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back to article Original thinking in a derivatives market

At some point in the latter decades of the 20th century, someone sat down and thought: wouldn't it be nice if all the money in the world was controlled by scientists rather than accountants and nice chaps from Eton? Now, as we march headlong into the 21st century, full of sub-prime fallout, to a decent approximation, what we're …

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Almost, but not quite correct

First of all, the liquidity has not been pumped in by governments.

The stock of the BoE may be owned by the UK, but it is independent. The Fed is privately owned.

Secondly, pumping cash into the market is not a wise thing to do, to say the least. It may bail out the speculators in the short term, but in the long term inflation get out of control. This insanity, in compination with bio-fuel nuttiness and speculative pressures from hedge funds is having a fairly bad effect on the staple foods of many countries.

For example, authorities in Chile were taken aback yesterday by the 1.1% increase in the Consumer Price Index for August, the highest spike since 1995.

Increases in the prices of basic staples are hitting consumers, especially the one million workers who earn only the minimum wage, very hard.

The general food price increase for August was 3.4%, but fruits and vegetables, as a sub-category, rose by 13.6%, while potatoes rose a whopping 48%, onions by 22%, lettuce by 17%, bread by 5.6%, and eggs and dairy by 3%. The government has taken a few steps to help ameliorate the situation for poorer sectors of the population, but they are woefully inadequate.

In neighboring Argentina, citizens have been stunned by the 20% increase in the price of chicken--a basic staple--in the space of 15 days! Price increases for bread and vegetables also hit record highs.

The cost of the monthly market basket increased by 3.1% in August, with the biggest increases showing for vegetables, which increased by 49%.

Potatoes, which are a basic staple in the Argentine diet, rose by 40% in one month, and have increased by 115% so far this year. Compared to the same period of 2006, the price increase is 500%! The government in Argentina is now threatening to import potatoes from Peru, to try to force the price down.

It won't be long before we see similar inflationary pressures in Europe. There are hints of it already. For example, the cost of Pasta in Italy.

In the UK, Hovis warned about the price of bread just a few days ago.

The whole basic global financial infrastructure is fatally flawed. We are in 1929 all over again, and it isn't going to be nice.

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Salutory Lessons ...... Hello, Wwworlds

"Banks will also make less money, and I can feel your sympathy from here." ..... :-) Priceless humour but one knows you really care, Dominic.

"However, the US and UK governments seem (for once) to have taken on a useful role in the markets, and pumped in liquidity."... Hmmmm? Presumably to be swallowed as collateral by IDEntities obligated to managing Debt Betas Better? A covert Bank International Rescue Secret Bond AIgent ..... Beta Noir/Black Op?

Anyone else would slap a few wrists and take away the toys from the boys but I suppose the indulgent parent is always to blame for not regulating the situation IT encouraged. With everyone to Blame, the Shame is equally Shared and therefore Diminished to Disappear with new Knowledge and Structures put in Place to Mentor and Monitor with Hindsight OverSight.

"They validate the models produced by quants, and try to run them into the future, to guess the probability of it all going wrong." .... Guess? I guess that may be the Chink in the suit of immaculate Armour.

"The days of lending to the right-sort-of-chap are long gone. ®" Given the accuracy and efficacy of the parameters used by Banks, as shared with us in the article, Dominic, we can QuITe rightly expect that to be equally accurate..... therefore the right-sort-of-chap must be the right sort of parameter ...... although I grant you that they may necessarily be a bit extraordinary/out of the ordinary.

But you wouldn't expect such Mastery of the Universe stuff to be home-grown/Earthbound, surely?

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risk ratings

The real root of the problem here is the conflict of interest at the rating agencies such as S&P, Moodys, Fitch, D&F etc. On the one hand they are relied upon to give a realistic estimate of the risk involved in the securitised debt, but on the other hand they make money from giving ratings to investment conduits. There has been an over-reliance on these ratings in substitution for quality first-hand research by investment banks. And as it turns out, they severely over-rated the sub prime debt.

As a result when mortgage holders in the US started defaulting, the real risk of these investments became appearent and the value of structured investment vehicles with exposure to sub prime plumited. As happens in the industry, when confidence in one sector is compromised, everything stops in all sectors until everyone's fears are eased. These investment conduites for the most part funded their invesment in packaged securities by selling commercial paper in the short term, adjusting and re-selling from month to month according to the prevailing interest rates. But once the value of the securities was questioned, the entire market for commercial paper stalled. Banks who funded their investments in this way had no way to raise the dough - and that's when things went _really_ bad! The credit crunch has created artificially low fund values and run some banks out of business.

