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CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk,

CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.

JumpCrisscross 7y ago
> it assumes that certain companies can create pools of loans that have well defined risk No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true. What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.) Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money. In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.
- coliveira 7y ago
  The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.

JumpCrisscross 7y ago

> it assumes that certain companies can create pools of loans that have well defined risk No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true. What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.) Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money. In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.

coliveira 7y ago
The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.