Posts Tagged ‘CDO’

Learn about CDO from Dilbert

Tuesday, December 16th, 2008

Today, we found this Dilbert comic strip here. It is the simplest explanation of CDO (see Collateral Debt Obligation?turning rotten meat into delicious beef steak) suitable for children.

How well informed is NAB’s CEO, John Stewart?

Monday, July 28th, 2008

On Sunday’s Inside Business interview with NAB’s CEO, John Stewart (regarding the recent write-down of $1.2 billion US home loans securities), there were some things he said that made us wonder how much he understands:

Taking those one at a time, I mean the rating agencies clearly are under pressure but in their defence, they couldn’t have foreseen the meltdown that’s gone on in the United States housing market.

Well, “couldn’t have foreseen” is a very common excuse. As we said before in An example of how the sub-prime contagion may spread, economists from the Austrian School already had strong reservations about the Housing Economy as early as 2004! Very long time readers of this publication would already know that we first voiced out our reservations in October 2006 in The Bubble Economy.

Next, John Steward said:

Well the answer to that really is that the only error NAB made was investing in Triple-A securities which have a one in 10,000 chance of defaulting…

Basically, what he is saying is that NAB was extremely unlucky, which it implies that it is none of their fault that this should happen. But as we said in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

The problem with mainstream thinking in today?s finance and economics industry is that the Bell curve is their cornerstone assumption. In other words, the Bell curve assumption is used extensively to model reality and derive conclusions and forecasts.

Unfortunately, the model of reality is completely incorrect. As such, nonsense such as the ones said by John Stewart get repeatedly perpetuated on TV. As we quoted Nassim Nicholas Taleb in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

If the world of finance were Gaussian [Bell curve], an episode such as the [1987] crash (more than twenty standard deviations) would take place every several billion lifetimes of the universe.

Given the fact that so many of such Triple-A securities in the US had already blown up, it is simply too ridiculous for anyone to believe that each of the blow-ups is a one in ten thousand year event.

The question is, why are such Triple-A securities given such high ratings when clearly, they are junk? To answer this question, we will refer you to our earlier article, Collateral Debt Obligation?turning rotten meat into delicious beef steak, to understand how CDOs work. Basically, through some ‘brilliant’ financial innovation that utilises complex mathematical models, junk bonds get re-engineered into AAA bonds. Unfortunately, there is a major flaw in those mathematical models. As this article from Platinum Asset Management said,

In particular lower rated tranches of mortgage securitisations (say BBB rated tranches) were pooled. The first cash flow on these tranches was sold as a AAA-security – the argument being that it was improbable that most of the BBB securities would default. This would be true provided that the BBB pools are themselves not highly correlated. If they prove to be highly correlated (as appears to be happening in the subprime mortgage area) then just three BBB tranches defaulting would indicate it was likely that a majority would default. Then the seemingly safe AAA paper might actually be quite risky.

If you do not fully understand what we mean, do not worry about it. The complex maths behind these toxic derivatives are meant to be un-decipherable to mere mortals and we do not pretend to understand all of them ourselves. But this fundamental fact remains: these models are convoluted and wrong. For this reason, perhaps we cannot blame John Stewart for having stuff up because he (and by extension, NAB) is probably being suckered by the dazzling world of derivatives.

Personally, we do not think John Stewart is deliberately being deceptive. Rather, we believe it is more likely that he (by extension, NAB) are simply not well-informed enough. In other words, NAB do not know what is going on. The same probably goes for the other banks too.