"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Monday, May 17, 2010

Really great links - Greece and inflation tax - Investment research - Eurocrats - Structured finance

James Hamilton - Inflation, taxation, and the underground economy - Greece - "Aruoba's interpretation is that the weaker a country's institutions, the greater the attractiveness of the informal sector, and the more the government is likely to rely on inflation rather than standard taxes to raise revenue.
        I was thinking about these correlations as we all ponder the storm clouds over Europe. Joining a common currency unit means losing the ability to adapt monetary policy to your own country's cyclical conditions. But it also means surrendering to your neighbors' long-run mix of formal-sector taxes rather than inflation as a source of government revenue."

Lorenzo Bini Smaghi, Member of the Executive Board of the ECB - Lessons of the crisis: Ethics, Markets, Democracy - "In recent years the use of market information for “promotional” purposes has grown considerably. In the mass media, i.e. newspapers and television, the opinions of the analysts of the major banks are often sought. Since information is scarce and should have a monetary value for a financial market participant, one may wonder why it is made available to all free of charge. One hypothesis is that this contributes to the market participant’s reputation, attracting new clients. But clients should prefer insider information, the information that others do not have. The alternative, more credible, hypothesis is that with their considerable presence in the media market participants seek to steer the entire market, i.e. acting as herd leader."

Nick Rowe - Eurocrats - "A couple of weeks ago, at a Carleton seminar, I put forward the following totally paranoid conspiracy theory: in a bunker somewhere, deep in the heart of Euroland, a group of Eurocrats is breaking out the champagne. "Finally, the crisis we always wanted and predicted when we set up the Euro has happened. Now they will have to create a United States of Europe!""

Alex Tabarrok - The Dark Magic of Structured Finance - "Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06. In terms of our original mortgages the true default rate is 20 percent higher than we thought--not good but not deadly either. However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase. Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!
        The dark magic of structured finance conjured many low-risk securities out of many risky securities. Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined."
        - from the comments: - "This math assumes that security defaults are independent, which is an assumption nobody ever made. It was not until David Li's seminal work on using the Gaussian copula to model correlations that anyone had any confidence in valuing these securities.
        Unfortunately, tranches, especially safe, senior tranches, are very sensitive to the correlation assumption - even worse than to misspecifications of the probability of default.

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