...all down to a temporary cash flow crises! nasty! The bounce back is happening already - those without the resources to weather the storm are being eaten up by the bigger players and a serious darwinian feeding frenzy is in process. This creates it's own market activity and the world keeps spinning. Funds without proper credit backing are a thing of the past.

So bottom line, this had nothing to do with using monte carlo versus - but rather an over-reliance on rating agencies. The capital model simulations you refer to are merely a way of tracking and projecting a fund's performance, not a method of risk analysis. While they are used to create cash flow models and even simulate distressed market conditions, it remains a question of acceptable risk - and ultimately the ratings control the outcome. And to bring it bakc to an IT focus: GIGO, baby!

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It takes a Market to make a Village...

This article is a good basic overview of the issues we are seeing with the derivatives market today. Which is good: most folks (and Beeb journos) seem to be puzzled over how this all came to pass.

What isn't said is how these things tend to play out, and how "lessons learned" are applied into the future. This is where it gets interesting.

In 1987 we had a severe "correction" in the global securities markets, caused by the failure of automated trading algorithms to react "reasonably" to market changes. The underlying issue wasn't so much the reaction of the program trading - after all, it did what it was programmed to do - but the effect the new products and processes had on the market. The new instruments (derivatives and hedges based on automated spread calculations) were exactly that - "new": they had never been played out in the real market game. Once the collapse occurred, and some additional rules applied to control the new instruments better, the market recovered and the derivatives and hedges became "business as usual" devices that all major players use to this day.

It wasn't the "bad instruments" that were the problem, just a temporary misunderstanding of how they worked in certain situations. Once better knowledge became available, these "volatile" instruments became "stable" and useful again.

More importantly, the knowledge gained from the market reaction to computer trading allowed responses to future "glitches" to be faster and firmer. Today, a market swing caused by automated triggers may not even make it through a single day of trading: everyone knows what's going on, and the market recovers almost instantly from the glitch.

The "sub-prime" loans of today, as explained by Connor in the article, are just the latest tool that is being used to improve income and liquidity in the market. And like program trading in the past, once the initial panic has subsided and the real consequences have been assessed, the market will adjust to the situation and these products will stabilize.

The bottom line in all this is that the markets will *ALWAYS* develop new products to exploit untapped areas of profit. The sale of risk is nothing even remotely new - Lloyds was founded on this principle hundreds of years ago - but the "product" is a new twist on this concept. And, like many new products, it will take an "SP1" to fix the initial errors we have observed.

A final pontification: this all has to do with unlocking value in the Production Possibility Frontier. This is the "edge" of the curve that localizes the trade-off between scarce resource allocations in the market - the old "guns and butter" saw. New "products" test the elasticity of the frontier by providing new alternatives for investment. If an alternative is viable, it pushes the frontier outward, creating new capital from an unrecognized source. However, to do this, resources have to be reallocated, and, in the process of moving around, "inflation" is added into the market. This "inflation" is temporary: it represents the reaction to the scarcity of resources for "traditional" trade-offs in the market, and is corrected in the future by either new capital becoming available from the new market (reducing inflation by returning value back to the market and removing deprecated choices from the trade-off mix) or by failure - where the bubble value is removed and the old trade-offs return to stability. Ensuring liquidity is the key to keeping this process working - not throwing fiat money into the market, but temporarily adding some off-setting credit that allows the old trade-offs to resume operation at the appropriate price levels. This allows the new products to either dissipate safely, or, if they are truly successful, to allow older products to resume stable operation. The liquidity then either is withdrawn gradually (in the case of failure) or remains in the market in the form of the new capital created by the new products.

Hey, it all makes sense to me. I'm not an economist, but I DID study in school...

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Oooh baby that's really free

Why are governments having to pump so hard to support the "free" market? Shouldn't they be "letting the market decide" like they always claim they are doing? I thought that was the whole point of having a free market?

Let the market decide while it keeps pumping profit into our corporate buddies' and party donors' pockets, intervene as soon as it starts looking like they may find themselves with a slightly lesser annual bonus free for their party donations.

