Subprimes and such

[helene_t]

I suppose most home owners see their income go up and their mortgages being eroded by the inflation. Those who must sell their house with a loss will often bye a new house at a similar (lower) price. So the only ones who get into troubles are those whose income goes down and/or for some reason must move to a rented house.

[ArcLight]

>>The point is that who gains from this financial carnage? The rich and the banks. They know in advance where the ship is headed. They can get out of the way and secure their resources in time to avoid losing everything.

 

Merrill Lynch

Bear Stearns

Citicorp

Morgan Stanley

UBS

the various monoline insurers (FGIC, ACA, etc)

various large banks in Germany and the UK

CIBC (Canada)

Countrywide

 

They all made out like bandits :-)

 

Not!

[Gerben42]

People bought homes at prices that they won't be able to sell them for. That problem is probably not solvable.

 

That is not the problem. If you buy a house to live in it so you don't have to pay rent when it has been paid off, who cares what it's worth?

[joshs]

People bought homes at prices that they won't be able to sell them for. That problem is probably not solvable. Maybe wise action will keep prices from falling through the floor.

 

But what is wise action? Governments always promise more than they can deliver. Democrats like me can supply plenty of examples involving our current president, but in the interest of harmony let me recall (I think correctly) that it was Bill who promised that by 2000 American children would be number one in the world in science and mathematics. Most of us have a portion of our brain that keeps us from standing in front of large groups of people to say things that are patently false. Successful politicians have overcome that disability.

 

I like simplicity. Start with No more zero rate credit cards, no more ARMS, no more interest only mortgages and so on. The arrange it so that if a borrower defaults you can draw a pretty short line from the person who approved the loan to the person who lost the money. Song from West Side Story: Everything free in America / For a small fee in America. This line seems to describe at least part of the problem.

Ken,

 

I am not sure about your notion of simplicity.

For instance, if price's go up 2% and you earn 6%, you are really making only 4% in constant dollars, while if prices go up 8% and you make 6% you are losing money. All calculations should really be made in constant dollars (accounting for inflation).

 

In constant dollars, an ARM has the same interest rate every year (and thus is not risky) and a fixed loan is in fact quite risky.

 

What eliminates the risk for the fixed loan for the borrower (and adds significant risks for the lender) is a quirky asymmetry in the mortgage contract:

 

If the mortgage contract was I give you this amount of money and you give me this many payments of X amount, we would have a symmetric contract. In fact, the lender has prepayment risk:

 

Lets say I lend at 5% and 2 years later the rates are at 6%. Well then the lender is losing 1% on its money (in constant dollars) relative to the original contract.

 

On the flip side if I lend at 5% and 2 years later the rates are at 4% then it may appear that I am gaining 1% (hence symmetry) but in fact a lot of your customers refinance, so you only gain the 1% on a fraction of your loans.

 

Therefore, when borrowers have a right to prepay, a fixed rate mortgage will result in a loss if you charge the customer the prevailing market rate for capital. So what happens is that you have to charge more for a fixed loan OR eliminate the borrowers right to prepay. Hence there is necessarily a cost to eliminating the risk.

 

Most of the changes to mortgages in the last 25 years:

a. made them more appealing to investors (who did not want huge interest rate risk, and wanted to know when approximently they were getting there money back)

b. thus making more money available for people to buy homes

c. thus made mortgages cheapers and enabled a lot more people to own homes

 

Further, home ownership has always been one of the primary vehicles of capitalism:

Hernando de Soto, for instance, found that 75% of all companies were started with money borrowed against that person's home.

 

P.S. I highly recomend Hernando de Soto's book The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else

 

Having said all that, the industry certainly went too far and allowed too many people to own homes. So the situation has changed from:

Old: That evil bank didn't lend me any money because they said I couldn't afford it

(I have seen this scene in 100's of movies over the years )

New: That evil bank lent the guy money despite the fact that they couldn't afford to pay it back

 

I think both descriptions are silly. I personally like the modern attitude which is "lets set up a good risk management scheme to help allow us to make more loans." Its just a question of keeping everything in balance...

[jtfanclub]

There is tons of info on alternatives throughout the internet.

 

The point is that who gains from this financial carnage? The rich and the banks.

