Jay Currie

For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compens­ation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises. Raghuram Rajan, financial times via equity private

Finance for grown ups. The “sub-prime mess” is a convenient shorthand for “Bankers gone Wild”. Understanding that will make what is coming rather easier to comprehend if not actually enjoy. The weird part being that the sub-prime issue is a really rather small part of the whole. Sort of like the fat girl taking off her bra; ugly but hardly the main event.

Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism. going private

Information asymmetry may be inherent in a particular transaction; however, across a bundle of transactions a bit of work should be able to bring information into rough balance. But not if the focus is on deal flow rather than deal quality.

The golden crumbs approach leads directly to deal flow. One piece of financial paper looks very much like another, the covenants are, more or less identical – quality? Well there were the four hundred appraisals but those are pro forma. Or are they. At the moment there are a lot of empty house with their pipes cracking in the frost which strongly suggest that appraisals and risk analysis are not just pro forma. They are what bankers do and if they don’t the information asymmetry bites them in the ass.