Your posts are a prime example of the best part of FR - experts talking about what they know. Thank you.
I appreciate your compliment, but I must make it quite clear to all here: I am NOT an expert on these matters. I’m not a professional in finance. Do not take anything I say as actionable financial advice.
I’m a hay farmer in central Nevada, who used to be a EE in Silly Valley. That’s it. I’ve forgotten more math (as a EE) than most finance people have every known, but the secret of modern finance is that finance “professionals” seem to get into more trouble the more math they know. The Black-Scholes option model is just one example — the academics thought they’d use the Gaussian distribution to make the math easier, and they assumed the underlying security price movement was like Brownian motion, when in fact the way that option pricing breaks down at the margins is anything but Gaussian and the movement of underlying securities prices is often anything but Brownian.
But hey, these eggheads (and a bunch of professionals like them) created these hedge fund models based on these academic notions of mathematics, and when human nature rears it’s ugly head in excesses, these models break down. Engineers can tell you that, because half of engineering is about “what can go wrong?”
Financial professionals only worry about the expected normal case, and how much money that they’ll make in these cases. Not how much they’re gonna lose when the statistical minority event blows up in their face. Go read up on Long Term Capital Management in 1998 for a wonderful display of how financial “professionals” with PhD’s act when their assumptions go wrong.
Never, ever in my worst nightmares did I ever think I would have to know crap like this CDO/CDO-squared/margin/hedge fund crap. Never. I’m just a dumb ol’ EE who wanted to be a farmer. That’s it. I’d much rather bale hay than deal with investment crap.
However, events transpired that necessitated me learning a great deal about finance because I make it one of my mottos in life that I’m never fooled twice in the same way. A financial “professional” fooled me once. Now I handle all our investments and retirements myself.
My only unsolicited advice for anyone dealing with a financial “professional” is to keep your hand firmly wrapped around your wallet if you’re ever being pitched ideas, products and services. There is nothing they do that you can’t do, if you have a little math background (as in, you could pass 8th grade math tests), a healthy dose of skeptical inquiry and a functional idea of your tolerance for risk vs. how much reward you want for taking that risk. That’s the real secret of America’s financial “experts” — they’ve been selling you, the investing public, a sack of organic fertilizer for years, trying to convince you that you MUST obtain “professional” advice, that you’re too stupid to do this stuff on your own.
You’re not. Matter of fact, 99% of the common public would not have done what the financial wizard “professionals” did with these CDO’s — either in creating them or buying them. Most of us non-professionals, the “ignorant masses,” would have demanded “hey, what is in this CDO thingie? Why can’t I just buy the investment-grade bonds directly? Why do they need to be wrapped up with all this other crap inside this ‘CDO’ shell? I don’t need that crap, just give be the AA-rated mortgage backed bonds and shut the hell up!”
That’s what you or I would have said if we were seeking to buy those tranches of debt. Why? Because we’re simple people, who want things broken down into stuff we can understand.
Financial “professionals” running billions of other people’s money bought into these CDO’s and CDO-squared without having much of any clue just how much risk they were buying, in what ways the risk would manifest itself, or gave a thought to the consequences of buying an illiquid investment asset.