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I have this growing conviction that some of the people working in financial markets are something akin to black hat hackers. They continuously probe the syste

I have this growing conviction that some of the people working in financial markets are something akin to black hat hackers. They continuously probe the system for bugs and weaknesses and then exploit them for profit. This "collateralization with obfuscation" exploit where it's impossible to calculate the risks of bundled investment packages should have been "patched" with legislation after the 2008 crash but wasn't. So, unsurprisingly, they go after it again.

bko 8y ago
Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products. > The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated. The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher. I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit. [0] http://www.leveragedloan.com/sp-report-clos-show-strong-historic-performance-with-few-defaults/ http://www.leveragedloan.com/sp-report-clos-show-strong-hist...
- gvhst 8y ago
  Thank you for saying this. In all honesty, the leverage loan (and thereby CLO) issues we are seeing now aren't really an issue of complexity. It's really an issue of how underwriting standards are deteriorating as more and more parties compete for these leverage loan deals to put into their CLOs. Companies can also fall into the trap of, "well I'm able to raise debt at these terms so I should be able to afford it." I will admit that complex securitization structures can obfuscate this risk, but the underlying financial risk comes from the cyclical properties of the collateral asset class (i.e. the credit cycle), not from the structure itself.
  - whatok 8y ago
    Underwriting standards are definitely deteriorating and debt covenants are just crazy in some cases so in all likelihood, recoveries should be lower during this credit cycle. That said, a capital structure is a capital structure and loans are still up there.
- ratel 8y ago
  A financial product that is said to be a strong and will never fail according to some commercial analysts. Although other experts seem to disagree. (Deja vu) Trading CLO's has been expanding. One could argue far beyond a point where there is enough safe companies to lend to. That must mean the risk for CLO's is growing (Deja vu again) Continues low interest rates make people look for better returns on their investments and people selling products to fill that need. They may forget to make sure their clients understand that there are no save investments in the market at current Fed rates. (Can we say deja vu) CLO's now cover leveraged loans, meaning loans with no collateral other than future profit. Like people taking out mortgages on for-rent properties. (Deja vu, deja vu)
  - gpsx 8y ago
    Back in the 2008 financial crisis I read articles about what went wrong, but I am not sure I understood exactly what was going on so well. I filled in details mysefl by guessing. Maybe someone can clarify this? When they combine a number of risky assets into a single asset, they factor in an assumption that a number of these will fail. Others will not and given the payoff of those, the net investment pays off. I don't know much about finance and how they do these calculations, so I'm going to say something dumb here, and maybe someone can tell me if they are being this dumb (or dishonest) when the calculate these things. Forgive the "explain it like I am 5" description. There is a naive way of combining these probabilities which high school students probably know. However, this assumes the outcomes in question are not correlated. For example if you flip two coins, the probability of each coming up heads is .5 and they are not correlated, so the probability of getting two heads on two coin tosses is .25. Of course, if the events are correlated, then that formula doesn't work any more. For example, if there is a new Quantum Coin Toss Manipulator (because we all know it would have to be quantum) that makes all coins flips near it come up the same, then the probability of getting 2 heads when you do two coin tosses is no longer .25 but instead it is .5. And, if you do 100 coin tosses, the probability is still .5 of getting all heads. Back to the CDOs or CLOs. The chance of individual components failing is clearly not completely independent. Economic conditions such as a big recession presumably will have similar effects on the different components. So the naive formula does not apply. Hopefully they are not being that naive or dishonest, but it seems like it would be pretty tricky to estimate the correlation and correspondingly difficult to estimate the true risk. Is it that case that they are just not good at estimating the correlation in the risks of these different assets?
mikorym 8y ago
Maybe in end result they are similar. I think though the institutional problem behind why this happens is compensation and bonus structures. It is even more foundational in the sense that one guys that manages to land a deal is literally valued $100m to a company which seems like a good cost-to-company argument for a $10m bonus, netting in $90m. Simplistically, at least.
pjc50 8y ago
> They continuously probe the system for bugs and weaknesses and then exploit them for profit. Well .. yes? If you can figure out a product and sell it to people, why not? You could make an argument that the customers don't understand the risks of the product, but these aren't being sold to the unsophisticated public but to other people in the finance industry who ought to know better.
- hannasanarion 8y ago
  You can't "know better" when the risk is deliberately obfuscated in millions of pages of paper.
  - cm2187 8y ago
    I don't think that the investors who got burned by CDOs in 2008 didn't understand the mechanism of transmission of losses in these structured transactions. They simply grossly underestimated the underlying risk they were exposed to (the assumption that the real estate market in the US was diversified and that it wouldn't all go down at the same time). Plus the quality of the underwritting had gone down the drain, but I am not convinced it was documented as such. But even if it was all documented, we are not talking about millions of pages of paper. A typical documentation for one of these structures is 200-500 pages, of which a lot is mostly irrelevant. An investor taking a significant position in one of these structures ought to read the relevant parts. But even highly paid professionals can be lazy too.
  - navigatesol 8y ago
    So why are people/institutions buying things they do not understand? If you ask me, they are the greedy party.
    - hannasanarion 8y ago
      Or you can be both. Part of the impetus for the 2007 crash was that investment companies like AIG were making complicated and obscure financial instruments that hid lots of risk, while also being the agency everybody looked to to grade the risk of financial instruments. They rated their own mortgage debt products as low-risk based on fraudulent analysis.
