This is actually fine. While CDOs were involved in the last financial crisis, they weren't the fundamental culprit. That honor would belong to ill-coordinated banking regulations between the US and Europe.
In order to provide a public backstop without encouraging moral hazard, banking regulators impose risk-taking limitations on banks. In the US, this took the form of encouraging asset sales into capital markets, under the assumption that this would make any risk the banks take dissipate away harmlessly. In the EU, this took the form of leverage limits based off the credit rating of the asset, with the highest rated asset commanding the largest leverage limits.
These regulations combined in a very unfortunate way in the transatlantic CDO trade. The CDO part isn't the important innovation, though; as long as the above structure persisted, something would be found to take advantage of it. Anyhow, the short of the crisis is that American banks would sell their risky assets into concentrated positions of systematically important banks, particularly ones outside of the narrow American regulatory purview. On the other side of the Atlantic, they accidentally applied a massive incentive to figure out a way to slap an AAA rating on stuff, and the market delivered that in spades.
The cherry on top of this entire system is that when American banks make loans, this cash gets transferred and winds up sitting in some money market fund somewhere. These funds are searching for short-term dollar-denominated yields, and the best way to get that is to lend money to European banks secured by AAA-rated assets. After all, with the generous leverage limits bestowed on them, they can borrow a hell of a lot of money.
These are all incidental issues. The real problem with CDOs and related financial products is that they deal with tremendous leverage without proper transparency. In a leveraged environment, you need to have a framework to understand who owns what and if the counterpart can pay for that leverage. Good examples of such a well regulated market are the options and futures markets. On the contrary, CDOs, swaps, and other exotic instruments give institutions the ability to leverage themselves, but nobody is regulating where the money is to pay counterparts when bets are wrong (and they eventually will be). The result are frozen markets! The only solution the financial world has at this point is to create money to bring liquidity to the markets again. This can only work up to a point, and in fact can exacerbate the results of a financial catastrophe.
Collateralized Debt Obligations themselves aren't a leveraged product. The originating bank issues loans and then sells on the assets. The various tranches are sold for cash and receive varying priority of cash-flow from the original loans. All the leverage is outside of the CDO itself - either European banks buying a dollar's worth of "AAA" assets with 98 cents of borrowed money, or some company writing a credit-default swap on it and backing it with cash worth a fraction of the value at risk.
This is not a regular CDO - this is a synthetic CDO.
The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure).
This makes a big difference:
1. Since individual tranches can be created on demand (unlike a regular CDO, where the full capital structure has to be placed), banks can create bespoke standalone tranches which are then hedged based on a correlation model. Thus there is much lesser market feedback to put a brake on unbridled issuance. A (very) loose analogy would be insuring your house (i.e. needing to own the loan under the CDO) and betting that your neighbour's house will burn down (where you have no skin in the actual asset). You can clearly do much larger sizes of the latter contract, for the first one, you need to buy a house each time you want to put the trade on.
2. The CDO invests in collateral to back the protection sold. One of the issues during the crisis was that this collateral itself was other CDO tranches (either synthetic or physical). When the market melted down, these assets became unpriceable given the opacity of the collateral. Result = even higher illiquidity
Of course the issued size is nowhere near becoming a systemic problem similar to 2007, but it does seem that those who do not learn from history are condemned to repeat their errors.
Yes. Most people missed the importance of the word synthetic. In order to explain it, let me make an analogy.
You think IBM is going to go up in price. (It should with the new CEO from Red Hat!)
You can send $100 to investment bank A which turns around and buys a regular share of IBM.
Or you can send it to investment bank B which offers a synthetic share of IBM. Investment bank B doesn't actually buy a share of IBM but collects bets from different people who think the price of IBM is going to go up, and other people who think the price of IBM is going to go down.
With investment bank A, your money may go up or down a little, but there's not much chance that investment bank A will go out of business.
On the other hand, with investment bank B, there are several different ways the investment bank could go out of business. It might not balance out it's up and down bets correctly because it's confident that IBM is going up. Or many of the other customers may be unable to pay up. Or maybe investment bank B made a deal with AIG to make sure that investment bank B would not lose money on the deal, but AIG was unable to pay.
With synthetics, there are additional risks which are more difficult to quantify.
I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth until it is again too late.
One of the key problems back in 2008 was that AIG was issuing something equivalent to insurance to everyone. Different investment banks were helping their customers to make big bets, and if things went south, they had "insurance" from AIG.
