I, Super-Senior CDO Tranche?
By Arnold Kling
We know Leonard Read’s famous “I, Pencil” essay, where he says that nobody knows how to make a pencil. Somehow, the market arranges it so that wood, graphite, dyes, cutting tools, and other inputs come together to make a pencil.
It feels very good to say, “Nobody knows how to make a pencil.” Now, say, “Nobody knows how to make a super-senior tranche of a mortgage-backed security.” Does it feel good? Or does it feel like there is a swindle in there, somewhere?
I don’t mind that the folks who manufacture dyes that are used on the outside of pencils know nothing at all about graphite. But somehow I mind that the folks creating complex mortgage-backed securities know nothing at all about what goes on in putting together the loans. Why is that?
1. Maybe it’s my problem. Maybe finance is no different from pencil-making, and I’m just being neurotic about it.
2. Maybe the financial process is more tightly integrated. The various steps are more highly interdependent, so it’s harder to partition knowledge safely.
3. Maybe the financial process is more prone to catastrophic sorts of failures. If somebody makes a mistake somewhere along the line in the pencil-production process, then the error is bound to be caught before anything really terrible happens. In the financial process, errors can be disguised by good luck or misleading accounting, until it finally catches up with you.