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The Dark Magic of Structured Finance

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!

I still think that the popular idea that the people creating these things were too stupid to know that there would be these 'glitches' is unsatisfying.

{2010.05.14 - 17:27}

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