The right wingers who gibber so furiously about state intervention in their business seem a lot less concerned about it when it's serving their ends rather than trying to protect their employees from dangerous, unethical or exploitative work practices.

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Anonymous Coward

It's a gas ?

Is there a particular reason why you illustrated your financial derivatives "it's a gas" gag with what seems to be a picture of laughing gas, or "clown crack" as I've seen it referred to in some clubbing circles ?

Just wondering ;-)

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Anonymous Coward

umm It dosnt take complicated maths can I have a 60k job?

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 your winning the money dosn't exist until you walk away with it.

4. if your 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.

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Stockbroker (def)

A person who invests your money until it's all gone. - Woody Allen

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KISS.... Keep IT Simple Stupid

Is the real root of the problem anything less than debt which can't be paid by creditors being parcelled up and sold as a viable asset and credit to others who have been spun a yarn that it has value?

A Scam in other words perpetrated by supposed diamond geezers but in reality, slippery toads? Pond Life masquerading as Tropical Fish?

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Anonymous Coward

wrong again....

"At some point in the latter decades of the 20th century, someone sat down and thought: wouldn't it be nice if all the money in the world was controlled by scientists rather than accountants and nice chaps from Eton?"

Eh.. Wrong - it's still "nice chaps from Eton". Can't tell you how many times i heard about traders ("my instinct telle me so!!!") go against what model says (let me see - mexican pesos in the 90-ies...).

Oh, sure they use some old models for credit - that's cause they didn't hire any senior quants in the past 5 years. Hey - almost every model works if markets keep going up...

Oh - and this subprime thing? In most banks they didn't even told risk management they hold those loans! Oh, well - all fired now. :)

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Confused rubbish

I usually kneel in awe before El Reg, but that article was confused rubbish - due I suspect to youth or alcohol. Who was he writing for? To begin with it seemed like the article was aimed at financial novices, but then he threw in unexplained terms like "sold off cashflow from loans" , "off the books", "instruments", "pumping liquidity". I was puzzled by the references to David Bowie and Bernie Ecclestone, and the ideal gas / pea electron analogy seemed spurious.

Then he tried to dazzle us (youthful vanity?) with a few throw-away mentions: "genetic algorithms" , "Monte-Carlo approach", "copulas". The meaning of "distribution" only became clearer in the following paragraph.

I suppose I vaguely agreed with the last sentence, but he really needs to raise his game.

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25-year-old Harvard MBAs

Problem #1 is making a borrowers market for anyone. Perhaps you can find someone willing to buy the risk of lending money to a crack addict or homeless person. But is it a good idea to make this loan? That is, does it help the borrower or hurt him that he can go way into debt? Those sub-prime loans shouldn't have been made. It just screwed up the lives of some poor folks worse than they were. It's amoral. And saying, "We're just making a market to satisfy demand." does not excuse the lenders from their unethical acts.

Problem #2 is new MBAs playing with shiny toys they don't understand. Anyone who uses a quantitative model derived from a genetic algorithm, which isn't even based on assumptions you can review, is cruising for a bruising in the market. These models always work perfect when this week's market is just like last week's, but get surprised by news. There aren't enough really experienced quants, who have gotten burned a couple of times, because the field is only 10 or 15 years old. This is the trial-by-fire for hundreds of high-paid young MBAs, only we're all paying for it.

Problem #3 is naive free-market thinkers who don't want the government to intervene. The problem with such thought is that we've all got a stake in the economy moving smoothly. It would be nice if all the bankers and MBAs and quants involved in this mess could be lined up for a good spanking. But if the banks go out of business, the broader economy seizes up. Sucks if you need to make a steady paycheck. Sucks if you are independeltly wealthy but need to buy food at the grocery store. Sucks if you live in a completely self-sufficient bubble with all the shiny toys you want, and some hungry mob comes to take it away.

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Responses from the writer

It's not "chaps from Eton" in the quanty game I have a database of their CVs, and we have more people from Egypt than Eton by a country mile.

The guy who didn't like my piece may have a point, but sure Reg readers know what a genetic algorithm is ? Most people I think know what "off the books" means.

A big criticism is that the "models aren't real", so I drew a parallel with quant and physics models, if you look I use that consistently.

I don't know what Breakfast is talking about. The quant types I know are of all political persuasions. Very few make political donations, though one is a local councillor (Labour).