In hindsight, AIG wasn't charging enough for this "insurance", and didn't have sufficient reserves to cover their losses if real estate prices across the whole country went down at the same time. Almost no one seriously considered that as a possible scenario at the time.
So the important questions are:
- Who is providing "insurance" this time around?
- Is the company providing "insurance" charging enough?
- Does the company providing "insurance" have enough reserves to cover losses if we have another situation where everything goes south at the same time?
The whole point is that those questions above cannot be answered ahead of time. The synthetic securities are so complex and intertwined that the risk cannot be safely calculated w.r.t. the amount of money being invested in them until after the fact.
Nobody can say if anyone is charging enough for insurance because nobody can quantify the risk accurately. Noone can say if the company has enough reserves because they we don't know how correlated that risk is or how large it is. If I'm shorting a stock I know exactly how much is at risk (within a reasonable margin of error), because these are complex contracts meant to balance out other complex contracts all with extremely high leverage any imbalance can spiral out of control. And any unexpected large change can destroy the entire financial system.
There are more degrees of freedom than can be well quantified in way something can go wrong.
It's not that people didn't think to ask and answer those questions above, it's that with the complexity of the system and the scale of money involved and leverage used they can't be answered with confidence. Only the appearance of confidence.
I much more agree with you than disagree with you! Almost everything you're saying is true. You make very good points!
I agree that pricing and setting reserves for this insurance is extremely difficult. I disagree that it is impossible. I agree that there are very few people capable of doing this. I disagree that there is no one. I agree that there may currently be no one at the regulatory agencies capable of doing this correctly. I disagree that they cannot hire someone from the industry who is capable of doing this.
BECAUSE it is so difficult and complex to price this insurance and to have sufficient reserves, it's important to not throw up our hands and say that it's impossible. Instead it's important to bring the issue into the open. If regulators are not currently up to the task again this time around, then THAT should be the headline of the articles... "REGULATORS CURRENTLY UNABLE TO PRICE SYNTHETIC INSURANCE AND SET RESERVE LEVELS WHICH COULD LEAD TO THE NEXT FINANCIAL CRISIS"
> I disagree that they cannot hire someone from the industry who is capable of doing this.
If the industry could've calculated the risk correctly, they wouldn't have blown up the economy last decade.
Not to mention if only 4 or 5 people can accurately do it, there is no reason that other's will be able to accurately judge who the correct 4 or 5 are. 50 people will say they can do it, 5 are right 45 are wrong, who decides which 5 to believe? People outside of the 50 who knew they weren't even capable of doing the valuation themselves? They're deemed ok to judge?
This is analogous to trying to solve a people problem with technology.
How much risk should society take on so that people have one more avenue to make profit? Everything is risk reward tradeoff, and the risk to the financial sector and borader society isn't worth the reward of having the freedom of profit in those areas.
> they deal with tremendous leverage without proper transparency
At least immediately post crisis, these products were super transparent. You have all the underlying loans and their docs in the closing package. Everyone knows who the ultimate borrower is, and how a dollar traces from them to their point in the chain.
As long as these assets are held outside the payments system, the contagion risk is contained. The problem happens when the public doubts the solvency of a payment processor.
Again, only true for regular (non synthetic) CDOs - this is where the issuer is a dumb (or managed) vehicle that buys loans and tranches them up. The best example today would be Mortgage Backed Security (MBS) tranches / Asset Backed Security (ABS) tranches. AS you say, if the intermediary is suspect the structure can become suspect - but this can be fixed by appropriate structuring and security.
In a synthetic CDO the cash raised from CDO issuance is invested in collateral (more often than not, chosen for highest return rather than real safety), and the investment return is generated by selling protection on CDS - the terms of this CDS may not always be very clear. If you have sold protection to Lehman for example and they go bust, your structure is in limbo, without a single underlying having defaulted.
If that is the case why were so many US entities victims of the collapse?
