Sunday, February 24, 2008

Who's to Blame V

In this article from Reuters, there is a pretty good discussion of how the credit contagion happened (subprime/CDOs/SIVs/Monolines/etc.).

Unlike some commentators, journalists, bloggers, etc., Reuters gives a fairly good account of how the situation evolved from a cascade of bad assumptions:

"The CDO folks, who were cut from the same cloth as CDO professionals all around the Street, who didn't treat bonds as real things but treated them as mathematical abstractions, blew up the bond insurers the same way that the same kinds of guys at Merrill (Lynch) and Citi caused major explosions in their firms," said Mark Adelson, a consultant at Adelson & Jacob Consulting in New York.

"These (banks) and the ratings agencies and the monolines (bond insurers) tend to be comprised of a lot of youthful, bright individuals who lack real-world experience," Dobish said. "They're not going to remember back 20 years ago."

Rob Haines, senior insurance analyst at CreditSights in New York, said: "They all got it wrong."

In my opinion this is a much better explanation of what happened. Incentives were set up to create a situation where it was easy to lose sight of the assumptions underlying all of the formulas.

Fraud played a part, which seems to have been primarily situated at the origin of the mortgages, but intent - in my opinion, at least - was NOT there.

The article alludes to the continuing effects of markdowns (a reduction of bank lending capacity - exposing borrowers who need more credit).

There are lots of moving pieces in this storm, and I don't believe there are any certainties as to where we end up.

Exogenous factors such as the Private Equity/Hedge Funds that raised large amounts of capital to take advantage of such a crisis, and the Sovereign Wealth Funds represent large pools of capital that could prevent prices from dropping too low (I expect a game of chicken as the funds vie to see who can hold out longest before buying in).

The impact of Credit Default Swaps on the markets is also unknowable. If banks hedged loans with counterparties that can't perform, there would be more markdowns. Nobody really knows what the exposure is (there have been numerous attempts to estimate it, but it's impossible to account for those situations where there is regular settlement of contracts).

I'm glad that there are some articles that are now noting the impact of systemic defects as opposed to blaming individuals or organizations.

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