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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) T
by 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 agoBack 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?
- grivescorbett 8y agoCorrelation is not binary, it’s on a 0-100% scale. For more detail: https://en.m.wikipedia.org/wiki/Modern_portfolio_theory https://en.m.wikipedia.org/wiki/Modern_portfolio_theory
- michaelcampbell 8y agoAlso, correlation changes all the time, and sadly tends to converge on the way down, but not up.
- alexis2b 8y agoMore like -100% (perfectly anti-correlated) to +100% (perfectly correlated) through 0% (perfectly decorrelated) and everything in between!
- grivescorbett 8y agoCorrect my bad, this is important :)
- pmart123 8y agoCorrelations in finance tend to be unstable. Take two equity stocks in the same sector and one year the correlation could be 0.8 and another year it could be 0.3. Obviously, there are relationships between rates, cost of equity, debt, etc. As Howard Marks says, “the seven worst words in investing are ‘too much money chasing too few deals’” So I think a better question to ask then what are the correlations between these assets is to ask “what’s driving CLO issuance, and is that sustainable?”