More on the Subprime Market and Derivatives

A correspondent makes three points:

First, Moody's response to requests to rate highly complex structured mortgage derivatives should have been:

We don't have enough historical data on securities like this in a housing price environment where rent-versus-buy ratios are this low. We cannot rate them to our usual standards.

Second, if you are collecting a fee for rating things, and if your fee is based on your past reputation for, providing good ratings based on long-term historical data, and if you use the same classification scheme to make ratings that are not based on sufficient historical data - then you do have a problem.

Third, the fact that there was an ABX index and therefore, provided an easy way for people to bet that the mortgage-backed securities market would crash probably cut short the bubble, because the true hedge funds were stabilizing speculators. The destabilizing speculators were (i) the funds that were long CDOs and, (ii) the banks and other issuers who retained the CDOs because their portfolio managers believed their marketers. A world without derivatives but with mortgage-backed securities would probably be a world in which we have a bigger problem than we have now.

This third point is very much the point that Sandy Grossman made about the 1987 crash. This was that the problem with "portfolio insurance" was that it was a trading strategy rather than a derivative security traded by a market. Therefore, nobody knew how large the demand for it was, and so those planning to implement the trading strategy in a market downturn had no way of assessing how expensive implementing it was going to be. However, on Black Monday, everybody found out.

Comments

[Decoy:]

If you are saying when Goldman Sacks met in 2006 and decided that the CDO bonds that they created were Bad ,that is one thing . But when they shorted them instead of alerting the world ,you call it stabalizing the market and I call it GREED.

2008 Apr 28 08:59 AM

[jjason:]

Isn't it ironic that those who were involved in selling products that should never have been sold ( IE. invented ) are getting away with being irresponsible? All these fancy products were poison to many small investors, banks, etc. The firms and people involved in these problems should be brought to justice in our courts, and, hopefully sent to jail and given heavy fines.

Also, many of these "products" should be made illegal.

2008 Apr 28 10:03 AM

[flow5:]

Re, the 87 crash: It was soley the result of an excessively "tight" monetary policy. That and nothing else. The proxy for the rate-of-change in real-gdp recorded its sharpest percentage decline since the inception of the data in 1917.

2008 Apr 28 10:14 AM

[sivere:]

The solution is not simple. The Fed allowed and even encouraged these problems. The problem is thus the US Congress who delegated their authority to the Fed, allowing this mess to occur. The only solution is to

TakeBackTheFed.com

2008 Apr 28 02:59 PM