Ali’s blog

Mostly quant stuff with occasional digressions

Financial engineering as the racket it really is

Posted by alifinmath on January 21, 2008

My informed readers are doubtless acquainted with the name of Joseph Stiglitz; here is a piece he wrote for the (London) Times:

Then these “toxic mortgages” were sliced and diced, bundled and rebundled, in complex securities. The bankers seemed, for a moment at least, to believe in financial alchemy. Take a bad mortgage, blend it with an A-rated security and the mix got an A rating from the credit agency.

It was all fed, of course, by securitisation – the notion that somehow by bundling bad mortgages together you get a good product. But the new religion of securitisation ignored two elementary realities.

First, diversification only works to reduce risk if risks are not correlated, but, when housing prices start to fall, all of the sub-prime mortgages turned sour together. Second, securitisation creates asymmetries of information, where those buying the securities know less than those originating them. In the old days, when banks held the mortgages they originated, they had an incentive to make sure that they were good loans.

But with securitisation, if you could find enough fools to take bad mortgages, you had every incentive to lend as much as you could. What is remarkable is how many fools (including banks with supposedly good risk management systems) there were. That game, too, is up, at least for the duration.


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