Sub Prime Crisis: A Risk Analyst view from the Trenches

Pricing of Future Securities and Derivatives Based on Mortgage Assets are all about projecting delinquency rates , and it depends on the analysts to be either conservative in projecting a high rate or optimistic in a low rate.

Based on these projections , the assets are priced, packed up in SPV’s or collateralized, and options priced. Now Senior Management gets a big bonus if they sell off their balance sheet like this, and business is able to use cash generated to create higher loans….. so they lean on the analyst to make projections optimistic.

This makes loan providers highly leveraged as the same loan is packed ,sold off, money used for giving new loan. It’s like a network selling of financial services , people sell to others who sell to others…like a musical chairs

The risk analysts are forced to therefore discard basic macroeconomic concepts like cyclic effects or even time series for GDP growth , stress testing , conservative financial assumptions ,

In good times everyone is happy , all team players get a big bonus. But due to lagged effect, and increase standard deviations of the leveraged value at risk…when default rates go up, it leads to adjustable rates kicking higher,thus making defaults even more…and when the underlying asset defaults ..people who are holding the Asset backed security lose.

So people who sold early like JPM and Goldman Sachs made bigger money, when the music stopped all people left holding securities got defaults, thus needing more and more cash to stay liquid…and throw good money after bad money makes it worse…….

Also job cuts and outsourcing are dumb at a macro level. If lots of people lose jobs, then default rates will only go higher for mortgages..most of these chaps have pricy houses anyways (like the Tom Wolfe novel Bonfire of Vanities)..

A perfect storm for risk analytics…and all because of simple greed….greed by definition cant be self regulated ..and the repeal of the Depression Glass- Seagal act by the Democratic govt in 1999 helped increase the magnitude rather than decrease the magnitude of present crisis.

An old saying used to be, When Wall Street sneezes, the rest of the country catches a cold. Now it is rest of the World.

Some Economists and analysts (like me) would rather see a return to Keynesian spending than Friedman monetary policy . If you take all the Fed loans in bailing out, and just give them back to the defaulters, I suspect the sub prime crisis would be over faster.

Author: Ajay Ohri

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