Structured Finance for Beginners

This is really excellent, from James Kwak. It may be “for beginners” but the careful reader will end up knowing more about derivatives than 99.8% of the population.

For a complete list of Beginners posts, see Financial Crisis for Beginners.

This is more of an advanced beginners topic – I already covered CDOs (collateralized debt obligations) in my first Beginners article – but I imagine that most of our readers are already familiar with structured products. At least, many people know that first a bunch of securities are pooled together, and then they are “sliced and diced,” in the common media parlance I find incredibly annoying. But Joshua Coval, Jakub Jurek, and Erik Stafford have a new paper, “The Economics of Structured Finance,” which does a brilliantly clear job of describing what these securities are and why they were so widely misunderstood, with the results we all know.

The paper is 27 pages long, not counting references, tables, and figures, and if you are comfortable with probabilities and follow it carefully you can understand everything in it. I will provide a summary to whet your appetite. I am not going to use numerical examples because the examples they use throughout their paper are so good.

The key to CDOs is that they could be used to manufacture AAA-rated securities out of underlying securities (like mortgages) that were not even close to AAA. (”AAA” is a bond rating, meaning that the security in question had about a 0.02% chance of defaulting in a given year.) This is well known. But although these new, synthetic securities had expected default rates comparable to traditional AAA-rated securities, they had other properties that were unlike their traditional brethren, having to do with (a) correlations between the underlying assets and (b) sensitivity to underlying default rates. (a) is the probability that, if one mortgage inside a pool defaults, the other mortgages will also default; (b) is the degree to which small changes in those default rates can affect the expected value of the manufactured AAA securities. This meant that these CDOs were much more sensitive both to errors in estimating their characteristics, and to macroeconomic changes, than most people realized.

If you didn’t follow that I’ll go over it again more slowly.

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