Thursday, December 27, 2007

Wall Street Wizardry

"Instead of spreading the risk of a global home-finance boom, the instruments have magnified and concentrated the effects of the subprime-mortgage bust. ... Norma ... was also part of a chain of mortgage-linked investments that took stakes in one another. The practice generates fees for a handful of big banks. But, say critics, it created little of value for investors or the broader economy. 'Everyone was passing the risk to the next deal and keeping it within a closed system,' says Ann Rutledge [AR], a principal of R&R Consulting, a New York structured-finance consultancy. 'If you hold my risk and I hold yours, we can say whatever we think it's worth and generate fees from that. It's like ... creating artificial value.' ... 'It is a tangled hairball of risk', Janet Tavakoli, a Chicago consultant who specializes in CDOs said of Norma. In March of 2007, any savvy investor would have thrown this ... in the trash bin.' ... But the system only works if the securities in the CDO are uncorrelated--that is, they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation. ... Mortgage securities, by contrast, have turned out to be very similar to one another. ... Yuri Yoskizawa, group managing director at Moody's Investors Service, says the firm figured some of these mortgage sevicers would be better than others at handling problem loans", WSJ, 27 December.

Yves Smith at, is critical of this article. I am not. While 98 column inches, it has a few gems. That Moody's thought the loan servicers identity was important is amazing. If I have two mutual funds: one 80% IBM and 20% MSFT, the other 75% IBM and 25% MSFT, no matter who manages them, they will have highly correlated returns. Welcome back AR, I couldn't have said it better. It is creating artificial value. All valuation is in the mind. Jim Grant, who writes for Forbes, wrote Money of the Mind, 1994, a good read.

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