papito 8y ago
They are also too smart for their own good. There is a direct correlation between Ivy League grads going to work on Wall Street and market crashes.
onion2k 8y ago
There's a term for it - disaster capitalism. Naomi Klein's excellent book "The Shock Doctrine" is worth reading if you're interested. https://en.wikipedia.org/wiki/The_Shock_Doctrine https://en.wikipedia.org/wiki/The_Shock_Doctrine
umadon 8y ago
No surprise, I think, given who writes legislation and to whom legislators are most beholden.
- Veelox 8y ago
  I forget, is it Big Banks, Big Tech, Big Pharm, Big Oil, Big Agriculture, Big Telecom, For-Profit Prisons, or the Military Industrial Complex that is most in charge of legislators? I can never seem to remember which one is really running the country.
  - umadon 8y ago
    I wonder if we could come up with some set of characteristics common to those groups, perhaps a useful umbrella term. Oh well, guess we can't!
    - Veelox 8y ago
      In all seriousness, who is it that you think is running the country?
      - departure 8y ago
        Rich, powerful, corporations? Is that who were suggesting?
  - wonderwonder 8y ago
    Big money runs the country, everything else is just noise.
  - codeulike 8y ago
    Very rich people and (to the extent that they are lumbering hive minds driven by their own rules to persue profit at any cost) corporations have undue influence at most levels of US government. Thats pretty obvious to most of us watching from afar. If you wanted a pithy term to sum this up you could go for 'big money'. The US has ostensibly good democratic structures and systems but they have to a very large extent been 'captured' by the rich and powerful, as the parlance goes.
kolbe 8y ago
You're not wrong, but many other industries behave similarly. I think of FAANG's massive A/B testing the same way: constantly probe to find legal ways to get people addicted to their content or to surreptitiously convince them to make bad decisions via advertising.
- tenpies 8y ago
  And it's also really funny to see Google take the deliberate strategy of being a nanometer less evil than Facebook, just so the media doesn't probe too deeply into Google. It's like how McDonald's and Walmart take all the heat, while Burger King and Target are virtually just as guilty of the same practices but remain off-radar.
kevin_b_er 8y ago
The legislation you're talking about is the "Dodd–Frank Wall Street Reform and Consumer Protection Act". After failing to defeat it with constitutional challenges, the Republicans gutted it in 2018 with the "Financial CHOICE Act". The banks are going after stuff again because the protections were removed, not necessarily because they've found a new way around them.
- smaddox 8y ago
  This is so mind-boggling stupid... We deserve whatever happens next for allowing this crap to keep happening... I'm sick to my stomach reading about this...
hammock 8y ago
The more of an asset class is owned by passive investors (now approaching 50% for US equities), the greater the reward for the type of behavior you point out. It's effectively leverage: any "bug" found gets multiplied across the portion of passive investment affected.
- pmart123 8y ago
  Well, passive credit is far worse than passive equity. At least in equity, you are buying more of the largest companies, in credit, you are buying more of the larger issuers of debt...
moosey 8y ago
> Leverage: Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. From https://www.investopedia.com/terms/l/leverage.asp https://www.investopedia.com/terms/l/leverage.asp I don't think that leverage is necessarily an issue, and it isn't black hat either. It's a normal part of any economy. The problem is scale. After the last two economic issues that we had to deal with, I have a sense that far too much of our economy runs on leveraging, in order to keep growth going. This isn't just happening with these C.L.O.'s, but with credit card debt, mortgage debt, medical & student loan debt, etc. on the personal level, and a whole slew of debt options for businesses. This is all necessary for the capital owning class to maintain their wealth, which is fed by a sea of debt: without economic activity to pay for goods, many things will lose value rapidly. I've seen these leveraging games blow up twice in my life. I get to listen to people who claim to know economics tell me that it isn't going to happen this time, that it's different, but you are right. We didn't alter our economy in some fundamental way. We didn't create reward structures for building an economic system that would prevent this issue from happening so often, nor did we create a punitive structure for those who benefit and thus try to make it happen. Instead, we allowed those who benefit from these processes keep far too much of their ill-gotten wealth. It's going to happen again, and my guess is that once again the middle class and poor will be punished for it. If a billionaire loses 90% of their wealth, it wasn't real anyways. When a middle class person loses 90% of their paycheck, or your more common millionaire loses 50% of their wealth, they can be completely devastated. I know, because I already saw it happen twice in my life. The actual black-hat hack is and was regulatory capture. Sure, with good regulation perhaps the economy runs a bit slower, but all of our growth is based on an engine that burns through billions of barrels of oil a year (yet another debt/leverage to pay off) so perhaps that's for the best. EDIT: Corrected tons of oil to barrels of oil.
- marcosdumay 8y ago
  Leverage is there because of the near zero interest rates for some kinds of loan. While those exist, people will invent new ways to create unhealthy leverage, and you'll be in an arms race trying to stop them all. That said, the GP wasn't about excessive leverage. It's about legalized scams, what is a very different problem, with much harder solutions.
deleted 8y ago
[deleted]
osrec 8y ago
And it's an age old paradigm: see, for example http://www.petemccormack.com/blog/?p=8077 http://www.petemccormack.com/blog/?p=8077
- whycombinater 8y ago
  Can't we just buy more AK-47s.
kartan 8y ago
> ...are something akin to black hat hackers. There is an important difference. The people working in financial markets have lobby power to change laws and create more weaknesses. So, it will be more like if black hat hackers paid part of the salary of the IT-Ops that have to patch the software. Half of the server will run on unpatched Windows 95 and there will be long discussions on why updating is not a good idea because of made-up-reasons.
rconti 8y ago
Everyone's trying to beat the market. When the market is doing well, it gets harder and harder to beat, without taking on more and more risk, which always looks smart in the short run because everything's going so well! Until it isn't.

