I have been ruminating a bit on the credit crisis engulfing the markets. I have been reading books and academic papers of late concerning valuation of collateralized debt obligations and mortgage backed securities for a couple of months now. I have been discussing the problems faced by traders and investors in marking portfolios to market and marking portfolios to model and what happens when there is a real contradiction between the model and the market. I have been doing this because I am a geek and I find the structured finance side of the market, and the implications on leverage and the implications leverage has on liquidity, to be utterly fascinating. You should, too, by the way.

One of the issues I think is most interesting is that the models created by hedge funds or by structured financial products traders rarely actually accurately models a total melt down. The models, take Bear Stearns recent debacle, probably did include the possibility that the exotic securities they were trading could go totally south, but the humans doing the trades and making the investments in the funds would have discounted that possibility down to very little if not nothing.

That's what we humans do. We make plans but we cannot honestly confront a worst case scenario. That's why we call it a worst case. We give it that name and that assume that the probability of it taking place is not worth discussing. I think it is human nature. We don't actually assign a real probability factor to the problem posed by the worst case. I think that the only place humans do this is with regard to estate planning. We know we're going to die so we make plans for that worst case scenario. But not everyone does this, you know, and not everyone who does do it can successfully contemplate the worst case scenario posed by their own certain mortality and do it efficiently and correctly.

We don't like to think about bad endings. Or monsters, come to think of it. But I think that they both exist.

No, human beings plan for the middle and include slight deviations from the middle. Some really smart humans can plan for volatility but even that will remain within artificially set expectation bounds so that when the volatility surpasses those bounds, trouble can result.

Where am I going with this?

I'm not 100% sure. Maybe I am just going with the thought that I have to be a better planner. I have to take disaster planning more seriously, for instance. I, and many others, will discount the possibility of a catastrophic disaster down to zero and stop thinking about it even though we know that power failures, for instance, can last days.

We plan not with our intellects but with our emotions.

I think it is time to take the emotional out of the planning stage.

It is time to contemplate both the worst case downside scenario and the best case upside scenario for this family corporation I am an officer of and start to plan accordingly even if the business and financing climate has changed. This is different from lawyer think and legal analysis. It is going to be an interesting exercise.

Oh, and I really have to finalize our wills.

You should, too.

Posted by: Random Penseur at 11:41 AM | Comments (3) | Add Comment
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1 Sage advice, as usual.

Posted by: Wicked H at August 10, 2007 02:44 PM (zOWa5)

2 Sounds complicated Should I even be thinking about a will at the tender age of almost 23?

Posted by: Hannah at August 10, 2007 03:09 PM (lUH62)

3 Great advice rp. Hannah, If nothing else you should have a living will that explains your views on life support, heroic measures, etc... This way people aren't left having to make a decision they "think" you would want. Main reason I have one is I don't want my family to have to decide whether or not to pull the plug. Kind of morbid thoughts at 23, but things happen.

Posted by: phin at August 10, 2007 03:30 PM (CQcil)

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