Comments on: The Price of a Haircut http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/ The Big Questions | Tackling the Problems of Philosophy with Ideas from Mathematics, Economics, and Physics Sat, 25 May 2013 22:34:26 +0000 hourly 1 http://wordpress.org/?v=3.3.2 By: iceman http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36832 iceman Mon, 12 Dec 2011 23:07:12 +0000 http://www.thebigquestions.com/?p=6743#comment-36832 Harold – to be sure…but I think you still want a theory as to how the slicing in particular turns a ‘non-disastrous’ rise in the overall default rate into a systemic crisis. Not saying there isn’t a good and interesting one. For example creating huge amounts of synthetic exposures relative to actual underlying loans could magnify the tranche 10 effects. (Still Gorton is trying to explain how this transmitted to seemingly unrelated markets.) Richard – yeah I saw that and think you’re right the ‘haircut’ is $50 million in the example. Harold – to be sure…but I think you still want a theory as to how the slicing in particular turns a ‘non-disastrous’ rise in the overall default rate into a systemic crisis. Not saying there isn’t a good and interesting one. For example creating huge amounts of synthetic exposures relative to actual underlying loans could magnify the tranche 10 effects. (Still Gorton is trying to explain how this transmitted to seemingly unrelated markets.)

Richard – yeah I saw that and think you’re right the ‘haircut’ is $50 million in the example.

]]> By: andy http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36826 andy Mon, 12 Dec 2011 21:31:10 +0000 http://www.thebigquestions.com/?p=6743#comment-36826 Interestingly enough, in old Scotland (beginning of 19th century) the unregulated banks actually weren't susceptible to bank runs (because the banking business as is is not 'ecologically rational' (to borrow a phrase from Vernon Smith), they made some provisions to do it so... And if I was reading history correctly, vast majority of bank runs (let's say except those in the 30's) were perfectly reasonable (i.e. the bank was really insolvent). And if I read history of the USA correctly, the bank runs were NOT pervasive; there were some crises, and even during these the bank runs were actually not like "everywhere"... I mean describing this as "being plagued by bank runs" seems to me a little strech. Interestingly enough, in old Scotland (beginning of 19th century) the unregulated banks actually weren’t susceptible to bank runs (because the banking business as is is not ‘ecologically rational’ (to borrow a phrase from Vernon Smith), they made some provisions to do it so… And if I was reading history correctly, vast majority of bank runs (let’s say except those in the 30′s) were perfectly reasonable (i.e. the bank was really insolvent). And if I read history of the USA correctly, the bank runs were NOT pervasive; there were some crises, and even during these the bank runs were actually not like “everywhere”…

I mean describing this as “being plagued by bank runs” seems to me a little strech.

]]> By: Alan Wexelblat http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36799 Alan Wexelblat Mon, 12 Dec 2011 16:41:32 +0000 http://www.thebigquestions.com/?p=6743#comment-36799 You reflect a fundamental misunderstanding of what Dodd-Frank is supposed to do. The idea is to force financial institutions to re-separate low-return/low-risk business from high-return/high-risk business. If I take out a mortgage, or put money into savings, I want that interaction to be low-risk. Without Dodd-Frank, institutions can take my savings or mortgage money and put it into higher risk instruments. They make higher returns (on average) but do so by gambling with my money. If a high risk institution wanted to offer consumer instruments and people chose to engage in them knowing they were high risk, and the people who made that choice had a chance to share in the (potential) rewards then I (and as I read it, Dodd-Frank) would have no objection. The present situation is one in which the consumer isn't given a choice, is exposed to high risk will he or no, and has no opportunity to participate in the rewards of that risk-taking. Oh, and the bank gets the Fed as backstop to ensure it won't suffer if its bets go bad, either. The situation is wholly crocked, and Dodd-Frank is not going to solve it, but it should re-establish the separation between low-risk and high-risk financial transactions. You reflect a fundamental misunderstanding of what Dodd-Frank is supposed to do. The idea is to force financial institutions to re-separate low-return/low-risk business from high-return/high-risk business. If I take out a mortgage, or put money into savings, I want that interaction to be low-risk. Without Dodd-Frank, institutions can take my savings or mortgage money and put it into higher risk instruments. They make higher returns (on average) but do so by gambling with my money.

If a high risk institution wanted to offer consumer instruments and people chose to engage in them knowing they were high risk, and the people who made that choice had a chance to share in the (potential) rewards then I (and as I read it, Dodd-Frank) would have no objection.

The present situation is one in which the consumer isn’t given a choice, is exposed to high risk will he or no, and has no opportunity to participate in the rewards of that risk-taking. Oh, and the bank gets the Fed as backstop to ensure it won’t suffer if its bets go bad, either.

The situation is wholly crocked, and Dodd-Frank is not going to solve it, but it should re-establish the separation between low-risk and high-risk financial transactions.

]]> By: Harold http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36782 Harold Mon, 12 Dec 2011 13:08:04 +0000 http://www.thebigquestions.com/?p=6743#comment-36782 Iceman: Yes, I think it is impossible to say "This was the cause". There are many chickens and eggs. Iceman: Yes, I think it is impossible to say “This was the cause”. There are many chickens and eggs.

