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Monte Carlo Simulation of CDOs: Part I


Who's rating the rating companies? Who's the ultimate guarantor of CDOs when the derivative boom collapses?


Most people have unanswered questions on their minds. Not me.

Right now I have two answered questions on my mind.

1. Who's rating the rating companies?
2. Who's the ultimate guarantor of CDOs when the derivative boom collapses?

The answer in both cases is no one (or if you prefer, Madame Meriweather's Mudhut in Malaysia) as I proposed in my blog in An email from Bernanke. If you haven't read about Madame Merriweather yet, you might want to click on that link for a good laugh.

To address the first question please consider the Bloomberg article CDO Boom Masks Subprime Losses by Richard Tomlinson and David Evans. What follows next is a clip from an important summary.

"Sales of CDOs worldwide have soared since 2004, reaching $503 billion last year, a fivefold increase in three years, according to data compiled by Morgan Stanley.

CDO holdings have already declined in value between $18 billion and $25 billion because of falling repayment rates by subprime U.S. mortgage holders, Lehman Brothers Holdings Inc. estimated on April 13. In many cases, investors don't even know that values have dropped. In this secretive market, there is no easy way for them to find out what their CDOs are worth.

The three leading rating companies, all based in New York, say that policing CDOs isn't their job. S&P, which controls 40 percent [of the market], asks investors in its published CDO ratings not to base any investment decision on its analysis. Fitch, which has 16 percent of the worldwide credit rating field, says its analysis are just opinions and investors shouldn't rely on them...

Editor's Note: Be sure to read the full article.

If that is not an eye opening piece what is? Be sure to check it out as there's a ton of information in there..

Short Summary

  • 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.

Based on the above it is highly likely that pension plans holding some of the CDO toxic waste are assuming big returns when in fact they are holding worthless paper. There is easily a potential of a waterfall event as I talked about in Liquidity Risk & Effective Leverage.

Long Term Capital Management blew up (see When Genius Failed) when models written by Nobel prize winning economists Myron Scholes and Robert Merton failed.

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!

Single Tranche CDO Pricer

Those wishing to delve into the CDO market can even purchase their own Single Tranche CDO Pricer complete with a Monte Carlo simulation method that employs a factor copula approach for handling exotic variations, a fast, specialized semi-analytic method and the Large Pool Gaussian Copula Model (Large Pool Model) approach. The Large Pool Model is a quick, user-friendly model that requires a minimal amount of data.

Who Owns What?

Initial pricing is one thing, subsequent pricing is another but compounding the problem is that no one even knows with certainty who owns what in which tranch. Please consider Paper Chase.

You're in luck. Your mortgage lender has flipped, sliced and diced your loan--and now no one knows who holds it. You can't be foreclosed on if no one knows who holds the paper or the paper can't be found. Assuming that people can figure out who owns what, the next question is...

Who is the guarantor? (If and when a credit event happens in the higher rated tranches.)

The guarantor (and how well financed the guarantor is) will be addressed in Part II of Monte Carlo Simulation...

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No positions in stocks mentioned.
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