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Complex SCDOs: Stupid Financial Engineering Tricks

Nerd on the Street Blog: Falling for a toxic mix of leverage and phantom assets.

Monstrously complex collateralized debt obligations (CDO) became even more monstrously complex when irresponsible financial engineers morphed them into synthetic collateralized debt obligations (SCDOs). Many informed discussions of these derivatives concluded not only that no one really understands them, but also that they were so intricate and subject to interpretation that it may be the case that no one could understand them.

Here’s a sampler of comments about complex derivatives from a few guys generally not considered to be babes in the woods:

“Financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett.

“We don’t really understand how they work” – George Soros.

“Potential hydrogen bombs.” – Felix Rohatyn

The legal documents for these teratoma derivatives are several inches thick. SCDOs are numbingly obscure. All of them have the magical feature of allowing unlimited risks to be tied to a particular asset, irrespective of how much of that asset actually exists — a deadly form of synthetic leverage.

An analogy would be to allow everyone in a town to take out insurance on one house. In normal practice, the insurer would be out the cost of the house after a fire. When there are thousands of policies, the normal single fire event can bankrupt the insurer.

SCDOs seem to be a toxic mix of leverage, phantom assets and many-times-removed counterparties that clearly establishes the inability of our current system to deal with the level of complexity and risk they embody.

Since SCDOs and other toxic assets were not traded on transparent markets, prices were determined by other means. The monstrously complex derivatives begat monstrously complex pricing models, made even more toxic by feeding them with data from previous generations of mortgage-backed securities, based on past experience with borrowers far superior to those holding the NINJA loans (no income, no job or assets).

“Noted systems analyst” Alan Greenspan elucidated the old “garbage in, garbage out” maxim for a 2008 congressional committee hearing on the the Role of Federal Regulators in the Financial Crisis : “It was the failure to properly price such risky assets that precipitated the crisis... The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

This is a complicated way of saying they screwed up and they should have known better.

David Leinweber is a Haas Fellow in Finance at Haas School of Business, UC Berkeley. He is the author of Nerds on Wall Street: Math, Machines and Wired Markets (John Wiley & Sons).

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