1. AIG
2. WamMu
3. Merrill
4. All the monoline insurers (MBIA etc.)
In my view, your comment is just one part of the (v complex) set of conditions leading to the financial crisis. There were also:
1. Substantial savings from mercantilist economies (China / Germany) driving a glut of malinvestment
2. A regulatory view that financial complexity always reduced systemic risk
3. A central bank seen as overly accomodative of speculators (the Greenspan put)
“The world has enough for everyone's need, but not enough for everyone's greed.” - Mahatma Gandhi
It has been argued that the current environment of low rates is driven by a safe asset shortage [0]. Many investors (e.g. insurance companies, pension funds) need to match liabilities with assets yielding reliable returns. With a constrained supply of safe assets, this demand drives yields down. Austrian economists argue that the resulting level of interest rates may be artificially low, leading to 'malinvestment' [1], a misallocation of investments that ultimately leads to economic contraction.
CDOs attempt to manufacture safe assets from riskier ones. Various debts are pooled, then the pool is divided into 'tranches'. Each tranche has a different rating, indicating riskiness of the tranche, according to the tranche's claim on distributions. A higher rated tranche will get paid before riskier tranches, allowing investors to choose their risk tolerance. Riskier tranches have higher yields commensurate with a greater risk of not being paid.
In theory, this structure is sound, provided that the debt being pooled has known characteristics. During the financial crisis, ratings fraud contributed to the breakdown of CDOs [2]. Lenders made unsound loans and lied about the characteristics of the collateral and the borrowers. Ratings agencies (Fitch, Moody’s and S&P) then rated this debt as being less risky than it actually was, due to having false information and perverse compensation incentives. Additionally, structurers assumed that diversifying geographically would prevent correlated defaults on individual debts (which was not the case). These assumptions led to CDOs having unsound risk pools. More exotic products, like CDO squared (CDOs composed of CDOs), further amplified problems.
Similar products (e.g. CLOs) have been in high demand, as there is a genuine need for safe assets. Ideally CDOs can be produced without succumbing to the issues they faced during the financial crisis. The current interest rate environment exhibits suspicious behaviors, including negative yielding sovereign debt and investment grade/high yield spreads [3][4] roughly as tight as they were prior the financial crisis. Increasing the supply of safe assets may help lead to a rates environment that would previously have been considered normal.
Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits.
Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think The Big Short would have been more interesting if it made that argument, rather than merely "CDOs are evil."
EDIT: I was reacting to the movie adaptation; I haven't read Michael Lewis's book.
CDOs could be more vulnerable to corrupt practices than other systems. The US banking system could be too corrupt to safely employ CDOs in the long-term.
This is difficult to put into theory because corruption is difficult to measure, but I think we've all seen one example already. It wouldn't be the first thing that's great in theory but not in practice.
one interesting fact the movie didn't mention about CDOs, IIRC, is that the repackaging makes sense only with the assumption that the underlying assets are independent variables.
I.e. if you have 2 independent bonds which will default with 50% probability you can combine 4 outcomes into a single one and issue two tranches.
The senior one should be payed back 3 times out of 4 (it's enough if one bond pays back) and the other will be paying back 1 time out of 4 (both need to work out).
But if the underlying things are correlated, they will fail or succeed at the same time, so when you buy the senior tranche your assumption that it's safer is wrong.
OTOH, buying the other one you'd get a good deal: you will pay for 25% chance of getting the money, but get something more than that.
Assets don’t need to be completely independent for their combination to provide an improved risk-adjusted return. In fact, all asset prices are correlated, but we still diversify. I don’t think the financial crisis happened because nobody heard of conditional probability. Derivative structuring is one of the places where people who are good at math go to get rich.
The devil is in the details - even if you understand the math, you have a lot of choices to make. Ultimately you are going to have to set parameters on your model where the data to estimate the parameter accurately doesn’t exist. And at that point, math suddenly turns into opinion.
sure, I didn't mean to imply that lack of basic understanding caused the financial crisis, but watching the movie (the Anthony Bourdain skit) and not having any knowledge of this stuff the first thing you'd think is: how could the soup be rated higher than the fish leftovers?
Understanding the probability bit explains that the trick depends on different modeling, not just on repackaging.
I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.
Where are you quoting from? It's not in the comment you were replying to, nor anywhere upstream that I could find. And, wherever it is, why do you think it justifies assuming bad faith?
What potential benefit of CDOs did you feel wasn't explained?
The movie is based on a book. Do you feel the book's author (Michael Lewis who has written about mortgage backed securities for years) also doesn't understand the theory behind CDOs? Or that the filmmakers didn't understand the book?
I've read the book. And all his other books. They're fun, but they're not a great source for serious understanding.
