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Steve Hsu: "How do illiquid securities get priced? Ultimately, it's competition between FEAR and GREED. At the moment FEAR is winning -- there are serious mispricings in corporate and municipal bond markets due to gigantic risk premia and a flight to security. Mortgage securities won't bottom out until GREEDY capital (controlled by investors willing to take a risk today in hopes of future profits) is sufficient. The problem is that price recovery can't take place until market confidence returns and, additionally, the ultimate value of mortgage securities depends on future projections about the bursting housing bubble, default rates, overall macro trends, etc. It could take a long time for markets to clear, with the Fed (taxpayers!) acting as the buyer of last resort in the interim."
Michael Lewis: Inside Wall Street's Black Hole
[create John Seo], cited: "The model created markets."
"That many of these people literally live inside the investment that they've speculated on sharpens the pain but fails to drive home the point. Financial panics have become almost commonplace; events that are meant to occur once in a millennium now seem to occur every few years. Could this be because the financial system was built on an idea that badly underestimates the risk of catastrophes--and so conspires with human nature to create them?"
Putting the blame squarely on Black-Scholes' shoulders sure makes for a tighter story; whether it makes for a truer, however, that's a different question. Peruse the (recommended) comments. Excerpt:
"VAR modeling and "normal distributions" parted company forever in 1998. Only complacency and greed have driven the recent pricing fiascos, which are nothing even vaguely new. There is a key variable that must be fit into all such derivative pricing schemes: Trader and Executive Compensation. If they are rewarded for building models that misprice inventory, and get paid in cash, the models will misprice inventory."
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