Friday, August 17, 2007

The spiral of risk

This is a first attempt to understand the sub-prime problem; the posts linked below seem somewhat understandable. John Kay in Financial Times (via bayesianheresy):
"The financial economics I once taught treated risk as just another commodity. People bought and sold it in line with their varying preferences. The result, in the Panglossian world of efficient markets, was that risk was widely spread and held by those best able to bear it.

Real life led me to a different view. Risk markets are driven less by different tastes for risk than by differences in information and understanding. People who know a little of what they are doing pass risks to people who know less. Since ignorance is not evenly distributed, the result may be to concentrate risk rather than spread it. The truth began to dawn when I studied what happened at Lloyd’s two decades ago."
A comment inRoubini's postlinks to
a letter from J. Kyle Bass, Managing Partner of Hayman Capital . Excerpt:
"He told me that the “real money” (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Subprime debt in late 2003 and that they needed a mechanism that could enable them to “mark up” these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of Subprime debt. "
There are aseveral posts on the topic in Information Processing. See in particular Profits from the meltdown and guide to the perplexed.
More at NY Times .

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