Click here to see Monte Carlo Simulation of CDOs: Part I


Monte Carlo Simulation: Part I addressed the question, "Who's rating the rating companies?" This part will address the question "Who's the ultimate guarantor of CDOs when the derivative boom collapses?"

• Investors are buying bundles of CDOs without having a clue as to what is in them.
• Rating CDOs is a cash cow for the rating companies.
• There is a clear conflict of interest between the rating companies and the deals they are involved in.
• Ratings programs are based on Monte Carlo Simulation but the initial input assumptions about defaults and recovery rates may be far off the mark.
• After the initial rating, CDOs are not marked to market thus no one really knows what anything is worth.
• No one is rating the rating companies or their models.
• No one is even concerned about this state of affairs.

Are the Monte Carlo models (or more importantly the assumptions going into the Monte Carlo models) any better? How can anyone even know if the only "mark to market process" is based on what the model says?!

The scariest thing is that we are in a monetary environment that is unprecedented in history. M3 is soaring in nearly every major country on the globe. Asset prices have never been more correlated than now. The amount of derivatives in play is in the hundreds of trillions of dollars all bet on Monte Carlo Simulation. Wow!

Who is the ultimate guarantor?

Let's now turn our attention on who is guaranteeing this stuff. The short answer is simple: MBIA and Ambac. The long answer (No One!) can be found in Who’s Holding the Bag?, a presentation by Pershing. The document is extremely well presented and highly recommended reading.

It sure seems like a hell of a lot is riding on the Monte Carlo Simulation of CDOs as well as the parameters and assumption that feed into the model. If and when a Credit Event occurs that rifles through multiple CDO tranches, the guarantors will be about as well capitalized to handle the guarantees as is Madame Merriweather's Mudhut Malaysia. Do I smell a government bailout coming up?