The book and movie does briefly explain all this, but it paints a picture that the instruments themselves were inherently toxic, which was not the case. What was toxic were the assumptions that went into modeling their risk characteristics.
The assets (like all assets) themselves were fine. The problem was that people didn't understand them.
In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing.
The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance.
You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.
> In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing.
It isn't the case that nobody understands them. We understand them just fine now. This is how civilization learns. For a long time we didn't know how to price options - now we're quite good at it.
> The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance.
Ponzi schemes are designed to defraud unsophisticated investors. These assets serve a useful purpose and work just fine as long as their risks are properly understood, which they now are.
> You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.
The evidence does not show that for these assets. You could make a similar case about basically any dangerous but useful technology. When dynamite was first invented i'm sure a lot of people died messing with it. That doesn't mean we should ban it, it means we need to figure out how to handle it and use it safely. We now understand these assets pretty well. I'll bet you basically whatever amount of money you want that the next crisis will not come from these assets.
I'm not persuaded. There's no such thing as "understand just fine now". Ponzi schemes have been understood since the 1920s, but people keep falling for them. More sophisticated investors can get taken by more sophisticated tricks. Having worked for financial traders, I know just how pleased people can be to have pulled one over on people they see as adversaries.
I agree it's possible that these assets could be fine now, either because people have truly learned a lesson, or just because of the "once bitten, twice shy" reaction that takes a few decades to wear off. But the principle by which you declare them fine, namely that all assets are fine, is definitely wrong.
> I'm not persuaded. There's no such thing as "understand just fine now". Ponzi schemes have been understood since the 1920s, but people keep falling for them. More sophisticated investors can get taken by more sophisticated tricks. Having worked for financial traders, I know just how pleased people can be to have pulled one over on people they see as adversaries.
You could make this argument about literally anything. You're not really saying anything specific to CDOs here, so I can't really give you a more specific response.
> I agree it's possible that these assets could be fine now, either because people have truly learned a lesson, or just because of the "once bitten, twice shy" reaction that takes a few decades to wear off. But the principle by which you declare them fine, namely that all assets are fine, is definitely wrong.
All assets are fine if you understand their risks. Sometimes we deem certain people or groups insufficiently responsible to handle the risks of certain assets. Non-accredited investors are not allowed to invest in private companies. The United States bans "contracts for difference", etc..
I think the problems with CDOs are extremely well understood at this point by everyone in that market. It has been one of the most studied issues of the last decade in quantitative economics. That isn't to say that it's impossible that there's some lurking risk we don't yet get. There absolutely could be. But the probability is much lower than basically any other complex asset class, precisely because this is the one that blew up last time.
If you want to go hunting for latent risk, CDOs are literally the last place you should look. Our economy is chock full of astoundingly complex financial instruments. If you are worried about CDOs because they blew up last time, you are really really missing the point.
If we used your system for banning assets, we'd have banned the stock market in 1929. We'd have banned tech stocks in 2001. Argentina would have basically banned all money by now.
My point is: just pointing at the fact that something blew up once is an insufficient argument that it is not worth the risk. The pattern of "new thing blows up in our face" is quite common across things that turn out to be incredibly valuable and useful. The question at hand is whether we understand it sufficiently well now to use it safely. And the answer is pretty unequivocally yes. We know what we did wrong with CDOs and we know how to correct for it.
You seem to be arguing with quite a lot of things I didn't say. E.g., I don't have a "system for banning assets".
I do agree that, "All assets are fine if you understand their risks," is moving in the direction of a reasonable principle. So you're making progress. Once you start to grapple with intentional information asymmetries, willful misleading of buyers, and engineering for complexity as a way of hiding risk, you might really get somewhere. I doubt you'll get far enough to prevent the next crash or anything, but definitely somewhere.
Blaming the problem on "people" is also missing a large part of the problem. The breadth of the crisis meant that it affected a lot of people who had never heard of CDOs, and never should have. People lost their jobs in totally unrelated fields. Companies couldn't grow because credit dried up while the mess was sorted out. People couldn't sell their houses because the entire market crashed. And so on.
Of the people who did know about CDOs, many should have understood them, because they were playing around with sums large enough to affect the economy as a whole. They didn't through a combination of inertia and fraud.
There were systemic effects, where a whole lot of people were making apparently sensible local decisions and nobody understood the entire interaction -- but that's not really a good justification for shrugging shoulders and say, "Well, I guess it's everybody's fault, then".
