Hilzoy, I promise you. If you find someone to pay me 50 million, preferably in Euros, I'll leave the financial system very much alone.

(promise my be rescinded upon receipt of 50 million Euros)

On second thought, is there any way in the world I could convince you to pay me in gold krugerrands? I'd really prefer gold krugerrands.

I found it unaccountably hilarious that Hilzoy, who is always so carefully mannered, and whom I always think of as professorial, chose to end the post with "Word." Not in any way inapt, but still hilarious.

I've said before that there is no way these CDOs could have been sold that is not fraudulent.

To me it seems easy to rake those thing back. THey're Ponzi schemes with a prettier name.

Hence, all the people Geithner wants to bail our are fraudsters. Ergo, natinalize them by another mechanism.

Hence, all the people Geithner wants to bail our are fraudsters. Ergo, natinalize them by another mechanism.

You think this is scary stuff? You haven't seen scary stuff yet; you'll be learning a new, improved, uber-definition to the Nth degree of scary stuff in the coming weeks and months.

For this morning's early-bird analogy, let's take a trip back in time to ancient Egypt. It'll be an enjoyable trip, due to metamorphic melding of Dr. Who's telephone booth with a 1920's-era railroad passenger train---complete with observation car and a fully-stocked bar.

The bar is now open---and drinks are on the house....

In this scenario, those Egyptians have decided to build the greatest pyramid of all; a magnificent edifice to what will someday become what our banking system has only recently discovered: an inverted pyramid known as CDO of ABS, whereby the base is the smallest layer of all, and a very delicate balance of each succeeding layer, coupled with the greater quantitative mass of the next layer up, keeps the whole thing in place without so much as a spot of mortar, or glue, or (in the case of today's global economy) regulation and common-sense mathematics.

But we all know that there's really no such thing as an upside-down pyramid in the ancient burial-fields of Egypt today, and we find ourselves---after three or four stiff drinks---wondering what happened between our magical tele-train excursion and the present day....

Fact of the matter is---the base stone had an internal flaw. It seems that "about a third" of the base-stone's interior wasn't stone at all. It was, instead, a balloon of brackish water, scooped up from a stagnant pool at some point during the formation of the depositional bedrock that was destined to become the quarry from which the base stone was cut---an entirely freakish and almost impossible-to-occur geological event that could have been detected, had someone simply bothered to give the base stone a good tap or two with a hammer to see if it was a sound stone, or a somewhat hollow stone. That lack of regulation; that simplest of simple oversights on the part of someone whose name we'll never know, triggered an about-to-unfold event that is about to become your worst nightmare.

The base-stone just collapsed; shattering into a thousand shards....

Now that you're all good and intoxicated, I can reveal to you the true horror of this little jaunt back into time.

Remember those "thousand shards"? If you'll click to the FT story linke in Hilzoy's piece, you can read down and fins---oh, at about the 7th-to-8th paragraph or so---these words:

"But now, at long last, one shard of reality has just emerged...".

One shard, out of a thousand.

While you're letting that sink in, my friends, you might want to look up at that ponderous, wondrous edifice that the Egyptians built---the one that we know nothing of in the present day, because it collapsed into the dust. That collapse is taking place right now. Each layer is beginning to crumble out from under the massive number of layers above it---not unlike the now-frozen-in-time moment when the Twin Towers cracked, beginning their final descent to Ground Zero. Here, unfortunately, is where your "education in scary stuff" begins.

Just as each extrapolation in the construction of our inverted pyramid was based on the soundness of that now-splintered base stone, so too is the current global economy equally dependent upon the "base stone" of the original "base CDO of ABS". As you begin to realize what this means; to internalize both psychologically and financially that the "base" has shattered into a thousand shards, and that the "quiet sifting of data by bankers at such places as JP Morgan Chase and Wachovia" have just now uncovered the first of those myriad shards, you'll probably notice that the sky above your Magical Mystery Train Ride just grew dark.

Remember the pyramid? It's tipping toward you....

Just as the pyramid is no longer able to withstand the eternal pull of gravity, the global economy---built for the past several years on the systemic repackaging of these toxic CDO's---is beginning to falter, as everyone begins to wake up from the dream of a well-oiled global money trip to the nightmare that the global asset-to-debt ratio, and the global GDP, for about the past four years or so, has been built atop a single, flawed base stone. The value of everything we own, and of everything we are, is about to come crashing down around our heads---just as everything upon which those tangibles and intangibles has been built is falling out from under us.

Remember Dr. Who's phone booth? It just left---and your magical train just changed into a nice little boat: the Royal Mail Steamer TITANIC. You're standing on the deck, watching this more-than-monstrous pyramid of stone approach you from above, watching the deep, freezing ocean approach you from below, discovering that there's no such thing as a lifeboat (Remember, you're still in the pyramid fields of ancient Egypt---where in the gods' names did you expect to find a lifeboat, fool? They're not even invented yet!)....

