Say I offer you a stream of payments.  You compute the present value and decide how much you’re willing to pay now for that stream of payments in the future.  This stream of payments comes from people paying their mortgages, so this transaction is called buying debt.

Now say somebody else has already bought the riskiest 80% … in other words, 80% of the payers (regular people) have to default before you lose a cent.  (In jargon, somebody else “bought the risk” … which implies higher returns iff the payers pay.)

You would probably suppose, quite naturally, that this is a “safe bet” — that it would take astronomically bad luck for a full 4/5 of the payers to default (fail to pay).  (And “safe bets” earn lowish returns.)

That supposition is the rub.  It sounds safe; therefore a salesman who knows that could trick you.  He could sell you something that’s quite likely to default all the way through — but sugar it up by saying that other investors have taken on the risk.  Nearly the whole thing would have to fail before you lost any money!

If you’re a big bank with billions that need to go somewhere, this sounds like an efficient way to make a safe, lowish return on your huge capital holdings.  Economically it sounds like we’ve divided up the financial jobs that need to be done.  Other noses have sniffed out the riskiness of this asset, and the bank has compiled many many small guys’ pocket change (mere $10 000’s) into real money — which can serve as the stable base to finance this so-called structured asset.

Now you know what a structured asset is, as well as the root economics of the late aughties financial meltdown.

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  1. isomorphismes posted this