Actually, in the usual funny way, it's the banks that are getting killed. They made massive profits when the prices were going up, and now that they're taking a massive beating they expect to be 'rescued'.

 

Change the capital gains taxes so that loans being forgiven aren't considered a profit except under certain dastardly circumstances. Other than that, let it ride. Bankrupcy is designed to keep banks from being overly stupid. If banks let their clients go into bankrupcy, they'll lose money hand over fist. So, what should happen is that these deals get renegotiated so the banks get something and the clients keep the house. Unfortunately, since the mortgages got sold, and it's often unclear who even owns them any more, I think we'll just see a whole lot of bankrupcies instead.

 

For now, if necessary, I don't have a big problem with the government offering low interest loans to banks to keep them alive, with some pretty heavy conditionals to make sure they pay it back. Outside of that, they should leave it alone. One of the major issues is going to be that our banks are going to end up being owned by foreign companies, so far mostly Saudis and Chinese. Oh well.

[kenberg]

 

Most of the changes to mortgages in the last 25 years:

a. made them more appealing to investors (who did not want huge interest rate risk, and wanted to know when approximently they were getting there money back)

b. thus making more money available for people to buy homes

c. thus made mortgages cheaper and enabled a lot more people to own homes

I confess that this makes some sense to me. But, in practice, is this working as advertised?

 

Lenders and borrowers have their self-interests, I have mine, different from theirs but common, I think, to many. Namely, I don't want to see a collapse of the system. My mortgage is paid off, my kids have fixed rate mortgages that will be paid off in the not so distant future. So my personal stake here is let's not sink the ship.

 

Home ownership is good for the owners and good for the country. I favor it. Debt beyond what a person can handle is good for no one. I bought a townhouse in 1970. It cost around 28K but of course we have to scale this for inflation. What is important, or seems to me to be important, is that after I put up my 20% or so down payment I was left with a mortgage that was in the neighborhood of twice my annual salary. Banks expected something like that. As I built up equity and moved into a house I think the mortgage was maybe three times my annual salary. But banks didn't go much beyond that. Now it appears to me folks are, or were, getting mortgages with little or no down payment and in amounts that may be seven or eight or more times their salary and then they run up credit card debt that astounds me. Out with the old, in with the new, but I find it hard to believe that this is sustainable and, from what I am reading, we are about to find out that it isn't.

 

In a phrase, this risk that they are so fond of spreading around seems to be spreading to me and to all of us. I don't wish anyone ill but I also do not wish to be dragged down by their wild speculations.

 

 

I imagine the fact that people ran up debt they could not handle and banks made loans they should not have made is going to cost me some money. It's the breaks, I guess, but I don't like it.

[joshs]

 

Most of the changes to mortgages in the last 25 years:

a. made them more appealing to investors (who did not want huge interest rate risk, and wanted to know when approximently they were getting there money back)

b. thus making more money available for people to buy homes

c. thus made mortgages cheaper and enabled a lot more people to own homes

I confess that this makes some sense to me. But, in practice, is this working as advertised?

 

Lenders and borrowers have their self-interests, I have mine, different from theirs but common, I think, to many. Namely, I don't want to see a collapse of the system. My mortgage is paid off, my kids have fixed rate mortgages that will be paid off in the not so distant future. So my personal stake here is let's not sink the ship.

 

Home ownership is good for the owners and good for the country. I favor it. Debt beyond what a person can handle is good for no one. I bought a townhouse in 1970. It cost around 28K but of course we have to scale this for inflation. What is important, or seems to me to be important, is that after I put up my 20% or so down payment I was left with a mortgage that was in the neighborhood of twice my annual salary. Banks expected something like that. As I built up equity and moved into a house I think the mortgage was maybe three times my annual salary. But banks didn't go much beyond that. Now it appears to me folks are, or were, getting mortgages with little or no down payment and in amounts that may be seven or eight or more times their salary and then they run up credit card debt that astounds me. Out with the old, in with the new, but I find it hard to believe that this is sustainable and, from what I am reading, we are about to find out that it isn't.

 

In a phrase, this risk that they are so fond of spreading around seems to be spreading to me and to all of us. I don't wish anyone ill but I also do not wish to be dragged down by their wild speculations.