bko 8y ago

Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products. > The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated. The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher. I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit. [0] http://www.leveragedloan.com/sp-report-clos-show-strong-historic-performance-with-few-defaults/ http://www.leveragedloan.com/sp-report-clos-show-strong-hist...

gvhst 8y ago
Thank you for saying this. In all honesty, the leverage loan (and thereby CLO) issues we are seeing now aren't really an issue of complexity. It's really an issue of how underwriting standards are deteriorating as more and more parties compete for these leverage loan deals to put into their CLOs. Companies can also fall into the trap of, "well I'm able to raise debt at these terms so I should be able to afford it." I will admit that complex securitization structures can obfuscate this risk, but the underlying financial risk comes from the cyclical properties of the collateral asset class (i.e. the credit cycle), not from the structure itself.
- whatok 8y ago
  Underwriting standards are definitely deteriorating and debt covenants are just crazy in some cases so in all likelihood, recoveries should be lower during this credit cycle. That said, a capital structure is a capital structure and loans are still up there.
ratel 8y ago
A financial product that is said to be a strong and will never fail according to some commercial analysts. Although other experts seem to disagree. (Deja vu) Trading CLO's has been expanding. One could argue far beyond a point where there is enough safe companies to lend to. That must mean the risk for CLO's is growing (Deja vu again) Continues low interest rates make people look for better returns on their investments and people selling products to fill that need. They may forget to make sure their clients understand that there are no save investments in the market at current Fed rates. (Can we say deja vu) CLO's now cover leveraged loans, meaning loans with no collateral other than future profit. Like people taking out mortgages on for-rent properties. (Deja vu, deja vu)
- gpsx 8y ago
  Back in the 2008 financial crisis I read articles about what went wrong, but I am not sure I understood exactly what was going on so well. I filled in details mysefl by guessing. Maybe someone can clarify this? When they combine a number of risky assets into a single asset, they factor in an assumption that a number of these will fail. Others will not and given the payoff of those, the net investment pays off. I don't know much about finance and how they do these calculations, so I'm going to say something dumb here, and maybe someone can tell me if they are being this dumb (or dishonest) when the calculate these things. Forgive the "explain it like I am 5" description. There is a naive way of combining these probabilities which high school students probably know. However, this assumes the outcomes in question are not correlated. For example if you flip two coins, the probability of each coming up heads is .5 and they are not correlated, so the probability of getting two heads on two coin tosses is .25. Of course, if the events are correlated, then that formula doesn't work any more. For example, if there is a new Quantum Coin Toss Manipulator (because we all know it would have to be quantum) that makes all coins flips near it come up the same, then the probability of getting 2 heads when you do two coin tosses is no longer .25 but instead it is .5. And, if you do 100 coin tosses, the probability is still .5 of getting all heads. Back to the CDOs or CLOs. The chance of individual components failing is clearly not completely independent. Economic conditions such as a big recession presumably will have similar effects on the different components. So the naive formula does not apply. Hopefully they are not being that naive or dishonest, but it seems like it would be pretty tricky to estimate the correlation and correspondingly difficult to estimate the true risk. Is it that case that they are just not good at estimating the correlation in the risks of these different assets?

