Thursday, March 18, 2010

Really Spicy Soup

In my previous post I tried to explain tranching via a soup analogy - you take the spicy soup and ladle it out unevenly so some get more spicy hot paste and some get less. This does leave a few questions unanswered.

Why the hell would I ever drink the bowl with all of the hot sauce?!?

The answer to that is: it's cheaper. If you and I were splitting the cost of take-out, maybe I pay for 2/3 of the soup and you pay for only 1/3rd. That's only fair, because you're going to take all the heat, so to speak.

Tranches are the same way - the tranches with an "unfair" share of the risk also return higher interest. you feel lucky, punk?

Tranching is just dividing up the hot sauce - how does this affect the system?

One of the effects of tranching is to bring players into the market who might not normally buy in.

Let's consider my mother. My mother will not eat spicy food. Her spice tolerance is really, really low. If we have her over for dinner, we're not going to buy the spicy beef soup, even though it is very tasty.

But wait -- if we just tranche it, we can buy the beef soup! All Lori and I need to do is not stir it up and serve the first bowl to ourselves, taking all of the hot paste to ourselves. The remaining soup is quite mild, and my mother, who normally would not be able to drink it (if it were evenly mixed) will be able to drink the remaining tasty broth. She'd probably like the beef ribs too.

If you are the Korean restaurant, this is a hell of a discovery - you can sell a lot more soup now, because you can sell soup to everyone, not just customers with a taste for spicy food.

There's just one hitch: you have to convince a few people to drink that first bowl, the hot bowl, the one with most of the spicy paste. I have had that bowl, and let me tell you, it's an experience!

Motivation to Lie

Now before I continue, I must be clear: the Westborough Korean restaurant has never lied or misrepresented the spiceyness of their food. They have never suggested that we not mix the soup, and they have never suggested that drinking the first bowl of unmixed soup would be a smart thing to do. Our discovery that the soup will "tranche" itself happened by accident, and this whole post is just a (badly stretched) analogy.

So if I can sell more soup by letting it settle (so the less spicy part is palitable to a wider audience), I might find that the limiting factor is finding people to drink the first bowl. Sure the first bowl might be cheaper, but how else can I sell it?
  • I could simply misrepresent how spicy it is. When someone asks me: "will I roll over and scream in pain if I chug the first bowl", I'll just answer "oh no - it's spicy but it's not that bad. You'll be fine." This isn't a very good idea - my customers might get angry at me for setting them up for pain, but that'll happen tomorrow, and I want to sell soup now.
  • I could agree to drink the first bowl myself if no one else wants it. This is a damn stupid thing to do because I might have to drink the soup, but again, I want to sell soup now.
That is pretty much what Wall Street did: they got the ratings agencies to represent the more dangerous tranches as "not that bad". In some cases, they agreed to buy the tranches back, or they kept them for themselves, a move that has caused them to lose a lot of money.

Those stupid could they be so dumb? Oh wait - they made bonus money when they sold the tranches. And...wait - we (the tax payers) are bailing the firms out now that they're in pain. Maybe we're the dumb ones.

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