People should be able to make the "assumption" that they'll be able to work in a functioning economy, without having to become experts in complex financial instruments. If the financial industry can't leave them to make that assumption, they'll vote for a government that will enforce it -- probably clumsily. If the system requires everybody to understand a financial network that most of them can't, they'll forbid it, which isn't good for the economy but is more acceptable to a lot of people than being told that the financial crash was their fault.
> Blaming the problem on "people" is also missing a large part of the problem. The breadth of the crisis meant that it affected a lot of people who had never heard of CDOs, and never should have. People lost their jobs in totally unrelated fields. Companies couldn't grow because credit dried up while the mess was sorted out. People couldn't sell their houses because the entire market crashed. And so on.
Sure, but i'm not sure what this has to do with my point. Should we ban internet stocks because the market was irrational in 2000?
> There were systemic effects, where a whole lot of people were making apparently sensible local decisions and nobody understood the entire interaction -- but that's not really a good justification for shrugging shoulders and say, "Well, I guess it's everybody's fault, then".
Ok, but how does that cash out in any kind of coherent policy recommendation?
To answer your first question: the benefit of derivatives, of which CDOs are a type, are that they theoretically allow people to _reduce_ risk.
The classic example is a put option. If you think a stock will go down in a future, you could short that stock; but if instead the stock goes _up_, you could be on the hook for an infinite amount of money. Instead, you can buy a put option and get a similar payout if the stock goes down, but if it goes up, you've only lost the money you spent on the option.
Another example is purchasing futures: if you're an airline and you think fuel prices are going to go up, you can buy up a messload of fuel futures, and you'll effectively pay the same price for fuel while everyone else is paying more (which I think JetBlue did in the 00s).
In this case, a CDO theoretically reduces risk by spreading your risk across a huge number of mortgage holders. If you sell someone one mortgage and they default, then whoops! You just lost a ton of money. But if you instead sell 100 different mortgages, you're "diversifying" your risk. Most people don't have billions of dollars to sell thousands of mortgages to make this sort of investment, so CDOs package the mortgages into purchaseable portions.
(Of course, what happened during the housing crisis was that there was a huge, systemic issue that would cause huge swatches of mortgages to default. That part sucked, and the contributors to that catastrophe definitely deserve the ire on them.)
[Disclaimer: I'm relying on my memory of finance classes I took 15 years ago, I'm probably wrong about some details.]
CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.
> it assumes that certain companies can create pools of loans that have well defined risk
No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true.
What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.)
Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money.
In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.
The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.
This is one reason why defined benefit pension plans are a terrible idea with hidden risks for employees, employers, and taxpayers. Everyone pretends things are fine but when investment returns come in below expectations the illusion will fall apart. As a society we should aggressively phase out pensions and replace them with defined contribution plans.
Defined benefit pension plans are a great idea, because you get something out of them, regardless of how long you live.
Even if investing in one makes you take a haircut, compared to a fixed contribution fund, they are still a great idea. For two key reasons.
1. You need money to live.
2. You don't know how long you'll live for.
If I retire with a fixed contribution retirement fund, that is planned to last me 20 years, and I die after year 5, it's of zero consolation to me that ~75% of my fund is still around.
... But if I live to year 21, I've now got zero income. A big fat zero. And I'm also not in a great physical state to work for more money to support myself.
Likewise, if there's a market crash, and a slow recovery two years into my retirement, that 20 years of runway may turn into 12.
Banking on a fixed contribution fund is like playing a game where we flip a coin. Tails, you triple your money. Heads, you lose everything you own.
This game has a positive expected net value for you, but you'd be an absolute idiot to play it at the age of 75.
With a defined benefit pension plan, you're playing a different game. Heads, you add 40% to your money. Tails, you lose half of what you own.
This game has a negative expected net value for you, but if you have to pick between one or the other, it's a much better game to be playing at the age of 75.
The optimal strategy, of course, is to diversify your investments, and have both a defined contribution retirement fund, AND a defined benefit pension plan, with the understanding that one of them may underperform for your situation. (The first if you live too long, the second, if the market in general has a rough time.)
Currently, something like 4-6% of my retirement 'savings' (In the form of social security contributions) are tied in defined benefit pension plans. I'd feel much more comfortable if I could shift my distribution of savings, so that they would be closer to 30% of them. And yes, I expect to take a haircut on them.
