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CDO and morgage backed securities

Joined
7/9/07
Messages
37
Points
16
I have read many postings on this great forum since my senior years at Baruch. There is so much talk about MS, MFE or PHD in Math, Engineering, Finance and the like . But, with the current financial meltdown, none of the degree seems to be valuable and sensible to me. There were many smart people working in the market and despite their PhD's and extraordinary Financial know how and math geniuses, they couldn't save the economy from meltdown. This forum talks a lot about exotic financial products and they seemed to be the time bomb(As Warren Buffet has called it) for the meltdown. I got a great education from Baruch and learned a great deal about Finance, but feel that Financial market is purely a gambling in more organized form. I do believe in the random walk theory. Financial engineers and their exotic equations that created the CDO and mortgage backed securities ail us now. So, what's the value of MFE and other quants in the future??

I have lost faith in the investment world and specially in the derivatives sector.
 
"I got a great education from Baruch and learned a great deal about Finance, but feel that Financial market is purely a gambling in more organized form."

Financial markets are gambling in a more organized form. Only in this arena you gamble with other people's money. Think about it. When traders they a position they call it "taking a bet". All you're doing is betting. Betting on spread movements, interest rates, etc.

I wouldn't lose faith in finance as a whole. From my short four years in the industry I've learned that you just have to realize that this industry attracts certain personality types that you have to deal with (i.e. greedy, cut-throat, pompous @$$es with enormous egos that think they know it all). It's just part of package.

Working on Wall Street is pretty much no different than working in Hollywood. You have to be very tough and thick-skinned to survive. It's dog eat dog and if you want a successful career you just have to play the game. If you only have a love and interest in finance in general then maybe academia is a better choice. I say this because most people in the industry aren't in it because this stuff fascinates them. They're in it for the money. To sum up this point, my first day in an analyst program at a major firm, finance was described as "how really smart people find ways to take money from really dumb people." So, there is an entirely different attitude on the inside. However, note that this is not the case at every firm on the Street.

As far as PhDs and geniuses that were unable to save the economy from the meltdown, no one really saw this coming and if they did they turned a blind eye to it. The quants and PhDs created the models; but, it was hubris and greed that caused the meltdown. Unfortunately, the people that created the models weren't always the ones making the key management and investment decisions.

Just my thoughts.



"It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another. "

"A fool and his money are lucky enough to get together in the first place."

And let's not forget . . .

"GREED IS GOOD!"

--The sad thing is that some people, not all, in the financial services industry have lived by these words and this is why we have the mess that we have today.
 
You made a very good point J Star. Greed and the management people who could barely or moderately understand the complex financial models and executed them led to the crisis. But then those models aren't always correct or most of the time are not even close enough and sometimes they get right and that becomes source of reliance.This doesn't mean that I don't believe in modeling, it is always a great practice to model before executing with the expected outcome . There are assumptions made in models.

I am aware of all the points that you made as to having thick skin to go getter type attitude in order to succeed in Finance.

I recently read a great article on Credit Default Swap(Fortune Magazine) and how it has increased from slightly under a trillion dollar of worldwide transactions from early 2000's to present leading up to 54 trillion dollars.....Now, that's scary...I bet many of you have read that article, if not I have included a link below..

Will credit default swaps cause the next financial crisis? - Sep. 30, 2008
 
Steve Shreve has an article defending the quant that I linked to on quantnet.
On the second part of the OP post, he seems to indicate the demise of cdo and derivatives. I don't know about cash cdo but I don't notice any panic among people who work in synthetic cdo or orther derivatives product. Nobody ever suggest that we will go back to stock picking.
I work in the credit derivatives and there is a general feeling that when this whole show ends, the landscape will be full of opportunities and liquidity. The operation mode and underlying products may be different but the complex derivatives are here to stay. I believe if anything, there is a greater need to understand the risk and complexity of these financial weapons.
 
IThere were many smart people working in the market and despite their PhD's and extraordinary Financial know how and math geniuses, they couldn't save the economy from meltdown.
The problem is that all those smart people were not decision makers. If some trader was making money for the firm barely having a high school degree, none of the PhDs could stop him from taking extraordinary risks. This is a sad fact. Blaming those PhDs is like blaming physicists for nuclear research they've done leading to creation of nuclear weapons.
Financial engineers and their exotic equations that created the CDO and mortgage backed securities ail us now.
MBS and CDOs were created as a solution for S&L crisis of 80-s. And they worked out beautifully. The problems we have now not because of MBS, but because lending companies loosened their underwriting standards a lot for the last year. The main factor they've done it is their assumption that house prices will always go up, like they did for the past 10 years. However, in 2007 they started going down, and everything collapsed. MBS were affected by this, but didn't create a mess.
I have lost faith in the investment world and specially in the derivatives sector.
A lot of businesses need derivatives to operate properly and safe. Read this article as an example:
http://www.dallasnews.com/sharedcon...ories/072508dnbussouthwestearns.87a53152.html
 
MBS and CDOs were created as a solution for S&L crisis of 80-s. And they worked out beautifully. The problems we have now not because of MBS, but because lending companies loosened their underwriting standards a lot for the last year. The main factor they've done it is their assumption that house prices will always go up, like they did for the past 10 years. However, in 2007 they started going down, and everything collapsed. MBS were affected by this, but didn't create a mess.

