Saturday, March 21, 2009

CDS & CDO: A Matter of Mathematics

While on this spring break trip for my daughter, I discovered probably the best article related to this current economic storm. I found it in Wired Magazine. It's an article written by Felix Salmon, titled "A Formula for Disaster". Most of you understand the factor greed played in this global disaster. Most of you understand how excessive borrowing poured a little salt on the wound. Almost everyone knows how the housing market functioned as the stage for the worst show ever. But if you are like me, you're wondering why would the driver and the passengers knowingly drive the car in the off a cliff?

The answer is apparently simple. First, you hire some Quants (math geniuses) to find a new way to understand something that's already understood. Second, you take the new discovery, which you don't understand, and create new products without the consultation of the Quants. Third, you just keep repeating steps one and two. To make this more simple, the math geeks were used to remove the factor of risk by using correlating factors (Gaussian copula function) in a narrow window of time. Translation - Johnny who always pays his bills on time, Tommy who normally pays his bills on time, and Billy who never pays his bills can be joined together to form a portfolio of borrowers who always pay their bills on time. If only the numbers guys and loan sharks had this nugget in their toolbox.

The other question that was answered dealt directly with the magnitude of Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO). How can a handful of bad mortgages equate to a mountain of bad debt and global financial crisis? Salmon explains this in a clear and scary illustration. As a financial institution, you can make money two ways - (1) loan money to the borrower, or (2) sell creditors insurance against the borrowers. The difference between selling a mortgage and a CDS is that you can sell multiple CDS against one single mortgage. That's where a billion dollar issue has turned into a trillion dollar problem. That's right, there's no constraint on the CDS market, but the bond market has a finite quantity. John Stewart put it best, this is a complex problem derived from a linear issue: mortgages.

If you have time, please give me your thoughts on this article, and how leadership messed up in the matter.

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