Even the governments themselves have realised that most of their interventions in the market did more harm than good.

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@Count Ludwig

I partly disagree with you - I thought it was an interesting article that brought together some bits that I already understood and some others into a (more) coherent whole, and threw in some interesting titbits about the IT techniques involved. I enjoyed reading it.

But I totally agree with you about some of the unexplained terms, like "sold off cashflow from loans"... how about a technical glossary Dominic?

Breakfast: I fear the problem is that we cannot afford to just sit back and watch whatever happens in the markets - we really don't want to live through another 1929. Of course, that is the reason why markets have to be regulated - we depend on them - something the free market guys do tend to forget when all is going well, don't they?

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BCCI ..... ITs MetaMorphOSIS of NarcissUS

"At some point in the latter decades of the 20th century, someone sat down and thought: wouldn't it be nice if all the money in the world was controlled by scientists rather than accountants and nice chaps from Eton?"

Is that a Phish, Dominic ...... a Call to Alms? :-)

And a Realisation of what is in Store ..... with an Adjustment to such latterday 20th century thoughts with some F1 style Finer Tuning of the Notion 42 Allow Rapid Deployment of SAPs?

Because, if New World Order Scientists have all the money that they need or even, to be more accurate, if a New World Order Scientist has all that he personally needs [and you would not need to be an Einstein to realise that that would be so relatively small, no matter how extravagant or eccentric he may be, although even that thought would be tempered in a Fit for Purpose response by anyone even remotely conversant with Order and its Drivers] they would be able to exercise Controls in all the money of the world.

Common Sense and a Lazy Wisdom, which might very well be the Simple Culmination of dDedicated ReSearch into Proper Planning and Preparation Prevents PiSS Poor Performance Permitting a Sane Disregard of Haste, would probably suggest that any New Order Player be Pragmatically and Covertly Sponsored to Server to Status Quo Systems thus to Assist them in a Seamless Change to A.N.Other New World Order System of Operation.

Such Sympathetic Cooperation would be much Wiser and much more Constructive than any Coup type Disruption caused by Arrogant Rejection of Inevitable and Inexorable Change Programming from Status Quo leaders. Although such Leadership would be Oxymoronic in that it leads with nothing new.

Such though, does require a certain level of Intelligent Awareness to be exercised by aged New World Order Systems Players/Present Status Quo Leadership which we could presume to be that which is interested in the Control of Banking and Banks for Banking Control of Commercial IntelAIgents.

IT is, of course, a product which could be sold to any Market or any Global Player as IT is Universally Systems Agnostic.

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Paying the piper

I read the article with the hope of getting some insight into what actually drove the panic when it occurred and how things have changed since when the game got played in the late 80s. The only thing I walked away from it with was the reference to 'Black Swans' which I just ran away and read, and liked.

Now to my comment.

If someone had asked me 5 years ago what the end result would have been of giving 0.5% variable interest loans to people with a diminished ability to pay off the loan, a bad history with dealing with money, in a market with inflated house prices I could have predicted the first order effects in about 10 seconds.

A pocket calculator, let alone a bunch of PhD's banging away on keyboards would have made no difference to my predictions.

I could probably have a stab at the second order effects (given how the central banks have behaved). But my predictions would be a series of branches based on decisions that actual people made, not on some bulk property of the market. Anybody who claims that they can use bulk properties to predict how things will behave an a non-linear system is a liar.

The market shake-up wasn't caused by some freak confluence of events (black swan), bad models, or a lack of understanding of models. It was caused by the simple fact that your worst days comes straight your best days, parties start slowly, but end quickly, you might be able to ride the wave for minuets, but it breaks in seconds.

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.

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Nice article

The only thing I still don't understand is the role of central banks in attempting to prop up this house of cards. If the interbank lending rates rise then surely central bank rates should rise as well. The regulatory authorities have failed and the market must correct itself. Governments might intervene by loosening fiscal policy but monetary policy must obviously be tightened. This can be done either by raising rates or perhaps by improving regulation by preventing some of the dafter products such as "sub-prime" mortgages: lending money to people who obviously cannot afford to meet repayments (not the same as debts) is irresponsible and should not be allowed to go unpunished. Buttonwood on the The Economist has a nice commentary on the dangers of relying on the rating agencies.