 

 

I imagine the fact that people ran up debt they could not handle and banks made loans they should not have made is going to cost me some money. It's the breaks, I guess, but I don't like it.

I doubt that anyone disagrees with you. But what has been going on recently is three things:

 

a. housing prices have skyrocketed in recent years (particularly on the coasts). The ratio of home price to rent rose around 40% this decade to its peak 2 years ago. This is of course unsustainable (this ratio should be in equilibrium long term) but created a bubble effect:

a1. some people saw prices going up and "speculated" hoping to make a profit

a2. others saw prices going up, were afraid that they were going to be priced out of the market if it kept going up, so they bought even though they really could not afford the homes (its just they felt they really really could not affod it in a year or two)

 

these behaviors kept price demand from reaching a natural equilibrium and let prices way overshoot there intrinsic value.

 

b. While home ownership is clearly a good thing, too many people got lent money who couldn't really afford it. There is lots of blame to be spread around. Lets suffice it to say when there are many people involved in any enterprise, there interests will not be completely aligned, so borrowers, brokers, appraisers, loan originators, investors, mortgage servicers etc all have different interests... as does the president of any company and the folks who work for it, so the worker bees may want to sell mortgages that are not really in the company's best interest to sell.

 

c. after the housing market began to soften, and mortgage defaults began to rise, there was an over-reaction in the investment community, which pulled a lot of money out of the mortgage market and made conditions even worse (its for isntance much harder to get a jumbo loan now, and the rates have gone up even for people with perfect credit).

[joshs]

I that's true isn't it wort it to lose your house and buy it on the auction?

Gerben mentioned the mayor reason.

 

And depending on the laws, the bank will

get the house and sell it, but this does not

mean (!), that you got rid of your complete

loan, at least in Germany you still owe the

bank the missing money, ...

unless you declare your self bancrupt, which

requires that you make your finnacial situation

public, and you are under surveilance for a

couple of years.

 

With kind regards

Marlowe

 

PS: And of course you may not get your house

back at a cheap price.

Afterall an auction is open to all.

It doesn't work this way in the US.

 

There are two types of foreclosures: Judicial and Non-Judicial.

 

A Non-Judicial foreclosure is used in 99% of the cases. The property is put on the auction block and the bank can bid up to the value of its loan + costs. It is a relatively quick process - 4-5 months, but the bank can't go back after the borrower for any shortage. The property is the only security for the loan, the bank can't go back and get a 'default judgment'. If after the property sells and the bank still hasn't collected its loan, its SOL.

 

Rarely, the bank will have a huge shortfall, and the borrower will have a significant financial statement where it pays to go back and get a judgment for the balance. This assumes the loan documents allow it, and the borrower has something to go after. It is also a much slower process, since the 'judicial' foreclosure doesn't get any priority on the court calendar, so it can take 18 months or so.

Actually there are two distinctions:

Judicial vs Non-Judicial Forclosures is one

The other is Recourse vs Non-Recourse loans

You sort have combined the two into one idea

 

The standard mortgage contract is a recourse contract. That is you have borrowed $X and have agreed to pay this money back. If you do not, the bank lays claim (holding a lien) to your property and sells it. Giving them your property does not eliminate there claim for $X. If you borrow 200K, and they foreclose, and sell the property for 150K you can still sue for a definciency settlement for the other 50K.

 

Now having said that, this doesn't happen much for two reasons:

1. Most of the western states (including CA) passed laws back in the depression against definciency claims on home mortgages. These laws effectively convert to mortgage contract from a Recourse to a Non-Recourse loans. Note though that these laws really are mostly in the western US.

2. Most people who default don't have any money, so its a waste of time and money (legal costs) to go after them....

 

 

For Judicial vs Non-Judicial see:

http://www.all-foreclosure.com/judicial.htm

 

Its really mostly about the forclosure process (and property auction process) and disposition of the property and not about the debt.

BTW, if you look at:

http://www.all-foreclosure.com/procedures.htm

 

It will tell you in which states its possible to get deficiency judgements.

[helene_t]

Home ownership is good for the owners and good for the country.

Why? I can see that home ownership gives owners motivation to invest money and effort in the local community, to avoid damaging the local natural environment etc. in order to support their investment. That's a good thing.

