Wednesday, February 25, 2009

The Formula That Killed Wall Street - WIRED

What is the chance that any given home will decline in value? Well, what if the costs of running a home go up? What are those costs? Well, electricity, driving from home to work, food bills... Hang on - are you talking about energy costs? on...I believe I am.
So higher energy costs, oil prices essentially, caused property markets to turnaround in value? [Want me to answer that for you or are you on your way to your own answers...]
clipped from
How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion-dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers.
Bond investors are very comfortable with the concept of probability. If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time.
The potential sums involved are staggering: Americans now owe more than $11 trillion on their homes. But mortgage pools are messier than most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted.
Wall Street solved many of these problems through a process called tranching
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