Why didn't the sophisticated, computerized pricing models that Wall Street firms use to predict returns and risk for complex derivatives save them from the sub-prime mortgage mess? The short answer is: Fund and portfolio managers rarely use them.
The long answer, of course, is more complicated. Many factors have contributed to the crash of hedge funds that invested in collateralized debt obligations (CDOs), including the irresponsible lending practices of mortgage brokers that made no-money-down, balloon and adjustable rate mortgages to people who couldn’t afford them; the reassuringly high ratings on instruments that have up until recently been provided by Moody’s, Fitch and Standard & Poor’s; the highly leveraged nature of many hedge funds; the unrelenting pressure to obtain high returns; and the herd mentality -- if everyone else is doing it, including seasoned veterans who have managed winning funds for years, it must be OK. As Igor Hlivka, director of the rates trading group at Mitsubishi UFJ Securities, observes, "The market is driven by fear and greed. It is not driven by realistic assumptions."
Those mortgages and others were mixed together into pools that were "securitized," rated and distributed to investors, who often borrowed money to purchase them. The value was determined by statistical models. And those models assumed that home values would continue to rise. In fact, such an assumption was critical to the marketing of the structured securities based on those mortgages. "The economics of the securitization would be negatively impacted by a zero growth assumption," Beardsell says, never mind a negative one.
But even if the models had factored in the risk of declining property values, it wouldn't have mattered. Business decision-makers weren't going to restrict lending in a hot market.
"People said, 'We've got to do it because if we don't, someone else will, and they'll take the money off the table,'" says Dennis Santiago, CEO at Institutional Risk Analytics. And once the loan was sold and off the books, it wasn't the loan initiator's problem anymore.
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Why didn't the sophisticated, computerized pricing models that Wall Street firms use to predict returns and risk for complex derivatives save them from the sub-prime mortgage mess? The short answer is: Fund and portfolio managers rarely use them.
The long answer, of course, is more complicated. Many factors have contributed to the crash of hedge funds that invested in collateralized debt obligations (CDOs), including the irresponsible lending practices of mortgage brokers that made no-money-down, balloon and adjustable rate mortgages to people who couldn’t afford them; the reassuringly high ratings on instruments that have up until recently been provided by Moody’s, Fitch and Standard & Poor’s; the highly leveraged nature of many hedge funds; the unrelenting pressure to obtain high returns; and the herd mentality -- if everyone else is doing it, including seasoned veterans who have managed winning funds for years, it must be OK. As Igor Hlivka, director of the rates trading group at Mitsubishi UFJ Securities, observes, "The market is driven by fear and greed. It is not driven by realistic assumptions."
http://www.computerworld.com/s/article/print/303185/Opinion_Greed_Analytics_and_the_Mortgage_Lending_Crisis
Those mortgages and others were mixed together into pools that were "securitized," rated and distributed to investors, who often borrowed money to purchase them. The value was determined by statistical models. And those models assumed that home values would continue to rise. In fact, such an assumption was critical to the marketing of the structured securities based on those mortgages. "The economics of the securitization would be negatively impacted by a zero growth assumption," Beardsell says, never mind a negative one.
But even if the models had factored in the risk of declining property values, it wouldn't have mattered. Business decision-makers weren't going to restrict lending in a hot market.
"People said, 'We've got to do it because if we don't, someone else will, and they'll take the money off the table,'" says Dennis Santiago, CEO at Institutional Risk Analytics. And once the loan was sold and off the books, it wasn't the loan initiator's problem anymore.