The father of modern portfolio theory, Harry Markowitz says that the problem with the financial engineering that created the spectacular bubble in the market for mortgage backed securities was that it ignored the first principle of his portfolio theory. He writes, "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero. But financial engineers should know that's not true of a portfolio of correlated risks."
It is now widely acknowledged that derivative instruments like Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO), and their underlying securities, all carried risks that rose and fell together. It should have been obvious that any bundled financial instrument that had its basis in home mortgages, was bound to be risky!
NYT has an excellent article on how the models of financial engineering were applied, understood and managed. It finds human failings evident everywhere - with analysts, traders, fund managers and rating agencies getting carried away in the wave of "irrational exuberance" that swept the financial markets.
For example, while the risk models used by Wall Street analysts correctly predicted that a drop in real estate prices of 10 or 20% would imperil the market for subprime mortgage-backed securities, the analysts themselves assigned a very low probability to that happening, and thereby underestimated defaults by subprime borrowers.
As Paul S. Willen, an economist at the Federal Reserve in Boston claims, "asset price trends are difficult to predict. The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs. It’s these hierarchies of beliefs — these behavioral factors — that are so hard to model."
Complexity, transparency, liquidity and leverage, each one fuelling the other in a vicious cycle, have made risks difficult to locate, price and therefore model. The securitization of the mortgage market, with loans sold off and mixed into large pools of mortgage securities, has prompted lenders to move increasingly to automated underwriting systems, relying mainly on computerized credit-scoring models instead of human judgment.
Now, across the spectrum, there is an increasing belief in need for stronger regulation, greater disclosure, higher capital requirements, and the use of exchanges or clearinghouses (most of the asset backed securities like CDS are not exchange traded) for the trade of exotic securities, so as to bring about transparency in pricing risks.
No comments:
Post a Comment