]]> By: richard http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36694 richard Sat, 10 Dec 2011 10:27:11 +0000 http://www.thebigquestions.com/?p=6743#comment-36694 Steve, > If there’s, say, a 10% discrepancy between the deposit and the collateral, we say that Bear Stearns has taken a half-billion dollar haircut. I don't understand. Do you mean 'has taken a 50 million dollar haircut'? Steve,

> If there’s, say, a 10% discrepancy between the deposit and the collateral, we say that Bear Stearns has taken a half-billion dollar haircut.

I don’t understand. Do you mean ‘has taken a 50 million dollar haircut’?

]]> By: Pierce http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36676 Pierce Sat, 10 Dec 2011 03:57:50 +0000 http://www.thebigquestions.com/?p=6743#comment-36676 I'm confused. Bear Stearns takes Fidelitys deposit for what purpose? If they can't do anything with the cash, why would they issue bonds at a haircut for the cash? That funding would need to be worth more than the value of the bonds issued. No? I’m confused. Bear Stearns takes Fidelitys deposit for what purpose? If they can’t do anything with the cash, why would they issue bonds at a haircut for the cash? That funding would need to be worth more than the value of the bonds issued. No?

]]> By: iceman http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36663 iceman Fri, 09 Dec 2011 21:17:55 +0000 http://www.thebigquestions.com/?p=6743#comment-36663 Harold - thanks for the link, but if I'm following it correctly (it's kinda sloppily written and the link to the calcs doesn't work), Tabarrok is still talking about the disproprtionate impact on 1/10th of 1/10th of the original mortgages (i.e. tranche 10 of the CDO, although at times he seems to refer to this as "the CDO"). I think this is what Gorton means by "not large enough to cause a systemic financial crisis by itself". Harold – thanks for the link, but if I’m following it correctly (it’s kinda sloppily written and the link to the calcs doesn’t work), Tabarrok is still talking about the disproprtionate impact on 1/10th of 1/10th of the original mortgages (i.e. tranche 10 of the CDO, although at times he seems to refer to this as “the CDO”). I think this is what Gorton means by “not large enough to cause a systemic financial crisis by itself”.

]]> By: Ken B http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36657 Ken B Fri, 09 Dec 2011 16:37:27 +0000 http://www.thebigquestions.com/?p=6743#comment-36657 @Harold: No. I cited an example of a regulation that was faintly crazy but served the purposes of some, and seemed quite sane to most. A not uncommon thing. When people call for more regulation it sometimes is worth looking to see how well regulation has worked in the past. People often talk as if the appropriate regulation were obvious and easy; it is rarely either and can create perverse incentives. As happened in this case. @Harold: No. I cited an example of a regulation that was faintly crazy but served the purposes of some, and seemed quite sane to most. A not uncommon thing. When people call for more regulation it sometimes is worth looking to see how well regulation has worked in the past. People often talk as if the appropriate regulation were obvious and easy; it is rarely either and can create perverse incentives. As happened in this case.

]]> By: Harold http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36630 Harold Thu, 08 Dec 2011 23:40:59 +0000 http://www.thebigquestions.com/?p=6743#comment-36630 Ken B: Is your point that the Basel II rules created a higher demand for AAA rated securities and therefore drove the creation of these CDO's? Ken B: Is your point that the Basel II rules created a higher demand for AAA rated securities and therefore drove the creation of these CDO’s?

]]> By: Harold http://www.thebigquestions.com/2011/12/08/the-price-of-a-haircut/comment-page-1/#comment-36628 Harold Thu, 08 Dec 2011 23:21:11 +0000 http://www.thebigquestions.com/?p=6743#comment-36628 Iceman: Whilst you may be technically correct, the slicing and dicing can only redistribute risk, this only applies if your assumptions are exact. Here is an example http://marginalrevolution.com/marginalrevolution/2010/05/the-dark-magic-of-structured-finance.html This shows how creating a CDO from mortgages with a 0.05 probability of default can create tranches of AAA rated CDO's with a default probability of 0.0005. However, if you had got your initial estimate of default risk off a bit, and it was actually 0.06, this means a 20% greater default risk - not disasterous perhaps. But in our sliced and diced securities, the CDO now has a default risk of 0.247 - or an increase of 45,000%. If that isn't an amplification of risk, I don't know what is. Iceman: Whilst you may be technically correct, the slicing and dicing can only redistribute risk, this only applies if your assumptions are exact. Here is an example http://marginalrevolution.com/marginalrevolution/2010/05/the-dark-magic-of-structured-finance.html
This shows how creating a CDO from mortgages with a 0.05 probability of default can create tranches of AAA rated CDO’s with a default probability of 0.0005. However, if you had got your initial estimate of default risk off a bit, and it was actually 0.06, this means a 20% greater default risk – not disasterous perhaps. But in our sliced and diced securities, the CDO now has a default risk of 0.247 – or an increase of 45,000%. If that isn’t an amplification of risk, I don’t know what is.

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