 

But home ownership also makes risk-averse people invest the bulk of their savings in a single property, and it open up for do-it-yourself work which cannot be taxed effectively. Even if capital invested in a home was taxed at the same level as capital invested in bonds or shares, renters would still pay more taxes than owners because the maintenance of a rented house is done by VAT and tax paying contractors rather than by the residents.

[Winstonm]

Out with the old, in with the new, but I find it hard to believe that this is sustainable and, from what I am reading, we are about to find out that it isn't.

 

Ken, you are way, way, w-a-y behind the curve on this news - about 1 1/2 years.

We've already discovered it's not sustainable - now the only question left is how much damage will be done.

[kenberg]

Out with the old, in with the new, but I find it hard to believe that this is sustainable and, from what I am reading, we are about to find out that it isn't.

 

Ken, you are way, way, w-a-y behind the curve on this news - about 1 1/2 years.

We've already discovered it's not sustainable - now the only question left is how much damage will be done.

Behind the curve? So I've been told. You avoid being beaned that way.

[pdmunro]

Below are some quotes from an article from WSJ.com as it appeared in our national paper, The Australian

http://www.theaustralian.news.com.au/story...from=public_rss   If anyone can put it into plain english, it would be appreciated.

 

How Wall Street wizards conjured up sub-prime's hurricane Norma

Carrick Mollenkamp and Serena Ng | December 29, 2007

 

IN recent years, as home prices and mortgage lending boomed, bankers found ever-more-clever ways to repackage trillions of dollars in loans, selling them off in slivers to investors around the world. Financiers and regulators figured all the activity would disperse risk, and maybe even make markets safer and stronger.

 

Then along came Norma.

 

Norma CDO I Ltd, as its full name goes, is one of a new breed of mortgage investments created in the waning days of the US housing boom. Instead of spreading the risk of a global home finance boom, the instruments have magnified and concentrated the effects of the sub-prime mortgage bust. They are now behind tens of billions of dollars of writedowns at some of the world's largest banks, including the $US9.4 billion ($10.7 billion) announced last week by Morgan Stanley.

...

Only nine months after selling $US1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk. The concept behind Norma, known as a collateralised debt obligation, has been in use since the 1980s. A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

....

In principle, credit default swaps help banks and other investors pass along risks they don't want to keep. But in the case of sub-prime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds. UBS Investment Research, a unit of Swiss bank UBS AG, estimates that CDOs sold credit protection on roughly three times the actual face value of sub-prime bonds rated triple-B.

 

The use of derivatives "multiplied the risk," says Greg Medcraft, an Australian who is chairman of the American Securitisation Forum, an industry association. "The sub-prime mortgage crisis is far greater in terms of potential losses than anyone expected because it's not just physical loans that are defaulting."

 

....

 

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, (What does this mean?) according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

 

Critics say the cross-selling reached such proportions that it artificially propped up the prices of CDOs. Rather than widely dispersing exposure to these mortgages, the practice circulated the same risk among a relatively small number of players.

[kenberg]

Thank you greatly for bringing this to my attention. I am going on vacation Thursday but I shall try to digest it.

[hrothgar]

Below are some quotes from an article from WSJ.com as it appeared in our national paper, The Australian

http://www.theaustralian.news.com.au/story...from=public_rss   If anyone can put it into plain english, it would be appreciated.

 

How Wall Street wizards conjured up sub-prime's hurricane Norma

Carrick Mollenkamp and Serena Ng | December 29, 2007

 

In recent years, as home prices and mortgage lending boomed, bankers found ever-more-clever ways to repackage trillions of dollars in loans, selling them off in slivers to investors around the world. Financiers and regulators figured all the activity would disperse risk, and maybe even make markets safer and stronger.

 

Then along came Norma.

 

Norma CDO I Ltd, as its full name goes, is one of a new breed of mortgage investments created in the waning days of the US housing boom. Instead of spreading the risk of a global home finance boom, the instruments have magnified and concentrated the effects of the sub-prime mortgage bust. They are now behind tens of billions of dollars of writedowns at some of the world's largest banks, including the $US9.4 billion ($10.7 billion) announced last week by Morgan Stanley.

...

Only nine months after selling $US1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk. The concept behind Norma, known as a collateralised debt obligation, has been in use since the 1980s. A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

....

