Now we know that there are uncertain inputs for payback on underlying mortgages, as well as uncertain risks with counterparties.

How are you solving the "garbage-in" side of the equation?

I know all about that stuff. I know how to construct a synthetic bond. I know how to stress test individual bonds and entire fixed income portfolios. I did this stuff for fifteen years. None of this is difficult. Anyone with a modicum of smarts, some decent training, and the right tools can do it.

And bond portfolios are regularly stress tested for extreme situations. It is a requirment for all banks, thrifts, credit unions and insurance companies to do so and file the results with regulatory agencies.

I am not sure what your point is. Mine was simply that the troubled assets that clog up the balance sheets of banks should be removed as per Paulsons original plan.

You seem to be buying into all the hype that it is impossible to understand and price these assets. But that is just simply not true. I know from experience that is not true. But do not take my word for it, Bill Gross says he can price any of them in a few minutes time. Really he can.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook.

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

And no, I'm certainly not going to double back when you name automated tools!!!

Do I need to dig up all the articles that say those tools were the problem? Fat tails, garbage in, algorithms only tested in up-markets?

The pricing of debt securities, even the most complex, is not that difficult to do. The simple straight forward securities can be priced with pen and paper but the more complex securities require the computing power and built in databases available only (to my knowledge) with a Bloomberg terminal.

Given the right tools and a little training even you could price any of these securities.

The trouble comes in getting your prepayment, default and payoff assumptions correct.

To help form your assumptions you have the entire history of the bonds collateral to look at as well as decades of historical comparisons of simililar collateral to view as well. But as we all know that 'past performance is no gaurantee of future results', and that is where the problem lies.

But once you plug your assumptions into the pricing program it gives your resulting pricing at the stoke of a key.

As a buyer you would want to assume the collateral performs worse going forward. This gives you the lowest possible purchase price. But as a seller you want to assume the perfomance improves going forward. This gives you a higher sales price for the security.

Some of the factors that go into helping determine what assumptions to use are such things as the direction of interest rates, the state of the economy, the job situation, the overall housing market, the housing market specific to the collateral, etc.

There is plenty of public information on all of the factors needed to make your pricing assumptions. So it really is not hard to do at all.

That is true of most all debt securities with the exception of treasuries.

Treasuries are not derivatives.

Bill Gross of Pimco said he could put a price on any of these securities in a few minutes. Having some experience in this field myself I can support his claim.

You kidding me? A CDS made up of a dozen CDOs each with different tranches and states of origin?

You'll do that in a few minutes?

The complexity of synthetic derivatives exploded, and the only group that could have said "slow down" (the ratings agencies) slapped AAA on them without looking.

James, this has been the pattern for this administration for going on 8 years. They're giving us a good-bye f*ck.

And if you want scary, just think about what sort of legally binding contracts Paulson & co. could be inking even now, with Wall St lawyers. Contracts which might not be revealed until 2009.

Ken, the problem is that these assets were never uniform, substitutable ... fungible ... to use the $20 word.

That is true of most all debt securities with the exception of treasuries.

Bill Gross of Pimco said he could put a price on any of these securities in a few minutes. Having some experience in this field myself I can support his claim.

For any mortgage backed security with a cusip number the underlying collateral is specified in great detail for both buyer and seller to see. Further, the performance of that collateral is tracked daily and its history is available for all to see as well. Additional research, a few keystrokes really, will give you the performance of the entire block of such collateral.

What is not given, because it must be provided by buyer and/or seller, are the assumptions regarding the future performance of the collateral.

As a buyer I want to make the prepayment and payoff assumptions as low as possible. As a seller I would want to do the opposite.

You are right about the difficulty of of pricing large number of diverse debt securities by reverse auction however. A straightforward auction market with the Treasure being just one of the bidders would work much better. At first the UST would be the sole bidder and sellers would be throwing product out there to see what the Treasury bid would be. Treasury can refuse to bid on some and bid low on others. Buyers can hit the bids or hold off thinking they can get better pricing later. But either way they now have a firm market price on bonds they were unable to find a market price on previously. That was the whole point of the 700 billion dollars in the first place.

I really think that Paulsons original instict to buy up the troubled assets was the right response. I am not against the further move to partially nationalize the banks I just think it should not be done at the expense of removing the troubled assets from bank balance sheets.

Any attempt to buy them, but especially at auction, created an instant information asymmetry. Any auction would buy some good CDOs and some bad ... where to set the price? The seller knew which assets were the real stinkers and the buyer (us) did not.

I'm sure the Fed rolled through all the auction designs they could think of to eliminate this problem but could not.

... so they'll probably stick with equity injections, not because they are ideal, but because they are simple and can be set up with less chance of being swindled.

Hey, remember when we had to get those bad mortgages off the books of the banks right now or our entire economy would collapse? Remember what they said? "No, you don't understand, it has to done right this second! Now,......