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Basic truths

The bottom line, is, you can't polish a turd, and with lots of clever people being daft enough to lend someone some dosh to buy a house, without checking (or being bothered by) how much they earn in the first place, some of these now not-so-clever folks are going to get a haircut.

Which is a risk to my eye!

The Sage of Omaha is right again...

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Normal Shormal

I recall a whimsical comment made in a textbook I read in school, to the effect that mathematicians regard the normal distribution as being grounded in physical reality. Physicists, on the other hand, regard the normal distribution as something that has been validated by mathematical analysis.

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Yet more responses from the writer

It is a standard complaint of journalists that it's easier to write 2,000 words on a subject than 1,000 :) Glossary didn't make it to the first cut, but it's a reasonable request:

A brief summary of risk management.

Banks are required to keep a rainy day fund of money to cope with random shit. The riskier the position, the more money they need in this buffer. The regulations are a bit old ,and not very sophisticated, so much so that banks sometimes have more reserves than leghally necessary.

A simple portfolio loan requires the bank to have this buffer, to cope with bad debts, since of course the people that the bank borrowed the money from (which can be retail customers), will still want their money, regardless of the banks losses.

The capital required is expensive for bank, since they can't do anything risky with it, typically putting it into other banks or high grade/low yield bonds like those of major governments.

Thus "on the books" means the bank takes the full upside and full downside of any loan it makes.

If it sells the rights to receive the money, it can get a rake off, and let someone else take the risk. That means a high street bank is in effect a retailer of loans. Sainsburys is not the source of own-brand goods it sells, and Barclays is not the source of the money it lends. Both sell stuff.

Liquidity is the ability to buy and sell.

In many markets there are "market makers". They quote two prices, both to buy and to sell. This makes life a lot easier, and the spread between the bid price and offer price reflects the "service" a MM gives.

The property market does not have market makers, and most of us have suffered the pain that this causes. It takes a long time to sell things, and discovering prices is very hard, and imprecise.

However, you need decent amounts of capital to make a market, because you must hold a considerable amount of the stock, and have the pockets to deal with the screwups that happen. If like me you've ever been on a trading floor after hours, you will pick up phone calls of the form "hello, this is VeryBigBank, did you buy 3 million quids worth of bonds from us ?"

If the price of their stock holding drops hard, it can hurt badly. So they don't want to have too much.

Market makers, and other liquidity providers typically don't make big margins in their work. That means they are a bit cautious, since a small number of screwups can undo a year of profitable work. Getting market makers to actually make the market at all times is a standard problem, and I spent several years of my life embroiled in that situation.

Thus in a worried market, liquidity providers hide.

This means that people who want to get out of a position, can't. This means that the market sees lots of stock desparately trying to move, and a vicious circle may develop.

The actions of central banks is typically quite secretive, I did stuff for HM Treasury a while back and I was covered by the Official Secrets Act. In the words of the senior civil servant "we know where you live..."

But I pick up that they are providing liquidity, but with a very hard nose.

They are offering to buy stuff, but at a steep discount. My reading of this state of affairs is that the Fed and BoE may end up making a shed load of money out of this.

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Anonymous Coward

Deal or no deal...

Everything has a price. It is only now that we are starting to realise the true cost.

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.

Complicated maths or man on the street, whatever your model, whatever your method, the tally man comes knocking sooner or later. You had the balls to borrow the money, now have the balls to pay it back.

Same old history, just repeating itself...

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Whe are passing from gas to liquid -A crack-

The market is a gas at normal temperature and pressure ;and like a gas ,its only gas in certain conditions .When the conditions changes ;it´s occur a change of state .The pass from gas to liquid is a crak .

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Arrogant Prigs and Pompous Prats....... of the Ruled Class.

"In the words of the senior civil servant "we know where you live..."

If he was there to assist you in sharing what you know, and what he wanted to know, I trust you told the sad little toad to F*** Off nicely, Dominic.

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Anonymous Coward

...controlled by ... nice chaps from Enron

oh, sorry, you said Eton not Enron.

Mind you, not sure how anyone would notice the difference, they all want locking up.

Speaking of sub prime and dodgy energy: if free markets are so brill at managing risk, is nuclear power going to be the sub-prime mortgage of the energy industry, only even more dangerous? Just ask the nuclear industry's insurers (that's you and me, the taxpayer, as the commercial insurers won't go near the nukes, because the risks are too high, hmmm).

