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It was 13 month ago I wrote my piece on “ Hedge fund and the Current Wall Street Money Crisis http://www.sciencenet.cn/blog/user_content.aspx?id=5847” . Apparently, human greed is not limited to hotshot young hedge fund managers. Venerable Wall Street institutions such as Bear Stern, Merrill Lynch, and Lehman Brothers are not immune and equally ignorant. It just takes longer for their folly to become vulnerable since these insitutions have more money to lose. They bought things heavily leveraged, i.e., they borrow money at fixed rate to make bets which they falsely believe will yield better returns than the rate they have to pay the lender. In effect, this is ma king money on money they don’t have – an infinite rate of return if it works. When things go the other way, reverse leverage takes over. The result can quickly overwhelm any of the investment the institution made on their own. The downturn in US housing is but a catalyst since many of the leveraged financial instruments were built with mortgages as collaterals called Collateralized Debt Obligations (CDOs). These CDOs were given fraudulent “A” ratings to make them look secure and stable while in reality they were nothing but cheap moon cake wrapped in fancy boxes and ribbons.
When things go well, people are willing to believe in anything. The elements of Financial Engineering are actually relatively simple. It is human greed that knows no end, delusional, and never learns. It could be a long time before the US and the world comes out of this crisis.