Need I say more? Have I forgotten anything?

Oh, yes....

Welcome to your nightmare---and the bar is now cash only---but cash is worthless now, as, I'm afraid to say, are Shantyhag's Krugerrands....

As for the wall street banks, let em die or take them over, and everything in between is crap. But Wall Street still runs the Treasury, so we are stuck. Geithner a week ago said he has been unable to come up with a plan that anybody would accept. The banks refuse to abandon the big bonus culture. And Geithner's a creature of Wall Street, so he's set up a stress test who's primary purpose is to prove that big banks don't need to be nationalized.

Big banks that have been largely responsible for the current financial crisis will be propped up by the taxpayers. Geithner won't fire his friends that run them. Neither will their shareholders and bondholders suffer the consequences of betting on losers. Obama's progressive credentials, such as they are, vanished with his administration's decision to continue to side with Wall Street, instead of the people who elected him to change it.

I for one am exceptionally grateful that our bailout billions are being paid out in retention bonuses to the very people with advanced math degrees paid seven- or eight-figure salaries who go these kinds of results.

It seems to me that the main source of this whole problem lies with the fact that the rating agencies are paid by the company issuing the securities. If they rating agencies do what they are supposed to do, which is closely and skeptically examine the securities, then the companies will go elsewhere and the agencies will lose business. As someone once said, "It is virtually impossible to explain something to someone when their livelihood depends on them not understanding." If the rating agencies were paid by the purchasers of the securities rather than the issuers then they would be racing to see who could be the most scrupulous rather than the most lax. Simple as that.

Dear Hilzoy,

Fairly certain you know this, but here goes:

Every single time an item of debt was issued, repackaged, repackaged again, transferred, repackaged, transferred, split up, repackaged, transferred, ad infinitum ...

Those doing the packaging received a cut, at each single station.

It started with the broker who approved a loan, to the bank that issued it, etc.
There was very little incentive to actually ever ask whether this was sound, since everyone was so busy getting theirs. Remember, not that long ago it was made clear that it's not possible to live in Manhattan on USD500 thousand/year. They all got used to silly money, thinking the wrapping they did (about as value creating as wrapping christmas presents at FAO Schwartz) - was essential, and that they deserved multimillion dollar rewards for work that could have been performed by a teenager at the McDonald's drive-through.

It's all a perfect storm, and the US is presently Wil E Coyote, having run off the cliff, waiting for gravity to make an appearance.

the good news is that Vikram Pandit still has a job, even after the latest bailout deal announced today. does he have pictures of Geithner with a sheep or something?

Much of this is over my head, but I think the incompetence conclusion misses the point.

The bundlers used optimistic formulas to create "safe" CDO's. If housing prices kepr going up, most people payed their mortgages, jobless rate didn't jump, etc., there was no problem. But as any of these things changed, the bundlers needed to mix more good ABS with the known toxic stuff to keep AAA ratings.

But as mortgage originators cheated more, median incomes went down, more people lost health insurance, etc., the formulas became more and more wrong, and the bonds weakened, even as the bad assets were being mixed into more and more CDOs.

I'm looking at a bond portfolio of a friend, who only bought AAA bonds and was assured that nothing in them included mortgages of any kind. They include insurance, student loans, large and small business loans. At this point only one (GE Capital) is still rated AAA, and even that one is questionable. I don't know where this goes from here, but the idea that a failed bank or CDO only affects its shareholders/bondowners is not the case.

As much as some people like to think we are independent and able to rely on personal responsibility alone, we are in fact far more connected to each other's destinies.

Wired ran an article about the flawed formula that calculated the risk of these asset backed securities.

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant

The Other Shoe.

Yesterday it was mentioned on CNBC that for millions of Americans their credit card debt is larger than their mortgage obligation. When that shoe drops the 5 percent of mortgages in default will seem like small beer.

And then, since we are still traveling with Dr Who, there is the Third Shoe. Commercial real estate. . .

"put all those nice little loan documents into piles at random, or tossing mortgages down the stairs and bundling them based on how they landed"

Are we sure that this is not how it was done? Maybe the CDOs were structured by cows instead.

Perhaps we should pay the bonuses contingent on acceptance of relocation allowances to Venezuela, North Korea, and Iran. Those countries could use some help with their economies. Overall the strategy could prove highly cost effective.

Money making money for itself.

Globalization.

Free falling economies.

Toxic, make that putrid, debts.

Endless war.

Global warming tipping point.

It will take 7 years to regain the losses of this past year.

We have a long, long road ahead folks.

