The Housing Price-Rent Ratio
Josh Micah Marshall and Paul Krugman Have a Request

Felix Salmon's First Golden Book of Collateralized Debt Obligations

20071208_delong_micro.jpg You see, children, it is very important to understand the differences in the correlation matrixes generated by an amalgamation of BBB bonds that are BBB because of idiosyncratic risk generated by individual local real estate markets, and the correlation matrixes generated by an amalgamation of BBB bonds that are BBB because they themselves are derived securities and hence subject not to local real estate market idiosyncratic risk but instead to the systematic risk that the whole industry will find itself past the second bend in the toilet. The first can be diversified away via the law of large numbers. The second cannot.

Felix Salmon writes:

Explaining CDOs, Overcollateralization Edition - Finance Blog - Felix Salmon - Market Movers - [W]hat happened over the past few years was that demand for those AAA-rated CDO tranches went through the roof, and it became harder and harder to find a nice diverse universe of BBB-rated bonds to throw into the cauldron. As a result, the ingredients getting thrown into the cauldron started getting less and less diverse, until it reached the point that all, or nearly all, of them were, in some way or another, ultimately reliant on subprime mortgage payments....

Now remember Fred? He was fourth or fifth in line for subprime mortgage payments, holding a BBB-rated security. And although a triple-B rating is indeed "investment grade", it turns out that Fred's investment wasn't a very good one. The default rate on subprime bonds spiked much more than anybody anticipated, and Fred, standing as he was at the back of the queue, ended up with no money at all.

Now that... would be bad for Fred if he had held on to his bond. But he didn't: he simply turned around and sold it to a CDO which was desperate for BBB-rated paper. As did Frank, and Fergus, and Fraser, and even Ferdinand, whom you might think would have been a bit more bullish. All of them bought BBB-rated subprime debt, and all of them sold it to a CDO, which reckoned that since it was buying lots of different bonds from all over the country, it was thereby diversified.


It would be churlish to point out that the fact that one should be extremely leery of arguments that diversification radically improves the safety of bond investments was well known back by Edgar L. Smith and others back in 1923.