Subject too big for me
Hi guys,
I think I tried but I failed to make this blog a success. Why so? Because the subject matter is complex, that my time is limited and that it requires a community to really make these subjects a productive discussion.
I thus suggest to all of you who liked reading the few articles I posted here to refer to the linkedin group I'm active in which can be reached here:
http://www.linkedin.com/groups?home=&gid=1457807&trk=anet_ug_hmSee you there and have fun in these days of turmoil.
sub-prime crisis - a short overview
Well, this will not be my most analytical post, but let's see how all this got berserk:
- A poor guy wants to buy a house and tells his mortgage broker that, well, he is not sure he can ever pay it back and is not even sure he will have a job in the future because his boss is not giving him good signs. The mortgage broker does not see the problem since the house value, in a bullish house market, is climbing so the collateral to the debt will always be worst something -> no risk. He even gives some fresh air to the poor guy by giving him a preferential rate for the next 2 years. The mortgage broker gets the money from a bank and pockets the corresponding commission.
- After some months the bank working with our mortgage broker above starts to have a lot of these uncertain mortgages and decides to go to a big investment bank to see if they can solve the problem. The investment bank takes the mortgages, issues new securities (CDOs for instance) with the logic that the mortgages are indeed smelling badly but there are so many of them that if we package them in a pool, cut it into tranches where the lower tranches protect the higher ones against bankruptcy and get higher interest for that, add a subtle touch of Credit Derivatives (instruments protecting against defaults) then we can issue very good papers that will be rated AAA by Moody's. Even the second tranch will be BBB because there are so many underlying mortgages that there is no chance all of them go bankrupt at the same time.
- Is this transparent? No! The guys who issue the accounting rules allow to have SPVs (Special Purpose Vehicles) somewhere in a non-transparent country that hold the underlying mortgages which disappear from the issuer's balance sheet. Wow. Cool.
- The CDOs are then sold to insurrance companies, banks and other insitutions looking for safe investments. There is no way to analyze the real underlying mortgage pool when buying a CDO. Moody's gave it a AAA so who care? Note: some CDOs are CDOs of CDOs up to 8 levels of CDOs. Pfff... transparency at it's best!
- Meantime the interest rates go up, the teaser rate period arrives at its end, the mortgage owner cannot pay back anymore, loses his house, more and more houses are for sales, the house prices go down, AAA tranches start defaulting, the embedded credit derivative protections cannot hold for so many defaults, the market loses confidence in CDOs and all CDO prices go down, banks who thought they had CDOs ready for selling when needing liquidity suddenly have a bunch of stuff worst less than before or nothing and start facing difficulties in liquidity management..... and here comes the global financial crisis.
I would welcome your ideas on how to prevent that in the future!
Walter
Labels: CDOs and other SPVs, sub-prime
My other blog: walter's ecology blog
I don't think that market economy will destroy the planet but I think that people could well do so. That's why I created my other blog about ecology:
walter's ecology blogHave a look if you are interested.
IRIS integrated risk management ag
I think it's fair to say a word about IRIS integrated risk management ag, the company which I'm working for directly or indirectly since 10 years now.
IRIS is a market leading provided of a Financial Analysis Infrastructure called riskpro(tm) (risk and profitability). I'm leading the development team building this product. In this sense I'm not a finance expert but more a specialist on how to apply financial theory in real life applications.
I hope this less formal knowledge of finance helps me vulgarize it.
Formal finance education
It is maybe interesting for someone to know that there are at least two organizations that provide training and certification in finance generally speaking and risk management specifically:
GARP Global Association of Risk Professionals
PRMIA
They provide courses, course material, networking and certifications.
Modeling complexity
Modeling precisely the macro-economic, micro-economic and contractual details related parameters influencing expected cash-flows of a given contract is a very complicated business.
Usually assumptions are taken and bundled into higher-order models. What does this buzzword of mine mean? Let's take an example:
Credit risk, i.e. the risk that a counterparty in a contract defaults, is driven by multiple factors that are very difficult to observe on one hand and model on the other hand. To solve this problem there are on one hand external rating agencies, like Moody’s, publishing "rating" of major counterparties (AAA means they have a very low probability of default and CCC a very high). To these ratings are associated standardized default probabilities and standardized credit spread curves, i.e. curves that, if added to the market expectation curves, used for discounting purpose give the price of the contract without applying difficult assumptions. I.e. we simply assume that if a contract is made with a more risky counterparty then the expected return of this contract should be higher by the amount defined by the spread curve.
Ok this post will need some refactoring, after second reading I don't even understand it myself.... sorry for that. :)
Financial impact of global economy and politics
It's not always easy to understand how global events, like the war between Israel and Lebanon for instance or before that the war in Iraq, George Bush's global war against terror or more regional events can impact financial reality of everyday life.
What has to be understood is that financial markets, company's life and every area of finance are completely interlinked through on one side the investors and the people as consumers and on the other side the work forces that make companies life possible. When there is a crisis in middle-east, oil prices climb because of the fear of shortage of oil, oil prices climbing make everyday life more expensive and consumers consume less other goods impacting in this way financial health of companies and their stocks.
Many other examples will follow...
Finance and mathematics
Finance analysis is a big consumer of math
We can distinguish mostly two areas of maths that apply:
- Analysis - In order to compute theoretical prices of instruments we take some assumptions, like the comparison to similar traded products described in another article, and turn these assumptions into formulas applied to compute the prices based on observed variables from the market and intrinsic characteristics of the instrument. Then we derive these formulas against the market variables to determine how risky they are, i.e. how strongly their value change when the market evolves.
- Statistics - In order to predict future events, potential losses, expected gains and so on we usually assume that there is a higher probability for past events to reoccur in the future than any other different event. These past events are taken into account through statistical analysis based on past observations.
This is also what makes financial engineering very interesting: it is strongly connected to reality of everyday through investments, pension funds, company's lives and so on but also very theoretically challenging.
Indexes
My article about stock pricing made me think that maybe some clarification about what an Index is could be a good idea.
An Index is an indicator of some category of instruments. This indicator is calculated by averaging the observed price of these given instruments. The choice of the instruments to be part of the index is very broad, you can have indices by industries (IT, Banking, Pharmaceutical, ...), by instrument type (Raw oil index, ...) or any other thing.
The interesting thing is that an index can be bought and sold. It is equivalent to buying a portfolio that will be always composed with the same logic like the index.
Evaluating the price of a stock (pricing a stock)
The price of a stock is driven by multiple factors ranging from the underlying company's financial statements which are rational measures to rumors, assumptions and other less rational factors.
There are various pricing strategies, i.e. strategies to estimate the value of a stock in case of market changes, the simplest one being the CAPM model (Capital Asset Pricing Model) which takes the historical variations of the stock into account with respect to the index of the market it's living in. (see
CAPM)
