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Pandora’s Risk: Uncertainty at the Core of Finance resources

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9 Insecuritization Large portfolios are commonly rated for risk as if aggre- gate losses are bound to fall within a few standard devi- ations of the perceived mean. This can be wildly inap- propriate, especially for senior debt tranches. Ignorance, greed, and bad regulatory incentives have driven gross misuse verging on fraud. We’ll examine some healthier alternatives. Readers who have been fretting the dearth of moneymaking advice in this book need look no further. Th is chapter will demonstrate how to rake in fortunes through creative statistical fraud. Granted, others have beaten us to much booty. Still, foolish regulations, negligent rating practices, and irresponsible fi duciaries invite more ill- gotten gains. Here is a basic recipe: • Take a big bunch of diff erent credit risks, just like a normal bank does, only with far less supervision. • Repackage the claims in tranches ranked by se niority, and give them impressive names like Collateralized Debt Obligations (CDOs). • Let the lowest tranches shoulder the mean observed risks and the middle tranches the risks of three to four standard deviation outliers. • Assume the risks are normally distributed to prove that the high- est tranches are nearly risk free. • Hire rating agencies to certify the calculations, and rely on regulators and major institutional investors to accept the certifi cations on faith. • Off ed tranches for sale as tradable securities. er the certifi

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