What allowed Wall St, the banks, hedge funds, the insurance companies and pension funds to simultaneously create and swallow risk that produced the situation we now face?

It was the Gaussian copula function.

If you have any familiarity with physics or chemistry the name Gauss may ring a bell.  He was known as the Prince of Mathematics.

But in the quantitative world of finance the Gaussian copula function deals exclusively with correlation of risk.  David X. Li, a native Chinese mathematician came up with an ingenuous way to model default correlation without looking at historical default data – instead he used market data of instruments known as the dreaded credit default swaps.

The market for these swaps grew rapidly because an unlimited number of credit default swaps can be sold against each borrower unlike the underlying bond.

This created a situation where the rating agencies no longer reviewed the underlying securities but went straight to the value of copula.  (In statistics, a copula is used to couple the behavior of two or more variables.)

As a result of this formula, just about anything could be turned into a triple-A credit rated bond regardless of the quality of the underlying security or even if there was one.

As we all now know, the theory and formula are built on unpredictable parameters.  It made no allowance for unpredictability assuming that any correlation was constant.

Even when the risk departments of banks were warned, the warnings were dismissed.  Everyone was making too much money.  Because the credit default swaps only priced risk during the period of time when housing values were going up default correlations were misleadingly low.  Why no one thought to ask what would happen if prices stopped going up let alone go down is why we now face the current reality and try to forget the theory.

Two articles were published this week on Marketwatch.  One had 5 reasons not to buy right now and the other article covered the pros of purchasing at this time.  We are reviewing each article in a point-by-point fashion dissecting each presumption in an attempt to find the bottom line and how they affect your decisions and actions.  You can find links to each article at the bottom.

The author begins by making several salient points: unemployment is increasing, home prices are reported as continuing to fall and your job could be next to see the ax.  All ominous signs.  The big psychological question posed is why not wait for the bottom?

The problem is that one can never know a bottom until it has passed.  That bad unemployment report could be the last for some time.  Home prices may be falling on a national basis but what's happening in the neighborhood you are interested in?  And be honest, you know your job prospects better than anyone else.

1.  Prices are still dropping.  The author attempts to make some distinction between local and national markets.  But not nearly enough.  One of our realty clients, John Thompson reported that one of his listings received 17 offers upon its placement in the MRIS.  In some markets prices have come down enough to meet buyer demand.

2.   This sale will be on for a while.  Here, a financial planner shows her lack of knowledge concerning the concept of leverage.  With a 20% down payment that appreciation increase of 5% becomes a cash-on-cash return of 25%.  Not too shabby.  With a smaller down payment the return increases.

When the market turns there is usually an initial burst of activity and the best properties are gone quickly.  Then there is a cooler period but interest rates have already started to rise in anticipation of a stronger market.  When do you want to buy?  The lowest possible price or the best rate?

3.  You may not stay put.  There's really no argument here.  It doesn't matter whether the market is hitting bottom or increasing at 20% appreciation.  If you can't determine whether you will be there in two years don't bother buying unless there is a tax issue such as a qualified exchange.  The costs of buying and selling can eat up any potential gain.  On the other hand, if you know you're going to be there for awhile...  For a complete discussion see my First Time Buyers page.

4.  Your job could be the next to go.  It's been said that here in the Washington, DC, metro market that we are insulated from serious downturns.  There are people now losing jobs.  But there seems to be new opportunities being created also.  Maybe it's been the change in the adminstration, maybe it's because major corporations are moving their headquarters to Fairfax County.  There's always opportunity with change.

5.  Your cash reserves will be eaten up.  Could you purchase a home and still have 5 to 6 months cash reserves set aside for a rainy day?  Some of us could, granted not everyone.  Here, the axiom is to prepare.  Start saving.  Pay down your non tax deductible debt freeing up more cash for savings in the future.  Rent is not tax deductible.  Mortgage interest and real estate taxes are.

Marketwatch article Five reasons not to buy a home this year