Random Pensées

Reading Recommendations: credit derivatives and markets

I have not shared any book recommendations for quite some time. Blame my basic indolence, if nothing else. But I want to share a couple of recommendations. If nothing else, reading these will give you some background to understand much better what is happening in the credit markets, the debt markets, and the equity markets as spreads diverge and traders (and you) are getting hammered in the markets.

First, read Richard Bookstaber's book: A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. This is a very well written and accessable book dealing with how innovations in financial engineering -- more complex models leading to more complex financial products -- are leading the financial markets down the path of an eventual collapse brought about because they have become too complex to understand. He is particularly good in explaining the causes of some of the great, recent, financial collapses, like Long Term Capital in 1998. I know one or two of the LTCM guys and this helped explain their demise to me much better than they ever did.

Then, go forth and get Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives, by S. Das. Das is a former derivatives trader and, on the buy side, consumer of derivatives. He gives very good explanations of how simple derivatives began in order to manage future risk in agricultural products and how they have mutated into Special Purpose Vehicles so that banks can take credit risk off of their books by repackaging the loans into various tranches and selling them into the SPV's who buy them by, often, exchanging government debt purchased on the open market and selling the tranches at various debt rating levels to investors who want or need to take on different kinds of risks for different levels of return. It is maybe a bit more quant orientated than I found helpful (no, even after trying, Mr. Das, I could not make the Black-Scholes model for valuing options make sense to me in terms of the math) but still a brilliant explanation. Taken together with Bookstaber's book, a very helpful read. I loved how Citron, the Orange County Treasurer, used astrological advice to decide which and how many inverse floaters to buy.

Finally, take a look at Taleb's book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. His views about how we know what we know and how we don't know what we don't know are fascinating reads. Basically, luck plays a much higher role in the success of your portfolio manager than does skill. I found it not an easy read because to fully appreciate it (and I am not sure I did) requires a real basic paradigm shift in the way you conceptualize knowledge and your own ability to judge risk and even the basic way in which you filter information in terms of decision making. A very thought provoking read.

So, there you have it, want to understand why the stock market tanked when the sub-prime and collateralized debt markets tanked? Read these books. I could tell you the answer, but it is way more fun to learn it by yourself.

And by the way, I spent about an hour and a half testing my knowledge on a friend who designs bespoke credit instruments for sale to investors in private tranasctions on the over the counter market. Several months ago, I had no real idea about what this person did for a living. Now, I had zero problems in having a detailed discussion about the issues.

You owe it to yourself to read these books, in the order I have listed them.

Posted by Random Penseur at August 30, 2007 08:09 AM | TrackBack