Most financial risk can't be reduced, only shifted around between parties. The problem with defined benefit pension plans is what happens when the sponsoring entity goes bankrupt and can no longer pay? It's just too risky and the existence of the PBGC actually exacerbates that risk, creating a huge moral hazard at taxpayer expense.
And as for a market crash two years into retirement, only an idiot would be in volatile assets at that stage. The default investment option for most defined contribution plans is a target date fund, which protects against that scenario.
> Most financial risk can't be reduced, only shifted around between parties. The problem with defined benefit pension plans is what happens when the sponsoring entity goes bankrupt and can no longer pay?
You take a haircut, and your pension ends up getting reduced to ~70% of what you were going to get paid. That's the "Flip a coin, and lose scenario". But at least you're still getting paid.
These funds don't magically drop to zero out of the blue, and neither will social security (Which is the biggest example of a defined benefit pension fund.)
> And as for a market crash two years into retirement, only an idiot would be in volatile assets at that stage. The default investment option for most defined contribution plans is a target date fund, which protects against that scenario.
Keeping all your money in safe, zero-return investments doesn't protect against the scenario of 'you lived longer than expected'.
My parents have recently retired. They aren't keeping every penny of their money in a zero-return mattress. If they did, it would run out when they hit 82. Investment orthodoxy agrees with them - it instructs that when you are 70, you should have ~30% stocks.
If you follow that orthodoxy, and get a recession a bit into your retirement, and live longer than expected, you are going to be old and broke, but I suppose you'll feel really smart for not getting hoodwinked by one of those defined payment pensions...
The thing is that to prepare for retirement, you cannot have a plan where you accrue a lump sum that you then draw down.
The only plan that can works is if you accrue a large enough amount, from which the interest earnings are enough to sustain you indefinitely (using a low interest but safe returns instrument like high grade bonds and gov't bonds, with a small mix of stocks selected for dividends). The expectation is to earn some 2-4% interest in aggregate, and that should amount to some $20-30k USD per year (after tax, if taxed - preferably work out how to get good tax treatment). That works out to be between $900k-1mil USD.
If you cannot hit this target by the expected time you need to retire, then you're already fucked. That's why retirement planning should start when you start your first job.
> The only plan that can works is if you accrue a large enough amount, from which the interest earnings are enough to sustain you indefinitely (using a low interest but safe returns instrument like high grade bonds and gov't bonds, with a small mix of stocks selected for dividends).
I don't plan to stay alive indefinitely, though, so I don't need a plan that will sustain me indefinitely. That is overkill, and most people can't afford to save that up.
What I, and most people need is a plan that will sustain the retiree until they die - and not just for an average case scenario.
Pension plans have lower expected returns, but handle the long-tail cases well, because they balance risk between different participants - some of whom die early, and some of whom die late. Someone who dies five years after retirement will draw much less from a pension than someone who dies twenty five years after retirement. The existence of the former provides safety for the existence of the latter.
401Ks have higher expected returns, but handle long-tail cases poorly, because there is no diversification of risk for the individuals participating in them. I may end up dying with 90% of my 401K in the bank. That does me no good. I may end up saving up to live into my 80s... Only to discover - too late - that it wasn't enough.
> That is overkill, and most people can't afford to save that up.
If you start when you're 20 (so 40 years of compounding time for a retirement age of 60), a $500 monthly savings contribution, on a 5% growth of stock investment (which, tbh, is low for such a long period), should net you some $745k (with $240k contributed, $500k interest earnings).
Is $500 a month of contributions a lot? I dont know - it depends on your income. But i think for a large portion of the working population, this is doable. It does mean sacrifice if your income is on the low end - you don't ever go on a holiday, you don't drive a new car (but instead, buy an old one so you don't have debt to service). You probably won't own property, and will continue to rent (and i'd include rent costs in the $25k in retirement cost per anum). It's not a fancy lifestyle - but it does mean you don't rely on a gov't social security, you don't rely on a pension fund that could go away.
And the end result is you will have some money left over when you die to contribute to either your children if you got any, or choose to donate/contribute to a cause you find worthy.
Under a pension plan, the person who dies early then leaves their children behind with nothing (or lost the contributions they would've deserved had they remained alive - albeit subsidizing somebody else's longer life). I don't find that fair, since a pension is part of your employment compensation, and yet you don't extract it all if you died, and thus you actually lose out.
