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Monday
Nov242008

Some of what you wanted to know about the instruments at the heart of the financial crisis

Here is a good explanation of how mortgage backed securities and other collateralized debt obligations work and why the individual tranches can be impossible to value. For example, the value of middle and lower tranches depends not only on default rates and recovery ratios but on whether the defaults occur in a big spike, especially early in the term, or at the same rate throughout the term. Thus, ultimate payouts may depend greatly on whether housing values are at the bottom now or will decline another 15%, whether the current recession in the real economy is nearly over or will get deeper and last a long time, whether adjustable mortgage interest rates go up or down, and on anything else that affects whether large numbers of people will pay their debts or default.

BTW, this explanation was posted in March 2007, so nobody in responsible positions in financial institutions or government should have been surprised by the public emergence of big problems more than year later.

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