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Coincidences...

1. The NY Times were reporting a couple of weeks ago (I think it was the 28/8) that this year, it will be the first year since 1950 (aka the time that the stats of the sort were recorded) that the price of the real estate in america will be falling. (I assume with the exception of Manhattan and Palm Beach where the limited space guarantees the value).

It appears that the speed of changing/moving into houses is lower than the available real estate, and G*d knows why? Is it because we got sick of moving around, is it because we telecommute, is it because we enjoy reading about the rise in the value of (our own?) properties... this is a fact.

2. Before the crisis the Fed was likely to increase the interest rates. That would have meant that capital would have moved from the markets to the bank coffers. Now, if you are a bank (that invests in the stock market as well... ) what would have been your pick? To pay higher interest rates to an even larger whole and a declining market or to pay low interest rates and have a steady-yuppie (upwardly mobile) market?

Of course you would go for the second gents... and you dont have to be a risk analysis expert and/or an Eaton graduate for that reason... ;)

I dont know what you make of this but I am a mere charterd engineer so I am happy to give my bet for the future in somebody elses field of expertise, with the ease that I bet Olympiacos Piraeus will make it through in the next leg of the Champions League:

1. We have seen just the beginning of the crisis.

2. Some Real estate funded funds will have to shrink in order to increase once more the speed of movement of capital, that gives life in to our system.

3. We may not see a collapse in the form of the 1920's (well... a third of our population never left that state since then) but we shall see some crisis.

4. The price of oil will fall. Putin's men have to win the elections over there in a couple of months and need some help till then.

Enough said...

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A history of banking regulation since the Great Depression.

Step 1.

Regulators set out rules (such as minimum cash on hand, maximum amount of high risk investment etc.) to prvent banks shooting themselves in the foot.

Step 2.

Very clever people employed by the banks find clever ways to cicumvent the rules.

Step 3;

Banks shoot themselves in the foot.

Step 4.

Government/central bank bales them out.

Step 5.

Return to step 1 with tighter set of rules and repeat every 9 years.

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A Simple Question

"Step 1.

Regulators set out rules.... "

James,

Who are Regulators?

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@ Matthew

Totally agree - this was nothing to do with what algorithms were used in the mathematical models. This was down to greed in the face of danger. Pure stupidity. Holding the capital models and their usage to blame for this is akin to blaming the fly by wire computer on an airplane when the pilot decides to fly directly into a storm. In order of accountability I personally think the following are responsible:

1. the sub prime mortgage originators

2. the rating agencies who gave them AAA ratings

3. the idiot credit investors who bought the securitised debt without engaging any kind of logic

4. the financial regulators who had to have seen this coming, or chose not to

somewhere along the line the idiots who borrowed money they could never ever afford to repay should also be apportioned a fair share of the blame - but they do hold a diminished responsibility owing to the fact that they are a) non-bankers and b)fools

And the risk departments are not nearly as culpable as the article suggests - the nature of the credit investment in a portfolio is down to credit investors. Risk teams merely monitor the portfolios and project possible problems (using amongst other tools, the algorithms blamed in the article). It's not their place to re-analyse the viability of the underlying debt.

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Pum

Actually, In the olden days (the 1980s)

Well, I took out a mortgage in the early 1980s, and I fairly easily got 3 times the joint income of myself and my girl-friend who was unemployed, which was nearly 90% of the property value. I also had a gay friend who got a mortgage no problem, although life insurance was virtually impossible.

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I've been reading the Reg tooooooo long

Amanfrommars is beginning to make sense.....!

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Anonymous Coward

Spreading the cost of the risk...

The action by the government banks to lend money to the market sounds reassuring, untill you realise that the banks are not lending their money. They are either repacking the loan to sell as an investment bond(in other words more of the same that got us into this mess, only the entire population takes the risk) or they run the printing presses a bit faster (and the entire population takes the cost by increased inflation)

Either way, the people that take big risks on the financial markets get bailed out because the consequences of their risks actually threatens the stability of the market ...oh and the UK public pay workers get their pay rises staged, as the government needs to fight inflation

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Great article - more like this please

Dominic - thanks for an engaging article. It's getting increasingly rare for journalists to sit down and explain current affairs to an uninitiated audience (speaking for myself, at any rate), AND in terms that the audience can relate to.