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Under a pension plan, the person who dies early then leaves their children behind with nothing (or lost the contributions they would've deserved had they remained alive - albeit subsidizing somebody else's longer life). I don't find that fair, since a pension is part of your employment compensation, and yet you don't extract it all if you died, and thus you actually lose out.
Yes, that's the point of a pension plan. It's not a 'inheritance savings plan'. It's not intended to support your aging adult children. It's intended to support you... So that they don't have to.
What's really unfair to your children is you living to 90, and expecting your kids to support you, when they are 70, because your 401k money has run out five years ago. That's going to do wonders for their retirement prospects, no doubt.
Defined benifit pensions can utilize the same investments as defined contribution pensions. The actual difference is who gets the surplus from early deaths, either other pensioners or children/charities etc. Equivalent investments are thus safer in defined benifit pensions at least in terms of a safe retirement.
Of course this is all rather dependent on good regulations and equivalent funding. Allow companies to issue dividends or stock buybacks with under funded pensions and you get seriously perverse incentives.
That is not how it actually works. Regardlesss of investment selection, most defined benefit pensions won't have a surplus. They will have deficits due to unrealistic expected returns. Many plan sponsors can't afford to pay the difference and will end up bankrupt (especially local governments). This is risky for retirees because even if the plan had PBGC insurance their payments will be cut.
Defined benefit pension plans are a hidden growing cancer in our economy and may cause the next huge financial crisis.
The elderly will receive some form on assistance in their old age if they have no assets or income. It’s a diffuse and therefore easily overlooked, but massive hidden cost. So, defined contribution plans are a much larger and more insidious long term threat that’s going to hit as an ever larger chunk of the oldest population run out of money and get government benefits either way.
Don’t forget this is a new system unlike pensions. The 401k system only started in 1978 and adoption lagged. It’s when people the entered the workforce in the late 90’s start to hit their 80’s that we are going to see a sudden spike in these costs. Worse it’s not limited based on incomes as anyone can out spend their nest egg.
For taxpayer funded defined benefit pensions, the actual difference is that in the defined benefit pension case, future taxpayers are on the hook for any underfunding and understating of costs in exchange for government employee votes as well as other kinds of fraud.
With defined contribution, politicians and senior union officials can’t play those numbers games since there is no lien on future taxpayers.
Local governments with unsustainable pension costs are likely to choose bankruptcy instead of large tax increases. Bankruptcy judges have the authority to unilaterally cut pension benefits.
For any young attorneys just starting out, Chapter 9 bankruptcy will be a growing and lucrative practice area.
> With defined contribution, politicians and senior union officials can’t play those numbers games since there is no lien on future taxpayers.
If you run out of money in your retirement, and are eating catfood under a bridge, you're going to ask future taxpayers to pay for your survival, either way. Regardless of whether the reason for it is 'my pension fund ran out of money' or 'I lived longer than my planned X years of runway.'
The fun thing is, if you've invested into both of those things, you are reducing the risk that you end up in this situation.
As you say, the incentives are out of whack. I'd say the other difference the defined benefit tend to have an extra layer of cost in them. Maybe this can be paid for strictly with the surplus but when it can't, they start chasing. I've always found defined contribution to be more fair (why can't my children benefit from my hard work?) and by definition lower cost.
With the low availability of reliable assets doesn’t that mean that any government could issue like 2% bonds and essentially get near unlimited buyers? Thus financing huge projects like a complete transition to green energy, or large infrastructure projects and at the same time help work against the potential severity of a future crash?
2%? They're issuing ~0% bonds in most of the Eurozone.
I also believe there can't really be a crash when interest rates are very low/at 0%, since the time value of money literally becomes null and debt can forever be pushed further. BUT since there is already existing debt to service - issued at higher interest rates - the debt size has to increase.
Then it works as a trap as the interest rates cannot easily go up without heavy defaults - because there is a lot of debt to service. Also, somehow low interest rates correlate with low GDP growth - max capacity, no room for growth left?
Disclaimer - not an economist, perhaps someone can debunk my theory and explain what I'm getting wrong.
One important thing to note is that both the buy and sell side wanted ratings inflation in the run up to the 2008 crisis. European banking regulation limited leverage based off the rating of the asset held, with the highest rating allowing the largest leverage limits. Even when the banks had an accurate understanding of the risks involved in it, they could buy something like $50 instead of $35 of assets if it had a magical AAA rating.