mikorym 8y ago

Maybe in end result they are similar. I think though the institutional problem behind why this happens is compensation and bonus structures. It is even more foundational in the sense that one guys that manages to land a deal is literally valued $100m to a company which seems like a good cost-to-company argument for a $10m bonus, netting in $90m. Simplistically, at least.

pjc50 8y ago

> They continuously probe the system for bugs and weaknesses and then exploit them for profit. Well .. yes? If you can figure out a product and sell it to people, why not? You could make an argument that the customers don't understand the risks of the product, but these aren't being sold to the unsophisticated public but to other people in the finance industry who ought to know better.

hannasanarion 8y ago
You can't "know better" when the risk is deliberately obfuscated in millions of pages of paper.
- cm2187 8y ago
  I don't think that the investors who got burned by CDOs in 2008 didn't understand the mechanism of transmission of losses in these structured transactions. They simply grossly underestimated the underlying risk they were exposed to (the assumption that the real estate market in the US was diversified and that it wouldn't all go down at the same time). Plus the quality of the underwritting had gone down the drain, but I am not convinced it was documented as such. But even if it was all documented, we are not talking about millions of pages of paper. A typical documentation for one of these structures is 200-500 pages, of which a lot is mostly irrelevant. An investor taking a significant position in one of these structures ought to read the relevant parts. But even highly paid professionals can be lazy too.
- navigatesol 8y ago
  So why are people/institutions buying things they do not understand? If you ask me, they are the greedy party.
  - hannasanarion 8y ago
    Or you can be both. Part of the impetus for the 2007 crash was that investment companies like AIG were making complicated and obscure financial instruments that hid lots of risk, while also being the agency everybody looked to to grade the risk of financial instruments. They rated their own mortgage debt products as low-risk based on fraudulent analysis.

papito 8y ago

They are also too smart for their own good. There is a direct correlation between Ivy League grads going to work on Wall Street and market crashes.

onion2k 8y ago

There's a term for it - disaster capitalism. Naomi Klein's excellent book "The Shock Doctrine" is worth reading if you're interested. https://en.wikipedia.org/wiki/The_Shock_Doctrine https://en.wikipedia.org/wiki/The_Shock_Doctrine

umadon 8y ago

No surprise, I think, given who writes legislation and to whom legislators are most beholden.

Veelox 8y ago
I forget, is it Big Banks, Big Tech, Big Pharm, Big Oil, Big Agriculture, Big Telecom, For-Profit Prisons, or the Military Industrial Complex that is most in charge of legislators? I can never seem to remember which one is really running the country.
- umadon 8y ago
  I wonder if we could come up with some set of characteristics common to those groups, perhaps a useful umbrella term. Oh well, guess we can't!
  - Veelox 8y ago
    In all seriousness, who is it that you think is running the country?
    - departure 8y ago
      Rich, powerful, corporations? Is that who were suggesting?
- wonderwonder 8y ago
  Big money runs the country, everything else is just noise.
- codeulike 8y ago
  Very rich people and (to the extent that they are lumbering hive minds driven by their own rules to persue profit at any cost) corporations have undue influence at most levels of US government. Thats pretty obvious to most of us watching from afar. If you wanted a pithy term to sum this up you could go for 'big money'. The US has ostensibly good democratic structures and systems but they have to a very large extent been 'captured' by the rich and powerful, as the parlance goes.

