Li Whiz!

Infectious Greed links today to a Wired article, "Recipe for Disaster", about the origins of the CDO mess. The piece highlights a mathematical formula developed by Dr. David Li. More interesting perhaps is a WSJ article linked to in the Wired article from 2005 about the same topic: "Slices of Risk: How a Formula Ignited Market that Burned Some Big Investors".

The 2005 WSJ article begins:

When a credit agency downgraded General Motors Corp.'s debt in May, the auto maker's securities sank. But it wasn't just holders of GM shares and bonds who felt the pain.

Like the proverbial flap of a butterfly's wings rippling into a tornado, GM's woes caused hedge funds around the world to lose hundreds of millions of dollars in other investments on behalf of wealthy individuals, institutions like university endowments -- and, via pension funds, regular folk.

Please read the whole thing. It is astonishing, 3 1/2 years later, to see that the WSJ was reporting that the three largest U.S. banking institutions had about $3 Trillion of exposure to CDOs and credit default swaps, the underpinning for which related to a theoretical complex mathematical formula (which is shown, incomprehensibly, in the Wired article). Dr. Xi's own ambivalence about his formula comes through, as does, in retrospect the arrogance, greed and stupidity of the financial companies that knew they were risking vast sums of money they did not have.

Now that these companies, Citigroup, BofA and JPMorgan Chase, are all being kept "alive" by taxpayers, it is even more maddening to realize that all their risks were disclosed long ago.
This makes the call by such interested parties as Bill Gross of PIMCO (the world's largest bond fund) to protect those who own corporate bonds of these companies nothing but self-serving claptrap. Every systemically important owner of the bonds issued by these financial holding companies knew or should have known that these were risky bonds.

No one but depositors should be protected from the insolvency of these companies. The sooner the guillotine falls, the better. And it looks as if Europe's big banks are in the same boat.

The good news is that all this is intangible stuff. The gamblers who lost need to pay the price. For every losing bet, there is a winner on the other side. Losing gamblers who can't pay their debts can suffer the consequences by working things out with the winners who can't collect. Government, through its various powers, needs to make this process happen ASAP and has been way behind the curve for years.

The productive capacity of the world is undiminished. The powers-that-be need to let failing companies fail and work together day and night to cancel out enough debt and other aspects of the over-financialization of the Western world so that normal business can continue and resume.

The shape of the financial markets is indicating that the more basic the asset, the better. Thus, gold and governmental debt show strength. Unpredictable, hidden "stuff" such as that within JPMorgan Chase and GE Capital are seeing money rush out. Unlike GE stock, which might go to zero, oil has a real use and will not go to zero so long as modern civilization as we know it exists.

So long as business and government continue to flail away and thus fail us, the debt deflation will continue. In that situation, short-to-intermediate highly secure credits, such as U.S. Treasury debt or demand deposits in a strong bank with FDIC coverage in addition, appear to be appropriate for funds that are not allocated as pure risk capital.

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