In principle, credit default swaps help banks and other investors pass along risks they don't want to keep. But in the case of sub-prime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds. UBS Investment Research, a unit of Swiss bank UBS AG, estimates that CDOs sold credit protection on roughly three times the actual face value of sub-prime bonds rated triple-B.

 

The use of derivatives "multiplied the risk," says Greg Medcraft, an Australian who is chairman of the American Securitisation Forum, an industry association. "The sub-prime mortgage crisis is far greater in terms of potential losses than anyone expected because it's not just physical loans that are defaulting."

 

....

 

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, (What does this mean?) according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

 

Critics say the cross-selling reached such proportions that it artificially propped up the prices of CDOs. Rather than widely dispersing exposure to these mortgages, the practice circulated the same risk among a relatively small number of players.

I suspect that Josh Sher is in a much better position to discuss this than me, but I'm on the East Coast, he's on the West so I might as well see what I can explain while he catches some Zs...

 

A Collateralized Debt Obligation is a financial instrument that is used to repackage risk.

 

Lets assume that I have a large number of risky assets - hypothetically, this might be a pool of 1,000 mortgages. An individual mortgage is risky. There is a certain chance that the borrower will default on his loan. In turn, this means that the mortgage issuer loses all of the downstream payments that they expect to collect and are stuck with a property of some kind which they aren't really in a good position to use.

 

In many cases, a pool of mortgages is less risky than a single mortgage. If we are lucky enough to be able to assume that the chance of foreclosure on individual mortgages are independent events then statistical averaging will decrease our variance. However, if there is systemic risk - a major economic downturn or some such - this assumption of independence might be unwarranted. Its possible that we might see significant positive correlation between the foreclosure chances of different individual mortgages. (This is all banking / insurance 101)

 

Enter the CDO: CDOs are used to repackage risk by creating a rules set governing the distribution of mortgage payments. For example, I might decide that I am going to divide the mortgage payments into three distinct tranches that are distinguished by the order in which they get payed.

 

The Senior Tranche will receive preferred treatment. All mortgage payments will be used to fund the Senior tranche up until the point that they have received all the money that is due them. At this point in time, the fund stream is turned to fulfilling obligations to the Mezzanine tranche. Anything left over gets used to pay off the Equity tranche.

 

Hopefully its clear that investing in the Equity tranche is much riskier than investing in the Senior tranche. Accordingly, the Senior tranche does not provide as high a rate of return as the Equity tranche.

 

CDOs are neat stuff. If used properly the significantly increase the efficiency of the market.

 

With this said and done, CDOs aren't without risk. As I noted earlier, a pool of investments doesn't necessarily offer much protection if there is significant systemic risk built into the system. Creating a new CDO whose payoff is based on the income stream produced by other CDOs can be viewed as a mechanism to compensate for systemic risk. Lets assume that I created a three tier CDOs based on the payment streams generated by a set of Senior tranches from mortgage backed CDOs. I am simultaneously increasing the size of the underlying mortgage pool while also creating a new risk tiers.

 

There a couple issues with this type of approach:

 

1. Wall Street charges fees to create CDOs. Each time you add a new CDO into the system, more of the returns get siphoned off into management fees. I'd argue that one of the main issues with daisy chaining CDOs isn't undue concentration of risk, but rather the management fee structures.

 

2. Let's assume that assume that I have set of 1 million mortgages. I use this to create 100 CDOs with three different tranches. I then create three new CDOs (each with three tranches). Think carefully about the following asset: I am going to create an asset which defined as an Equity level tranche of a set of 100 equity level tranche each based on a pool 10,000 mortgages. This is an extremely risky asset. (As much risk as possible has been shoved into this one tranche). In order for the system to work, you need to find someone who is willing to buy the "Toxic Waste"

[kenberg]

Thanks, Bro. It helps, but I'm still working on it. While I am trying to digest this very sophisticated analysis would you care to comment on my very unsophisticated thought that at least part of the cause is this very complexity coupled with a diffusion of responsibility? We (we=those reading this) all know enough not to send money to some guy in Nigeria so that he can get his gold out of the country and split it with us. But people do fall for it. Here you say it is necessary to get someone to invest in the Toxic Waste portion of the debt. Who would? Well, there's a sucker born every minute and the population has increased considerable since Barnum made that observation. So there was this long chain. Loan officer approves loan. Everybody is happy. Bank sells off loan to folks who will create CDOs. Everybody happy. Investors buy CDOs. Why not? Sounds good. etc.