I personally think central banks are acting a little bit like Dr Jekyll and Mr Hyde.
First central banks prop up the interest rate market with cheap interest rates. So there is less and less places to invest for investors to get safe returns.
Then the low interest rates created by central banks drives investors towards riskier investments. Then we get back to square one which was complex financial packaged products likeCDO that we could not predict the risk of.
Of course they will invest in them. They will make profits. Or they will steal from all citizens if they will lose big.
In Ben Bernanke's book, it showed how the Fed used citizen's money to buy all mortgages that collapsed (that AIG insuranced) for FULL PRICE. This means their fraudulant peak. He paid 100% of the full price. That way the entire supply chain of mortgage holders (MBSs, CDOs, Synthetic CDOs) would never lose a penny.
Hopefully by now, everyone knows a bunch of banks bought CDO's, and then in '08 they collapsed, or nearly did, and took the world economy with them.
If you run a bank, and you know this product is dangerous and causes banks to fail, why in the world would you buy one of these products? Maybe you told your brother-in-law to take a massive short position on your bank?
They didn’t collapse because of CDOs. They collapsed because GSEs had pushed the real estate market to ridiculous levels. The GFC was a classic case of government interference creating market distortions.
Investors wan't leverage. Always. When you plug one leak, they will scramble and innovate until they find another way to get it. Buying on margin, options, CDS, structured products... the list goes on.
Might be a product of the generous bankruptcy system in the US. I.e., investors are rational in their willingness to take big risks because of the asymmetric payoff associated with highly-leveraged investing. It's a great system, but not without negative unintended consequences such as this kind of moral hazard.
Written language can be used to overturn history as well as reinforce it.
In this case, the article mentions "meatier yields", and that two-word combination by itself is something I would bet on in a fight against any article-length analysis of the 2008 crisis.
There is nothing wrong with CDOs. The mistake was treating junk loans as investment grade. You can do that regardless of how the loans are securitized.
You will always have the haves and have-nots. You will always have tribal borders.
The haves will gain and use knowledge and technology to make their lives and those of their tribe easier and it will benefit them more than those of the have-nots.
So written language containing the body of science and technical knowledge benefits them always. The effect on the entire species is unimportant to those with comfortable, limited lives.
Other non-technical written language to create a world of mystical morality to keep the other side in check also benefits the haves.
Until the human species changes into something new where competitive behavior is not a base need/instinct, nothing will ever change.
This is an ideological claim, not a normative one. I will similarly claim with st least as much validity that humans can cooperate more then compete in the right context and dont need to be physically changed to do so.
100%. We have a powerful conscious mind that we use to rationalize our primate biases. It used to bum me out, but I've developed a more zen-like outlook. It just is. Everything just is.
I'll bite. So how do we fix it? Most people just want to live their life and not fight the powers that be. Only when things get really bad to people stand up in numbers. Voting for change is just living "Animal Farm" in real life.
I'm not trying to be snarky or cynical. I'm really not sure how we exit this spiral.
Basically, by 2006, CDO originations were ~$250B. It took about 4 years for originations to get that large, and by 2008, there was probably less than ~$600B total.
GDP was ~$14.7T.
If history repeats itself, this is the beginning of the end. Not the end. But anything can happen. Who knows?
In order to provide a public backstop without encouraging moral hazard, banking regulators impose risk-taking limitations on banks. In the US, this took the form of encouraging asset sales into capital markets, under the assumption that this would make any risk the banks take dissipate away harmlessly. In the EU, this took the form of leverage limits based off the credit rating of the asset, with the highest rated asset commanding the largest leverage limits.
These regulations combined in a very unfortunate way in the transatlantic CDO trade. The CDO part isn't the important innovation, though; as long as the above structure persisted, something would be found to take advantage of it. Anyhow, the short of the crisis is that American banks would sell their risky assets into concentrated positions of systematically important banks, particularly ones outside of the narrow American regulatory purview. On the other side of the Atlantic, they accidentally applied a massive incentive to figure out a way to slap an AAA rating on stuff, and the market delivered that in spades.
The cherry on top of this entire system is that when American banks make loans, this cash gets transferred and winds up sitting in some money market fund somewhere. These funds are searching for short-term dollar-denominated yields, and the best way to get that is to lend money to European banks secured by AAA-rated assets. After all, with the generous leverage limits bestowed on them, they can borrow a hell of a lot of money.