It's clear from the quality and quantity of comments above that this kind of article provokes sensible and intelligent discussion - more of this please El Reg!

Jock

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Solly

My apoligios to "amanfrommars" I an goood at spilling but not veru god at tuping.

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Further Reading

If you like this kind of thing, and want to learn more about structured finance (CFDs, CDOs, MBSs ... ) then I can highly recommend "Traders Guns and Money" by Satyadis Das (IBSN 0273704745). As well as tracing these things from the start, and thereefore rendering them understandable, it's also damn funny.

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Some have it right, others like the author are way off base.

In the 90's, banks used a monte carlo simulation to run risk scenarios.

They created multiple CMOs and other derivative type products to reduce their risk. The secondary market worked as long as the assumptions about the rate of pre-pays held.

Only they didn't.

Part of the problem is in the loan origination process and the lax control over loan origination.

There has been a rise in mortgage fraud.

Its in part of these fraud which has caused a large portion of the problems.

Not that the fraud alone is to blame. You can blame it on the highly leveraged mortgage providers who probably didn't manage enough reserves to account for this issue.

Add to the real problem of complex products (teasers, arms, etc ...) and unsophisticated borrowers who are in the subprime group, and you can see how they can easily get in over their head and can't keep up with the payments as the interest rates change more than 2-3 percentage points.

Its these scams and higher rate of "normal" forclosures which started to trip up the system.

Definitely more to the problem, but the article and some of the posters are correct that most of these "casual" analytics don't handle boundary issues well.

There has to be a change in the assumptions made about pre-payment risk due to the fraud.

The bottom line, the systems that the author complains about have been in place for most of the 90's thru today and didn't have a lot of problems. It just needs more refinement.

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Even More Comments by the Writer

I just would like to point out *again* that there is no bail out.

None.

The central banks are buying stuff off the banks and hedge funds cheap. My call is that they will make a serious profit.

There is a possibility of more inflation in this, but the net effect of the summer seems to have been to reduce such pressure.

As for public sector pay, that's a difficult and different issue. The government has been neither efficient nor honourable. But then again nor has any administration in my memory.

I note how the dimmer end of Labour politicians like Peter Hain complain about City pay, but somehow never manage to find the time to criticise those footballers, singers or actors who make far more.

I pimp for people who are the total opposite of morons like Dawn Primarollo, ie smart, extremely well educated and useful. The single most common name on my data is "Mohammed". Hain's cronies want such people to stay poor and grateful for handouts. I get them jobs which pay obscenely.

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Finance for geeks

Was it a bit tricky to understand for some people? Sounds like a good oportunity to do a little extra learning for those that care.

As I work in a mostly finance role the language of the article was pretty clear to me, and as a semi geek the IT angle was an excellent primer in how these guys use IT (Monte Carlo analysis has many roles, cost modelling to nuke reasearch).

I personally think this was an excellent Reg article, starting with a global issue and showing the Sci/IT input. Didn't really mention the hideous greed that has fuelled this whole event as much as I would, but seemed pretty good never the less.

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umm It dosnt take complicated maths can I have a 60k job?

6. Borrow long, lend short.

AndyD 8-)#

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@Even More Comments by the Writer

Dominic,

I wouldn't disagree with that post but to think that the serious profit is real whenever it is still toxic debt is the Banking System in Denial and a prisoner to itself ...unless it has a New Game to Play or is it a case of .. unless IT has a New Game for IT to Play, which would give them something to New and Real 42 Invest in.

"I pimp for people who are the total opposite of morons like Dawn Primarollo, ie smart, extremely well educated and useful. " Yes, of course they are, and some of them are magnificent whores a gentleman would never refuse such is the delight.

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The writer responds yet again

Matt might recognise me as DCFC...

But I don't buy the "greed" thing. At various times I've worked as a chemist, journalist, programmer, barman and now pimp.

In all those industries, people wanted more money, and I've found encountered more criminality in the IT business than in banking.

The actors and artists I've met are really greedy, mostly poor, which just seems to make them more hardcore on the cash front.

The Reg has carried stories of the music and film industry using thugs to intimdate small children and old people. Never once seen that in investment banking.

EDS and Accenture, well if you're a Reg reader or simply someone who occasionally reads a newspaper you will have seen them do more damage than a barbarian horde of bankers.

Bankers are simply better at greed.

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