 

A question: Would it have helped to have required more comprehensive information available to investors? One of the more scary things in the article above is that some folks who are in the business were, or say they were, surprised by the speed and severity of what happened.

 

I moved two years ago. After I bought my new house I had to sell the other, and I insisted with the realtor that we find a price where it would move fairly quickly (it did). I could live without getting the top price but I was sure a crash in housing prices was coming and I did not want to own two houses in a falling market.

[hrothgar]

Thanks, Bro. It helps, but I'm still working on it. While I am trying to digest this very sophisticated analysis would you care to comment on my very unsophisticated thought that at least part of the cause is this very complexity coupled with a diffusion of responsibility? We (we=those reading this) all know enough not to send money to some guy in Nigeria so that he can get his gold out of the country and split it with us. But people do fall for it. Here you say it is necessary to get someone to invest in the Toxic Waste portion of the debt. Who would? Well, there's a sucker born every minute and the population has increased considerable since Barnum made that observation. So there was this long chain. Loan officer approves loan. Everybody is happy. Bank sells off loan to folks who will create CDOs. Everybody happy. Investors buy CDOs. Why not? Sounds good. etc.

 

A question: Would it have helped to have required more comprehensive information available to investors? One of the more scary things in the article above is that some folks who are in the business were, or say they were, surprised by the speed and severity of what happened.

 

I moved two years ago. After I bought my new house I had to sell the other, and I insisted with the realtor that we find a price where it would move fairly quickly (it did). I could live without getting the top price but I was sure a crash in housing prices was coming and I did not want to own two houses in a falling market.

There's a number of ways that one can sell "Toxic Waste".

 

The simple way is to price it attractively. There is always a chance that the toxic waste will yield some positive returns... Indeed, if you are living in a housing bubble where no one ends up foreclosing, toxic waste can be a very attractive investment vehicle.

 

Moreover, you can collateralize losses. Sometimes companies want losses for tax purposes...

 

My impression is that root of the crisis is not with the concept of CDOs per se, but rather with

 

1. The credit rating agencies - Moody's investment Services and the like - which did not do a very good job evaluating credit worthiness of the Mezzanine tranches of the CDOs.

 

2. High degrees of correlation in mortage returns

 

3. A number of the players seem to have been using derivatives as speculative vehicles rather than hedges.

[mike777]

Richard's 3 point summary is excellent.

 

One could break it down in more detail but I would rather combine all three points into one. Call it the superportfolio. A large unstable structure of partially overlapping arbitrage posititions.

 

An event, less than cataclysmic, causes the superportfolio to begin to unravel. In other words spreads widen or call it implied volitility increases in an increasingly illiquid market forcing further sales.

[Winstonm]

Concerning the credit rating agencies, there were a number of problems - one of these being conflict of interest where the agencies themselves who rated these CDOs also helped create them - for an enhanced fee.

 

The second problem was the computer models they used. From an article from Mish Shedlock:

 

What follows are excerpts from Absence of Fear, an excellent article written by Robert L. Rodriguez at First Pacific Advisors.

 

 

We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions.

 

FPA: “What are the key drivers of your rating model?”

Fitch: They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years.

 

FPA: “What if HPA was flat for an extended period of time?”

Fitch: They responded that their model would start to break down.

 

FPA: “What if HPA were to decline 1% to 2% for an extended period of time?”

Fitch: They responded that their models would break down completely.

 

FPA: “With 2% depreciation, how far up the rating’s scale would it harm?”

Fitch: They responded that it might go as high as the AA or AAA tranches.

 

Might as well call this Ponzi Ratings, as the model was based on an neverending upward price movement of housing.

 

As this shows, the main driver behind the problem not only of foreclosures but also of the financial losses is the reduction of value of the underlying collateral. When the leverage is high, it takes very little adverse movement of prices to cause large losses to occur.

[Winstonm]

Richard's 3 point summary is excellent.

 

One could break it down in more detail but I would rather combine all three points into one. Call it the superportfolio. A large unstable structure of partially overlapping arbitrage posititions.

