
Scott Adams explains CDOs - sanj
http://www.dilbert.com/fast/2008-12-13/
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Eliezer
Explanation fail. This works perfectly well so long as you know how diseased
the cows are, and the odds of any one cow dying are independent from the next.
It's called math.

The actual _problem_ with CDOs is that the cows were all more diseased than
the historical track record suggested (because _after_ they started putting
together CDOs, a flawed incentive structure created a new motive to buy
_sicker_ cows) and that the probability of one cow dying wasn't independent of
the next cow dying.

~~~
mattmaroon
Make that into a funny comic. I only learn from things spoken in a rectangular
bubble.

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Xichekolas
Even this doesn't capture all of the problem.

As I understand it[1], there were people that made their living by taking the
BBB tranches based on sick cows and re-securitizing them (dividing them into
yet more tranches, some of which would be upgraded _again_ ). The more you did
this, the closer you could get to having _all_ of the original subprime loans
be AAA rated.

For an example, say you had 100 subprime loans. You divide them up into
tranches, and the top 86 become AAA, and the other 14 become something else.
Then you combine this left-over 14 with the left-overs from other funds, and
end up with, say, 100 of these lower rated securities. You then divide this
set of 100 up into yet more tranches, 86 of which become AAA and the remaining
14 become something lower. Combine this 14 with left-overs from yet other
funds, repeat many times, and eventually you can get nearly everything to be
highly rated.

There are claims that some groups of sick cows had dozens of levels of
securities built up upon them, allowing ridiculously unsafe stuff to
eventually become AAA.

[1] Described here: [http://www.portfolio.com/news-markets/national-
news/portfoli...](http://www.portfolio.com/news-markets/national-
news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom#page6)

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sanj
"What are the odds of them _all_ dying?"

"You'll get the last one standing!"

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akronim
Though the real problem was that the sick cows were signed off as fighting
fit.

~~~
Retric
Not all of them where signed off as fighting fit. The assumption was that less
than 10% would fail so you could break the risk out so someone who want's zero
risk and is willing to only make 4% is safe as long as 80% of them live. The
math would have been fine if each morgage was independent but because the
economy as a whole tanked the default rate went way up and people who where
not willing to take much risk still got a beating.

~~~
time_management
_The math would have been fine if each morgage was independent but because the
economy as a whole tanked the default rate went way up and people who where
not willing to take much risk still got a beating._

Close, but I'm going to disagree with you on one detail. The subprime debacle
began in the spring of 2007, and really began to spiral out of control on July
26 with various calamities in the CDO markets. By August 6-10 (the week of
quant turmoil) it was starting to have an effect on equity markets-- which
were strong at the time, and didn't start taking a real beating until Jan.
2008.

The economy was strong in 2007, with 4.9% (annualized) growth in Q3. Subprime
didn't blow up because the economy tanked, because the mess began during a
great economy, and turned it into a bad one. Of course, the tanking of the
economy has made the credit situation even worse and will lead to even more
defaults.

The default rate goes up during a bad economy, and everyone knew that this
risk was there, and that a cyclical recession would occur sooner or later.
What caused the rate to be "unexpectedly" high was the prevalence of
speculation. In a bad economy with falling house prices, a resident homeowner
is still going to make his best efforts to avoid the embarrassment and hassle
of foreclosure, even if he has negative equity. Negative equity is irrelevant
if he's going to live there for 10 years. On the other hand, a greedy and
unscrupulous speculator has no reason not to default.

~~~
Retric
To clarify people that where taking the high risk stuff got hit early when the
economy was doing "well" but for the most part the "AAA" stuff could withstand
a fair amount of foreclosures with little impact. The crap nobody wanted was
really high risk so banks kept it which is one of the reasons why Lemon
Brothers failed. Granted there was also a fair amount of crap rated like gold,
but late 2007 to now we have been in a recession which kept feeding off of
more and more people getting bitten as an ever increasing number of mortgages
failed while nobody wanted to buy the property's.

Let's say a bank loans 300k on a house that was worth 200k but got inflated to
300k in a bubble fine somebody takes a 100k hit when it fails but they are
only down 33%. However, if nobody is going to buy it for six months and by
then it's only worth 150k and the spiral continues.

I also think the economy was fubar as early as 2005 with the fed using low
interest rates to make everyone pretend that the economy was fine this was
really helped by CDO's and people taking out risky mortgages. Then there was a
little bump in interest rates which finally set this ball rolling but it was
obviously going to happen at some point. Basically, when any little thing is
going to upset the house of cards there is already a problem even if it looks
ok.

PS: When the economy tanks it's a lot harder to prop up stupid companies so we
are seeing a lot of things that where on their death beds for a while all fail
but in the long term this is a good thing.

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eru
Ben Graham would buy sick cows for the price of dead cows any day.

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blogimus
Ah, but are they _spherical_ cows?