kolbe 8y ago

You're not wrong, but many other industries behave similarly. I think of FAANG's massive A/B testing the same way: constantly probe to find legal ways to get people addicted to their content or to surreptitiously convince them to make bad decisions via advertising.

tenpies 8y ago
And it's also really funny to see Google take the deliberate strategy of being a nanometer less evil than Facebook, just so the media doesn't probe too deeply into Google. It's like how McDonald's and Walmart take all the heat, while Burger King and Target are virtually just as guilty of the same practices but remain off-radar.

kevin_b_er 8y ago

The legislation you're talking about is the "Dodd–Frank Wall Street Reform and Consumer Protection Act". After failing to defeat it with constitutional challenges, the Republicans gutted it in 2018 with the "Financial CHOICE Act". The banks are going after stuff again because the protections were removed, not necessarily because they've found a new way around them.

smaddox 8y ago
This is so mind-boggling stupid... We deserve whatever happens next for allowing this crap to keep happening... I'm sick to my stomach reading about this...

hammock 8y ago

The more of an asset class is owned by passive investors (now approaching 50% for US equities), the greater the reward for the type of behavior you point out. It's effectively leverage: any "bug" found gets multiplied across the portion of passive investment affected.

pmart123 8y ago
Well, passive credit is far worse than passive equity. At least in equity, you are buying more of the largest companies, in credit, you are buying more of the larger issuers of debt...

moosey 8y ago

> Leverage: Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. From https://www.investopedia.com/terms/l/leverage.asp https://www.investopedia.com/terms/l/leverage.asp I don't think that leverage is necessarily an issue, and it isn't black hat either. It's a normal part of any economy. The problem is scale. After the last two economic issues that we had to deal with, I have a sense that far too much of our economy runs on leveraging, in order to keep growth going. This isn't just happening with these C.L.O.'s, but with credit card debt, mortgage debt, medical & student loan debt, etc. on the personal level, and a whole slew of debt options for businesses. This is all necessary for the capital owning class to maintain their wealth, which is fed by a sea of debt: without economic activity to pay for goods, many things will lose value rapidly. I've seen these leveraging games blow up twice in my life. I get to listen to people who claim to know economics tell me that it isn't going to happen this time, that it's different, but you are right. We didn't alter our economy in some fundamental way. We didn't create reward structures for building an economic system that would prevent this issue from happening so often, nor did we create a punitive structure for those who benefit and thus try to make it happen. Instead, we allowed those who benefit from these processes keep far too much of their ill-gotten wealth. It's going to happen again, and my guess is that once again the middle class and poor will be punished for it. If a billionaire loses 90% of their wealth, it wasn't real anyways. When a middle class person loses 90% of their paycheck, or your more common millionaire loses 50% of their wealth, they can be completely devastated. I know, because I already saw it happen twice in my life. The actual black-hat hack is and was regulatory capture. Sure, with good regulation perhaps the economy runs a bit slower, but all of our growth is based on an engine that burns through billions of barrels of oil a year (yet another debt/leverage to pay off) so perhaps that's for the best. EDIT: Corrected tons of oil to barrels of oil.

marcosdumay 8y ago
Leverage is there because of the near zero interest rates for some kinds of loan. While those exist, people will invent new ways to create unhealthy leverage, and you'll be in an arms race trying to stop them all. That said, the GP wasn't about excessive leverage. It's about legalized scams, what is a very different problem, with much harder solutions.

deleted 8y ago

[deleted]

osrec 8y ago

And it's an age old paradigm: see, for example http://www.petemccormack.com/blog/?p=8077 http://www.petemccormack.com/blog/?p=8077

whycombinater 8y ago
Can't we just buy more AK-47s.

kartan 8y ago

> ...are something akin to black hat hackers. There is an important difference. The people working in financial markets have lobby power to change laws and create more weaknesses. So, it will be more like if black hat hackers paid part of the salary of the IT-Ops that have to patch the software. Half of the server will run on unpatched Windows 95 and there will be long discussions on why updating is not a good idea because of made-up-reasons.

rconti 8y ago

Everyone's trying to beat the market. When the market is doing well, it gets harder and harder to beat, without taking on more and more risk, which always looks smart in the short run because everything's going so well! Until it isn't.