 

An event, less than catclysmic, causes the superportfolio to begin to unravel. In other words spreads widen or call it implied volitility increases in an increasingly illiquid market forcing further sales.

Well said, Mike, and I might only add that opacity (clearly?) added to the increase in spreads and risk aversion that began the unwind of the portfolio.

[Winstonm]

Ken,

 

To add another point, it is my opinion that deregulation was the main culprit behind this fiasco. A gentlement named Robert Kuttner testified before the House Financial Services Committee describing this phenomenon. Although it is only one man's opinion, I believe he articulates the problem well, and I happen to concur with his views.

 

Here is a link: http://www.prospect.org/cs/articles?articl...n_1929_and_2007

[mike777]

Ken,

 

To add another point, it is my opinion that deregulation was the main culprit behind this fiasco.  A gentlement named Robert Kuttner testified before the House Financial Services Committee describing this phenomenon.  Although it is only one man's opinion, I believe he articulates the problem well, and I happen to concur with his views.

 

Here is a link: http://www.prospect.org/cs/articles?articl...n_1929_and_2007

I did not find this article as helpful as you.

 

 

The whole question of just what is a bubble and if such a thing exists and the underlying causes is a huge unknown question. Let's start with a simple question.

What is a bubble, do they even exist, and why should we care? I do not know.

 

As for his other comments:

TOO much leverage, what does this mean?

TOO little regulation, what does this mean?

 

 

I only guess at this but it seems he would define 100% of the institutions as too leveraged and too unregulated.

[Al_U_Card]

Au contraire. Well presented, clear and concise. As a layman with a modicum of personal finance savvy, these items that directly influence my well-being lead to confusion and mistrust.

 

We don't have to take a step backwards....we just have to avoid stepping off the .

 

.

 

.

 

.

 

.

 

cliff. ;)

[Winstonm]

Mike,

 

Sorry you did not find the article of value, but for me, this quote...

 

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy.

 

...fairly well sums up the securitization markets and how they worked. When the prices of housing doubles in a few years, it is fair to wonder if "bubble" is a correct term, but asset appreciation certainly occured - and now it appears that the appreciation was exorbitant, as home prices are falling. There is no doubt that bankers became intermediaries who simply sold packaged loans for a fee - hence the comparison between now and 1929.

 

I also thought he made it clear with this...

 

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way.

 

....the type of deregulation of which he was speaking.

 

And I don't think he said excessive leverage, but pretty well spelled out his meaning with this...

 

Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money.

 

....again, simply comparing the leveraged risk to the attitudes that prevailed in 1929.

 

But I thought his best point was that you can't have it both ways - non-regulation during the boom times and government and Federal Reserve bailouts during the busts. You either have free markets and live with the consequences or you have regulations - no cake and eat it, too.

[mike777]

Mike,

 

Sorry you did not find the article of value, but for me, this quote...

 

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy.

 

...fairly well sums up the securitization markets and how they worked. When the prices of housing doubles in a few years, it is fair to wonder if "bubble" is a correct term, but asset appreciation certainly occured - and now it appears that the appreciation was exorbitant, as home prices are falling. There is no doubt that bankers became intermediaries who simply sold packaged loans for a fee - hence the comparison between now and 1929.

 

I also thought he made it clear with this...

 

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way.

 

....the type of deregulation of which he was speaking.

 

And I don't think he said excessive leverage, but pretty well spelled out his meaning with this...

 

Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money.

 

....again, simply comparing the leveraged risk to the attitudes that prevailed in 1929.

 

But I thought his best point was that you can't have it both ways - non-regulation during the boom times and government and Federal Reserve bailouts during the busts. You either have free markets and live with the consequences or you have regulations - no cake and eat it, too.

No no no. I go back to my post and the questions I asked.

[mike777]

1) What is an asset bubble...do they even exist and why should we care? He keeps talking about asset bubbles, whatever they are, but does not say what they are, dutch tulips, maybe no, and why we should care compared to all the other worries.

 

I am not saying people do not claim there are asset bubbles and that they are bad/evil...but saying so means nothing.

2) What is too much leverage?

3) what is too little regulation?

 

If you give me vague answers to these questions you get vague results. :)