It's actually hard to understand how the banks managed to do this badly...

unless of course you do NOT start from the position that the responsible people are all innocent and just made some stupid bad decisions. If you DO assume at least some of them are pretty smart people (as the money masters keep saying) that happen to be obsessed with making vastly more money than anyone should ever need or want, then you come to the logical conclusion that at least for a chunk of them, this get rich quick scam was intentional. In which case they are criminals and should be investigated and prosecuted.
.

W.C. Fields summed it up decades ago:
"You can't cheat an honest man."

I'm not a statistician, but an engineer, and the idea that you'd use a fixed correlation to base some very sensitive analyses is pretty insane. If Wall Street actually used this formula as-is, it's deliberate malpractice.

This is sort of like designing an enormous, envelope-pushing suspension bridge. Then, when it comes to determining the tensile strength of the steel, just pull a number from the average of the last couple of decades for a bunch of different types of steel and use that. No sensitivity analysis, no nothing. Would you trust this bridge?

Then, there's the bigger problem that most systems are definitely not linear, and behave very differently when they're very stressed. All these correlations will probably go to 1, -1, or some random noise when the shit really hits the fan. This is obvious stuff.

If this kind of analysis was really the case on Wall Street, it was just eyewash for the management and customers.

Even so, I would hazard a guess that this is easily the worst outcome for any assets that have ever carried a "triple A" stamp.

How soon we forget.

WPPSS (I think that is the right acronym) the Washington Public Power Supply System (???) were all rated AAA. If you read the perspective you saw "These bonds are irrevocably guaranteed by the Bonneville Power Authority, an agency of the United States Federal Government." Again, I haven't seen the bonds in 20 years.

In any event, guess what? People lost tons of money, especially on tranche 4 and 5 which, as it turns out, were not or were guaranteed. The answer is that it became a mess. The losses were huge.

Don't forget, these weren't just AAA, these had an unconditional and irrevocable guarantee of the BPA.

I believe they have high pay relative to other industries for one reason. Their pay is based on "X" number of basis points on a large sum of money. Everyone else's pay is seen as dollars of expense.

With numbers like these so early in the game (AAA risk of default is supposed to max out at 3%), it seems a foregone conclusion that, in addition to the criminal-fraud investigations there will also be civil actions that will pretty much take out whatever remaining shreds of capital the players had.

People off the street would have done much better, because they wouldn't have had the bright idea of badgering loan originators into selling them ever more of these highly profitable securities.

The most logical answer as to how this happened is that the folks who started this and made the most money are simply thieves.
The fact that it isn't on the books as a crime doesn't absolve them from their thievery.
We must realize that these individuals want ALL of the money, that is their obsession, and all the rules in the world won't keep these thieves in suits away.
I think that only if we individuals withdraw from these gambling tables will things change and money can only be made by creating things with real, touchable, value.

Heard on MarketPLace this morning:

JABLONSKI: And then comes a company like AIG, which lost a lot of money 'cause it couldn't live up to those commitments for credit-default swaps. That brings us to this question from a listener from Florida that says, you know, with that and the fact that AIG had backed up a lot of banks with credit-default swaps, aren't we paying twice for the same loss?

HIRSCH: Well, we should probably go back and talk about what it was that initially got AIG into trouble, and that again is this collateral issue. You know, AIG has the, had this collateral that it had put up, and it had an agreement that said if its credit rating fell, then it would have to put up more collateral -- that is to say, more cash. And that's exactly what happened -- whenever Lehman Brothers went into bankruptcy, there was a systemic failure or potential systemic failure, the ratings agencies dropped the ratings on a number of financial services companies, including AIG. AIG then had to put up more money, and that was money that it didn't have.

JABLONSKI: So what you're saying is we may very well be paying more than twice.

HIRSCH: Quite possibly, yeah.

It's actually hard to understand how the banks managed to do this badly

Its actually not; the whole point of the instruments was to distribute the risk associated with credit decisions away from the people making the credit decisions. Its a perfect recipe to build a speculative bubble, and it was done at a time when the housing market was already in a bubble. You essentially had a bubble on top of and accelerating another bubble, causing both to blow up faster and explode harder than either would have on its own.

Unregulated, or ineffectively regulated, markets are prone to that kind of short-sighted efforts with that kind of disastrous consequences. If we regard this collapse as some kind of inexplicable, sui generis event caused simply by a some ineffable confluence of cosmic market stupidity, we might effectively manage the short-term effects, but we won't do what is necessary to address the causes.

Thanks. This explains why our "safe, conservative, low-risk" investment strategy lost as much as the DOW over the past 8 months. Sigh.

Where were you when many others were pointing out the CDO fraud? To refresh yourself you might want to read William Black's article http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html that summaries some of the public evidence.

Quit picking on the bankers. Don't you realize these "Masters of the Universe" were bamboozled by poor people intentionally buying more house than they could afford? Now they face the tragic prospect of having to pick up their lives and move on with not a clue where their next 8 digit bonus will come from.