So there is a really interesting and lucrative optimisation problem here in balancing risk and reward, so complex that some outfits use genetic algorithms to crack it. Although efficient, the problem is that the answer „just works“, without anyone understanding the underlying problem. And of course this means that when it goes wrong, no-one really knows why.

Collateralised debt obligations can be put together with many different components, for different customer demand, or more cynically to make them look attractive to fund managers and the advisors of high net worth individuals.

The problem is that these black boxes are tough to understand, even if they are explained gently by the bankers. Just because you have the Linux kernel source, doesn’t mean you know what it will do. […]

It’s been clear for a while that some of the banks have been pushing products whose risks are far from clear, unless you are a specialist.

Nor have the banks completely washed their hands of the original risk, since many act as prime brokers to hedge funds in mortgage derivatives, lending money secured against holdings in instruments, which may have been created by the retail arm of the same bank.

Thus, the risk is now spread very widely in complex ways, which meant that when the sub-prime mortgages started to smell bad, no one could work out which institutions were being hurt. […]

Many use the lognormal distribution, which resembles what we see in real life. Except that it gravely under-estimates the probability of big price movements, as Nassim Taleb has been telling people for a long time. Ignoring this has led several banks to encounter issues that „should“ happen only once in the life of the Earth, actually happening twice in the same month.

Quelle: Original thinking in a derivatives market

Was lernen wir daraus? Investment-Banker wissen kaum mehr als du und ich, mit dem grossen Unterschied, dass sie der Technik und ihren fragwürdigen Algorithmen mehr vertrauen als wir dem normalen Menschenverstand. Ah, und dass sie Ende des Jahres einen massiven Bonus kriegen, weil sie (und ihre Modelle) so wunderbar funktioniert haben. Mal schauen, ob es Ende 2007 auch ein Weihnachtspäckli von der Bank gibt …

Kommentare

Auch ganz gut fand ich einige der 21 Kommentare zum Artikel:

Its a sanitised form of gambling.

1. Plan for the worst, hope for the best
2. Never bet … err … „invest“ money you cant afford to lose.
3. If you’re winning, the money dosn’t exist until you walk away with it.
4. If you’re winning, people get greedy, set a figure and walk away when you reach it.
5. The little person gets shafted allways, the game favours the Banks in the long run.

Stockbroker (def): A person who invests your money until it’s all gone. – Woody Allen

[…] Hey – almost every model works if markets keep going up…

The sub prime market got used up like any resource, and when the was no place to expand to, it imploded. It’s what we humans do to any resource, and it’s what we’ll do with oil, coal, uranium, the next round of financial regulation loop holes, p2p downloads and everything else.

Old debt, new debt, sold debt, transferred debt, it’s all still debt. Payback time is upon us, and the vultures are starting to circle.