Brad DeLong boldly attempts to exhaustively list the factors which can affect the value of a fixed income asset. This is some Mac generated i document and I can’t cut and paste. Go here and search for “there are four”.
The four are called “default”, “the safe real interest rate”, “risk”, and adverse selection.
I view the assertion that “there are four” as a challenge and quibble after the jump.
First the instruments in question promise nominal payments so the safe interest rate in question is the safe nominal interest rate not the safe real interest rate. The word “real” is essentially a typo.
Second “default” and “risk” are the same things for fixed income instruments (clearly what Brad is discussing). By “risk” I assume he means “risk bearing capacity” or “risk aversion”. However, default is a much broader problem than Brad seems willing to admit. He counts exactly two sources of default risk — 1 trillion in housing related defaults and 3 more trillion from defaults caused by the recession. This leaves out other sources of changes in estimated default risk (not risk aversion or risk bearing caspacity but risk).
That is, I see a fifth cause of the decline in asset values. I think many assets were over-valued in the past, because the ratings agencies were tricked or cashing in on their late lamented excellent reputations (or both). The loss of confidence in said agencies causes an increase in estimated risk not because risk has increased or risk aversion has increased but because the old estimates are now known to be bogus.
More generally, risk modeling by traders was similarly complete nonsense. I don’t know to what extent the traders were tricked and to what extent they were in on the scam (nor I suspect do they).
Structured finance created a huge illusion of wealth by creating an illusion of safety. The financial engineers knew how the agencies rated (the agencies explained for a consulting fee) and how traders estimate “value at risk”. They knew people assumed (or pretended to assume) that all stochastic variables are normally distributed. Thus it was profitable to sell instruments with skewed returns (fat lower tails) unless the rare negative event occurred during the testing period (in which case the instruments could be re-engineered). A senior tranche of a pool of moderately risky assets has a skewed distribution.
Similarly money could be made by reducing own variance for a given beta by pooling assets and issuing claims on the pool. The variance of an average is less than the average variance. The covariance of an average and the market portfolio is the average covariance. Thus a claim on a pool of BBB rated corporate bonds was rated AAA. Turning BBB to AAA is worth a lot of money except for the fact that it was a scam (investors could pool themselves — they don’t seem to have understood that pre-pooling reduces the benefit to them of their own pooling — or they were in on the scam).
That is there were trillions of fantasy dollars created out of nothing by financial engineering (on top of whatever real wealth had been created by financial engineering which genuinely made better insurance and diversification possible). The loss of that illusion can’t be estimated easily as “housing related defaults” (and note my example has nothing to do with housing or recessions).
The risk of a nationwide decline in house prices was estimated at 0 by S&P (I am not exaggerating). Now there has been such a decline, and they must admit that there is the risk of another such decline in the future. Even if the current decline costs just $ 1 trillion, the future possible declines also cost money.
So much of the wealth was an illusion which won’t come back soon. This end of systematic miss-estimation of risk is not on your list.
Also institutions took huge gigantic bets against each other (as in AIG lost writing CDSs). This increases counter party risk. No one knows if a counter party is solvent. That reduces the value of a huge number of instruments. The damage could have been done without involving the housing industry or the stock market if, say, investment bank CEOs played a really high stakes poker game and all claimed to have won money. Also bankruptcy is costly. Even if the CEOs had played hundred billion ante poker on camera, wealth would have been destroyed and more wealth would have been shifted from investors to lawyers. This is another item not on your list.
Finally, much of the strange new finance was designed to help agents avoid prudential rules and regulations which they considered to be costly. Now they have learned two things. First that the regulations weren’t so pointless so they will have to pay that cost to avoid bankruptcy. Second they will be audited by banking regulators, trustees etc and found wanting. This last point is semi redundant as it amounts to an increase in perceived risk or a reduction in perceived capacity to bear risk (default or risk in Brad’s terms). However, it explains why I keep speculating that this that or the other operator was in on the scam.
UPDATE: DeLong indirectly replies here. [klh]