wrong, was the correlation between the risk of default of different borrowers. A single value was used for the middle of the distribution and for the tails, even though the correlation was actually much higher in the tails.