Or -- one of those headlines I've always wanted to write -- "down in the tranches." Via ScienceBlogs, here's an excellent explanation (caveat: I know as much about statistics as I do about finance) of the way statistics were used in all the "complex," "innovative" financial instruments that have been so much in the news lately:
ne of the big questions that comes up again and again is: how did they get away with this? How could they find any way of taking things that were worthless, and turn them into something that could be represented as safe?
The answer is that they cheated in the math.
The way that you assess risk for something like a mortgage bond is based on working out the probability of the underlying loans failing, and using that to compute the likelihood of the entire bond package to end up losing. ...
It's easiest to describe how this works by using an example. Suppose we've got a package of 100 mortgages, each of which borrowed $100,000. So we've got 10 million dollars worth of mortgages. Suppose, for simplicity, that the total interest earned on the loans was going to be 150% - so at the end of the 30 year term of the loan, the bonds were expected to pay $25 million.
Now, suppose that these were really lousy loans - they expected that each loan had a 10% probability of defaulting, and that they'd lose the entire amount of the loan on a default.
By assuming that the probability of default for each of the loans is independent of the probability of default for any other loan, they can say that the probability of any particular loan defaulting is 10%. Assuming that defaults for loans are all independent, they can build an argument that probability predicts that only 10% of the loan will fail, and that it's incredibly unlikely for the rate of failure to reach higher than 20%. Based on that, they say that by using tranching to separate risk, they can claim that they're being extra careful, and put 80% of the mortgage bonds into a top tranch fund, which is supposed to be super safe.
But the probability of defaults aren't independent. Sure, there's random failures, where someone gets sick and can't work, and ends up defaulting on a loan. That kind of default generally really is an independent event. But that's not the story behind most defaults in low-quality loans. The garbage loans are almost always variable interest rate, and the most common cause of default is interest rate changes, which cause the loan payments to become too large for the borrowers to pay. When that happens, they're not independent events. The same thing that causes one loan to fail causes others to fail. Huge numbers fail at the same time, for the same cause. ...
As a result of this, tranching didn't work. They set up the tranches so that they partitioned things so that the top tranch was safe given the assumption of independence. But if independence doesn't hold - and it doesn't in these - then even an extremely conservatively structured tranching package doesn't guarantee the safety of the top tier.
Hope that helps. Like all scams, at bottom it's simple. The tranches were separated and given ratings (which determine prices) based on the idea that the values in each tranche were independent. In fact, they were all dependent and interconnected, so the ratings (and the prices) are buggered.
And we should give these fraudsters a trillion? Why? (I know: Because they'll shoot us if we don't hand over the money; it's a stick up.)
NOTE This statistical chicanery is separate from Taleb's ideas; Taleb is focused on randomness, and how "past performance is no guarantee of future results" especially when huge random perturbations are possible, which is always.
- lambert's blog
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All this is far more that I wanted to know
About the scams in finance. We shouldn't have to know about all this. We have enough to worry about with our own lives. Regulations are essential everywhere - in nature, in mechanical things, and in finances.
Criminal con people, that's what they are. It's so much easier and safer to just con people while wearing a suit that it is to do armed robbery. They should all be prosecuted the same as any bank robber.
"A little knowledge is a dangerous thing. So is a lot." - Albert Einstein
Don't you love statistics?
It can be so useful in covering up financial scams and getting desired conclusions in scientific and medical research:
http://www3.interscience.wiley.com/cgi-b...
Statistics, tartu,
like any tool, can be used for good or ill, and can be used in a valid way or an invalid way.
The point is not to throw out the use of statistics altogether. We're pretty much fkd without it, too.
As my hero Henri Poincaré said: "To doubt everything, or to believe everything, are two equally convenient solutions; both dispense with the need to reflect."
Lambert, thanks for the recent statistics-related posts. These are really useful and necessary tools in our anti-truthiness armament.
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We can't afford not to have single-payer!
To reflect
I agree with your statement that it can be used for good or ill, but it is not in principle evil. It is, on the other hand, not well enough developed for analysis of complex and not fully controlled systems. Unfortunately, for both finance and biology, instead of attempting (at least not devoting enough time) to establish new/better statistical tools to interpret and predict complex "black box"-like systems, we are all attempting to force such systems to fit the existing tools. Sort of like forcing a square peg into a round hole.
That's a pretty good summary of the problem.
I'd say there's some of that in the area of baseball as well.
(Although, oddly or not, there seem to be more serious efforts to develop better methods in the baseball arena as well. Which makes me go "hmmm...")
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We can't afford not to have single-payer!
Probably due to lack
of Fantasy Finance and Fantasy Cure Cancer Leagues.
My question is, is there anything to prevent them doing the same
thing all over again? They've sold, say, tainted milk to me, they get bailed out, and then they sell me a car, say.....how do we know what's really in the stuff before we get bitten in the a@@ again?
Elliot Lake