Southern New Hampshire Real Estate and Short Sales

Does "The Big Short" Fall Short? Part 1

Don't get me wrong, I liked it.  I mean, it had comedy, profanity and a bathing beauty in a bubble bathExplaining Subprime Mortgages in a bubblebath explaining (sort of) the subprime mortgage market.  I like absurdity as much as the next person so what's not to like?  And, as a movie taken solely as a depiction of the mania, stupidity and arrogance that was rampant on Wall Street at the time, it's great!

However, if it's taken as a complete explanation of what really happened to cause that mania (the stupidity and arrogance just came naturally, I'm sure.) it falls far short. 

You're probably saying to yourself, "who cares if "The Big Short" is a huge oversimplification?  It's a movie."

Well, unfortunately, it seems to  me that it is being pushed as far more than a movie.  It's really being pushed as a true and complete representation of the underlying causes of "the crash".  And, if we accept this gross oversimplification as the full story, any decisions we make about how to prevent something like this happening again, are bound to be flawed.

So what did "The Big Short" oversimplify (or leave out entirely)?

Let's start with poor Lou Ranieri and Mortgage Backed Securities.  Mortgage Backed Securities had been around for many years before the crash and were bought and sold by many investors including Fannie Mae and Freddie Mac with nary a problem.  No, it wasn't Lou that caused the problem but if you want a name and an idea to point the finger at, wait a moment and I'll give you one.

One of the problems with pooling thousands of loans into huge packages is how to assign risk levels with something as disparate and messy as mortgages.  There are so many moving parts; maturity dates, who's going to refinance, who's going to default. 

Who's going to default?  That was a big, messy question.  The slicing and dicing called "tranching" helped somewhat from the investor point of view because they could choose their risk level by choosing which Tranche level to buy and that worked fine for the calamities that can befall a single borrower and cause them to default...loss of job, illness. 

Still there remained the question of correlation.  If home values drop in an area and someone loses their home, would that not affect the values of other homes in the area and if other homes also lost value would that not possibly cause other people to default?  How do you correlate that risk? 

The traditional way was to gather reams of data on actual defaults and analyze them....zzzzz.

Enter David X. Li, one of the quants (Wall Street's name for their mathematical wizards, not to be confused with the squints on "Bones") at JP Morgan Chase and his Gaussian Copula Function (I know it sounds vaguely obscene but get your mind out of the gutter.  This is high math, people.)

Actually, to be precise, Li did not invent the Gaussian Copula Function (apparently that is a standard technique in the wild world of statistical analysis) but he was the one who came up with a way to apply it to the complicated correlation problem and to make it simpler, the equation didn't even look at historical data.  Instead it used market data about the prices of....ready...

....credit default swaps.Gaussian Copula Function

It was an elegant, simple and desperately flawed mathematical equation. The problem was that the folks who had the brain power to understand the flaws in the equation lacked the real world experience to recognize them as flaws and the folks in the real world who were using the simple risk numbers popping out of that magic black box lacked the brain power to really understand the equation and it's ommissions and inherent dangers.

So, everyone...banks, investment firms, rating agencies and regulators...all bought that bridge.  And why not?  They believed it was a safe investment.Bridge - The Big Short Falls Short

Oversimplification will bite you in the butt every time.

One of the most disturbing things to me is that, despite the hideous outcome of this exercise, this concept is still in use.  Whether it's to calculate Net Present Value (to decide whether to foreclose or try to work with a distressed homeowner) or to determine the value of YOUR home using Fannie Mae's Collateral Underwriter, the financial market and the feds just can't let go of this desire to reduce the complex to a simple formula.

And, that is not good because...why? 

Because...

Oversimplification will bite you in the butt every time.

Next up...the Fed.  A brief (very brief, I promise) history and a look at their policies leading up to this mess.

Be patient and stop salivating...I know you can't wait...

 

 

 

 

 

 

 

Comment balloon 11 commentsJoy Baker • February 01 2016 10:01PM
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