I agree with Max. If there something that the structurers and financial engineers (& the rating agencies) should be blamed for are the naive assumptions that price of houses would keep going up , the underwriting would stay high at historical level and that the expected loss would stay low. This back-ward looking (statistical) approach of predicting the future performance of MBS & CDOs based on historical data has proven to be seriously flawed.

But the bottom line is if the underlying mortgage portfolio is performing badly, no amount of fancy waterfall or structure is gonna save the deal. The underwriting of the subprime mortgages the last two years has been quite atrocious to say the least.
 
When traders they a position they call it "taking a bet". All you're doing is betting. Betting on spread movements, interest rates, etc. Street.
We don't call it "betting". We call it "expressing one's view on the market"
To be fair, there is significant resources spent on Wall Street to pursuit the kind of non-directional trading that reduce/eliminate "known" risks. It's the Holy Grail of trading. Even then, it's not easy to realize when one in fact executes a "directional trade". The lesson can only be learned after failure or careful study.
Some have success but I believe a good chunk of trading is directional i.e betting on the direction of correlation, spread, yield, interest rate, default, etc.
 

From wikipedia:
In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment.

A hedger (such as a manufacturing company) is thus distinguished from an arbitrageur or speculator (such as a bank or brokerage firm) in derivative purchase behaviour.

So, if they lost money as a result of hedging, that wasn't really hedging. Looks like they were hedging + trying to compensate for the previous losses betting on the direction of the oil price. Now they've learned the lesson in a hard way.
 
If there something that the structurers and financial engineers (& the rating agencies) should be blamed for are the naive assumptions that price of houses would keep going up

I don't really think it was "naive". There was a huge conflict of interests everywhere:
  • mortgage agents were working on commission, and therefore were interested to underwrite any mortgage they could, no matter how secure it was;
  • politicians were trying to get more votes by "helping" people to achieve American dream by loosening legal standards of underwriting;
  • rating agencies were interested to keep their clients (investment banks) coming again and paying huge fees for assigning AAA ratings to the garbage securities;
  • investment bankers just needed to make profits as high as possible to secure an enormous bonuses and didn't care if the whole country goes down after the bonus time (Bear Stearns had the largest bonus pool on Wall Street in 2006, and it was the first investment bank to fold).
 
From wikipedia:


So, if they lost money as a result of hedging, that wasn't really hedging. Looks like they were hedging + trying to compensate for the previous losses betting on the direction of the oil price. Now they've learned the lesson in a hard way.

I think you're mistaken; I was being facetious. What they call "losing money" is not really; it's expressing the downside of the hedge. If you look at the article, something like 20% of their hedges are underwater; it is costing them an additional 1.5% of their fuel costs with the decrease in oil prices.
 
Some have success but I believe a good chunk of trading is directional i.e betting on the direction of correlation, spread, yield, interest rate, default, etc.

That's what I meant when I said they call it betting.
 
Because of the Enron and WorldComm Scandal, Sarbanes Oxley act was passed to strengthen corporate acounting controls.

I think there will be new compliance rules for unregulated Hedge Funds, who use derivatives extensively to hedge their positions as well as strict lending practice in the entire financial markets in the days to come. It will be interesting to see how hedge funds will perform with regulation:dance:
 
In my opinion we should not blame any financial engineers or rating agencies because (as far as I know) there just do not exist model which takes “greed” as a volatility factor. Big guys (investment banks and mortgages houses) needed these new debts to construct complex credit derivatives and make billions of dollars out of it. In turn lending companies loosens their underlying factors to lend more and more and creating new pools of debts. But I really doubt that at least some of them did not understand that they making a bubble which is going to explode sooner or later. And I’m sure (but can not support this because have no data) that some of these lending companies did very good and had enough time to step out of “debts” business with a good profit. As we can see not that many small banks across US are going bankrupt or looking for government help because a lot of what they lend was right away sold to the BIG guys. I do not think any PHD guys who wrote the model for CDO pricing could imagine that mortgages will be given even to the people with bad credit history or 15K year income. Mathematical models in general is a good tool to calculate EXPECTED future market prices but all models go worthless when greed and struggle for the money come in the first place. In general all this crysis is a good lesson to the BIG guys but very sad that becuase of these many people who have nothing to do with this gambling are losing their jobs where some CFO who created this mess leave the arena with multimillion bonuses...
 
Because of the Enron and WorldComm Scandal, Sarbanes Oxley act was passed to strengthen corporate acounting controls.

I think there will be new compliance rules for unregulated Hedge Funds, who use derivatives extensively to hedge their positions as well as strict lending practice in the entire financial markets in the days to come. It will be interesting to see how hedge funds will perform with regulation:dance:

while some of the HFs posted lower results in 2008 (to a great extend attributable to the naked short-selling ban), it's interesting to notice that there hasn't been a Lehman-like collapse of any of them. yet.
so the banks that were subject to tougher regulation fared much worse than the relatively free HFs. interesting.

couple of good articles on HFs attached.
 

Attachments

  • WSJ - Citadel Dispels Rumors But Can't Mask a Bad Year.pdf
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  • Economist - Hedge funds, Collateral damage.pdf
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