Filed under: Forecasts, Magazines, Economic data, Housing

The New York Times magazine presents what looks to me like a compelling case that if we don’t change the way securitization works, credit busts like the one we have now will be a permanent fixture of the global economy. That’s because securitization — the process of packaging loans into bundles wrapped in insurance and ratings and then selling them to investors — enriches banks by letting them sell asset backed securities (ABSs) that have no clearly determined value. And yet, the owners of the ABSs report their value precisely.

The gap between ABSs’ reported and real value puts our entire global financial system at risk. Here’s an example. The market for collateralized debt obligations (CDOs) — which are packages of mortgage-backed securities (MBS) — totals $6.1 trillion. Hedge funds and investment banks — which borrow $32 for each dollar of capital — have $340 billion in capital between them. So if hedge funds and investment banks owned just CDOs and they dropped in value by 6%, the decline would wipe out the capital of the hedge funds and investment banks. The $250 billion in ABS-related write-offs so far suggest a large gap between stated and actual value.

As the Times reports, the ratings agencies that were supposed to attest to the safety of the ABSs were compromised. I’ve posted on this before. The banks gamed the ratings agencies — providing them information about the ABSs that would get them the highest ratings. And the banks played the agencies off against each other to reward the lucrative ratings contract to the one that would offer ideal rating. And in awarding the ratings, the agencies did not investigate the credit quality of the individual mortgages — resulting in a flimsy basis for the ratings.

Despite support from Alan Greenspan, securitization is a concept whose usefulness has expired. Here are four reasons why:

• No credibility in values. It is impossible to predict the present value of the future cash flows from an ABS. That’s because there are too many uncertainties about the factors that will affect the amount that individual borrowers will repay each month. Since the present value cannot be predicted, there is no credible basis for setting a price for an ABS. And without a credible price, there’s no basis for placing a value for that security on an investor’s books.
• Compromised quality control. As noted before, the ratings agencies were being paid by the banks to take an objective look at the ABSs and estimate their riskiness. Notwithstanding that I think they’re impossible to value, this blatant conflict of interest makes an objective ABS rating compromised at ideal. This conflict of interest problem could be remedied by finding a way to pay the ratings agencies that didn’t create such obvious moral dilemmas.
• Past is no predictor of the future. Statisticians who develop models to forecast future cash flows assume the past is an excellent predictor of the future. This might be true for short periods of time. But as happened with the collapse of Long Term Capital Management in 1998 and has happened with the current debacle, the future often behaves differently than statistical models predict. And there’s nothing that statisticians can do to make their models predict those differences with any assurance.

In 2002, Greenspan saw securitization as a way to make the global economy immune from risk. In fact, securitization is exposing the global economy to one of the biggest risks in current memory. I don’t know how many innings are left in this disastrous game. But I’d guess that when it’s all over securitization will have cost enough that people will agree that enough is enough.

Peter Cohan is President of Peter S. Cohan & Associates. He also instructs management at Babson College and edits The Cohan Letter.

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An anonymous reader points out an article up at Science News on a question that, remarkably, is still being debated after a few thousand years: is mathematics discovered, or is it invented? Those who answer “discovered” are the intellectual descendants of Plato; their number includes Roger Penrose. The article notes that one difficulty pointed out with the Platonic view is that, if mathematical ideas exist in some way independent of humans or minds, then human minds engaged in doing mathematics must somehow be able to connect with this non-physical say. The European Mathematical Society recently devoted space to the debate. One of the papers, Let Platonism die, can be found on page 24 of this PDF. the author believes that Platonism “has more in common with mystical religions than with modern science.”

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SillyConCarbide writes “Every six months, the Materials Research Society holds a science as art competition. The winners from their most current meeting are particularly astounding. Materials researchers might struggle for years with stubborn instruments, fragile crystals or difficult chemical reactions before obtaining a bit of precious data from the exotic substances they study. Now, the scrutiny of samples not only yields potentially important data, but also artistic inspiration. Polymer films, cerium oxide membranes, and tantalum oxide crystals can look beautiful in the right light — especially if that light is an electron beam.”

