By Rolfe Winkler in Option ARMageddon:
Nobel Laureate Harry Markowitz is one of the architects of Modern Portfolio Theory, well-known to finance students as the inventor of the Markowitz efficient frontier. In the most recent volume of Financial Analysts Journal, he wrote a short article proposing a method to identify toxic assets on bank balance sheets:
…hundreds of billions of dollars of obscure paper remain, and much of it will continue to remain for years. Judging the worth of the holder as well as the worth of the paper itself is difficult with regard to instruments in private hands. If the government wishes to purchase such instruments, the obvious question is what a fair price would be. If such instruments pass into government hands and as the housing situation changes, questions about the instruments’ fair value will continue to arise…
Thus, the problem of valuing these instruments will continue for years to come if nothing is done to bring transparency to them.
Markowitz’s proposal is four-fold:
- Take a census of the institutions that own various instruments CMOs, CDOs, CDS, and the like—noting the assets, liabilities, and “rules of the game” of each instrument. Although this proposed survey is large, it is no larger than such government efforts as the U.S. Census Bureau’s Annual Survey of Manufactures.
- Calculate the direct and indirect exposures of each instrument. For example, CDO A contains Tranche B of CMO C, etc., and thus is exposed to these amounts of those underlying mortgages. The mathematics of tracing out these direct and indirect relationships is similar to the techniques by which a search engine (e.g., Google) finds thousands of web pages that match a given phrase.
- Aggregate the direct and indirect exposures of a given instrument (and the instruments of a given institution) into meaningful categories. Simply knowing that a given instrument is directly or indirectly exposed to a long list of mortgages is insufficient. These mortgages should be aggregated in various ways (e.g., by zip code and late-payment history). The leverage of the instrument and of the institution that holds it should be analyzed, both directly and indirectly (e.g., has the institution borrowed to buy a tranche in an instrument that is itself leveraged?).
- This information should be disseminated on a need-to-know basis to various parties, including stockholders, counterparties, regulators, and academicians…
He devotes another segment of the article to Credit Default Swaps. He agrees with OA contributor Arthur Kimball that CDS are insurance and should be regulated as such. He notes that reserves held against CDS should be higher than those held against life insurance policies, for instance, since “deaths are fairly uncorrelated events, but business risks are usually correlated.”
The whole piece is here.