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SpaceAdmiral writes “An experiment on the Space Shuttle Columbia has been analyzing your ice cream sundae. Or, rather, it looked at the phenomenon of “shear thinning,” which explains why whipped cream comes out of the can like a liquid, but sits atop your sundae like a solid. The experiment actually involved shear thinning of xenon, a substance used in ion rocket engines, but whipped cream tastes better.” I’m not sure it was cost effective to fly Herb Alpert & the Tijuana Brass into low earth orbit either, but hey it’s NASA, who am I to judge?

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Roland Piquepaille writes “As you can guess, hardwired personal systems are much faster than general-purpose ones because they’re designed to do a single task. But when they fail, they need to be totally reconfigured. This can be just a pricey problem in a lab on Earth, but it can be vital in space. This is why a University of Arizona (UA) team is working with NASA to design self-healing personal systems for spacecraft. The UA engineers are working on hybrid hardware/software systems using Field Programmable Gate Arrays (FPGAs) to develop these reconfigurable processing systems. As the lead researcher stated, ‘Our objective is to go beyond predicting a fault to using a self-healing system to fix the predicted fault before it occurs.’”

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Lucas123 writes “A automobile used by an off-site archive company to transport patient data was broken into on March 17. The University of Miami just made the theft public last week, saying the thieves removed a transport case carrying the school’s six personal backup tapes. On those tapes were more than 2 million medical records. In fact, the archive company waited 48 hours before notifying the university itself. A University spokeswoman stated the school has stopped shipping backup tapes off-site for now.”

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jackieduvall writes “Medical gauze has received its first upgrade since World War I. Chemists have infused it with nanoparticles derived from kaolin clay, which somehow give it an incredible ability to halt severe bleeding. It was developed when the Navy approached a team of inorganic chemists at the University of California Santa Barbara to solve a problem with QuikClot, a zeolite-based hemostatic agent that became way too hot and caused burns when it came in contact with water or blood. While performing blood clotting tests, they realized that kaolin clay, which has been used as a control for clotting experiments since the 1950’s, could also be used as a first aid product.” There is a video demonstration alongside the article. It shows the gauze halting the bleeding from a pig’s aorta. The blood isn’t excessive, but if you’re bothered by that sort of thing, you may want to skip the video.

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fyc brings us some information from Universe Today about what happened to Soyuz TMA-11 when it re-entered the atmosphere late last week. Reports indicate that a failure of explosive bolts to separate the Soyuz modules delayed the re-entry and oriented the capsule so the hatch was taking most of the heat, rather than the heat shields. CNN reports that the crew was in ’severe danger.’ They experienced forces of up to 8.2 gravities. NASA officials have voiced their approval of how Russia handled the crisis. They expect to rely heavily on Soyuz spacecraft once the shuttles are retired in 2010.

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Loether writes “Space.com has a fun article about how astronauts aboard the ISS play ’sports’ in zero gravity. It speaks about learning how to throw in a straight line instead of the arc we all take for allowed, relay races, and using massive water filled bags as medicine balls. ‘We realized that you could toss and catch and then go for a ride on this large thing as it takes you away.’ The astronauts also put out a request for new ideas for space sports. Have any recommendations?”

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esocid alerts us to news that scientists from the University of Texas at Austin have created a microbe capable of making cellulose, which can then be turned into ethanol. The bacteria use sunlight as an energy source, and the cellulose can be harvested without destroying them. Quoting: “The new cyanobacteria produce a relatively pure, gel-like form of cellulose that can be broken down easily into glucose. ‘The problem with cellulose harvested from plants is that it’s difficult to break down because it’s highly crystalline and mixed with lignins [for structure] and other compounds,’ Nobles says. He was surprised to discover that the cyanobacteria also secrete large amounts of glucose or sucrose, sugars that can be directly harvested from the organisms.”

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