Subprimes and such

[mike777]

I am not sure but WinstonM are you trying to get the police to arrest people and throw them in prison who:

1) buy overpriced stuff they should not?

2) lend money to risky people they should not?

 

Or what are you saying?

[pdmunro]

I came across an article titled Investment Landfill: How professionals dump their toxic waste on you.

It explains the subprime crisis in plain English.

http://goldnews.bullionvault.com/files/Inv...nt_Landfill.pdf

http://goldnews.bullionvault.com/user/paul_tustain (Click 30 Jun '07 — Investment landfill)

 

Here is my attempt to summarize the article.

 

The task:

 

Combine a number of risky mortgages into one collateralized debt obligation (CDO).

Now find a way to sell it.

 

The solution:

 

1) Point out that house prices are rising and so mortgagees are making their monthly payments. Use the money obtained to lend more easy money, then bundle those mortgages into a CDO, and onsell. Keep repeating. With easy money available, house prices will keep rising, people won't default on their payments (they will want to keep an asset that is going up in value), and investors will keep buying CDO's. This is the strategy that investment banks and their hedge funds have marketed to the retail banks.

 

2) Tired of trying to sell the riskier investments? Then keep the CDO and its cash stream but take out an insurance policy. This insurance policy is called a credit default swap (CDS). The underwriter of the CDS gets a big return at the cost of having to pay up if the mortgagee defaults on his loan.

 

Interestingly when a number of CDS's are combined, they are called "synthetic CDO's" which better reflects their origin.

 

3) Parallel to the growth of the subprime market has been the growth of a derivatives market where bets are laid as to when the whole process is going to fall over.

 

Governments have shored up the subprime market. After the dot-com "boom and bust", legislation was introduced which forced funds to buy investment-grade bonds. And with house prices rising, the CDO's and CDS's were made to look like suitable investment-grade bonds. So retirement funds have invested in them.

[hrothgar]

I came across an article titled Investment Landfill: How professionals dump their toxic waste on you.

It explains the subprime crisis in plain English.

http://goldnews.bullionvault.com/files/Inv...nt_Landfill.pdf

http://goldnews.bullionvault.com/user/paul_tustain (Click 30 Jun '07 — Investment landfill)

Not sure if I'd take my economics advice from individuals who have a strong vested interest in selling bullion.

 

They tend to spin things in a completely ridiculous manner.

[kenberg]

There have been a number of interesting thoughts here. I'm going on vacation Thursday so I won't be following it to closely for a while.

 

My wife and I have one of these cross-cultural marriages. She grew up in SF not far from Haight-Asbury and I grew up in Minnesota. I was shocked to discover that while she had seen live, and early, performances by Janis Joplin and the Jefferson Airplane she has never driven a car on a frozen lake. We are off to northern Minnesota to correct this gap in her upbringing.

 

Anyway, I'll try to look in on new posts. I think they have heard of the Internet up there.

[Winstonm]

I am not sure but WinstonM are you trying to get the police to arrest people and throw them in prison who:

1) buy overpriced stuff they should not?

2) lend money to  risky people they should not?

 

Or what are you saying?

Your obfuscation is typically better than this, so I will answer in kind.

 

If you let unsupervised kids play with matches, don't be surprised when the house burns down - and when it happens, don't expect the government to buy you a new house.

[Winstonm]

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

 

Maybe this from the San Francisco Federal Reserve will help:

 

 

In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a nonfundamental bubble component that may reflect price speculation or irrational investor euphoria or depression. The expansion of an asset price bubble may lead to a debilitating misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy.

 

I underline "irrational investor euphoria" as to me this is the base cause of excess in asset overvaluation, and not even the brightest among us is exempt from its affect.

 

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months."

- Irving Fisher, Ph.D. in economics, Oct. 17, 1929

[jtfanclub]

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.

Asset bubbles.

 

Let's suppose that you decide to buy an asset you've heard good things about. Lots of other people think that the asset sounds good too, and bid against you. The price goes up. As more people get interested, the price goes higher, not because of anything about the asset, but because more people are bidding on it. Pretty soon, people are speculating not on the asset, but on the excitement about the asset...as long as people stay excited about it, the price will continue to increase. Eventually, people will lose interest and the asset's value will drop to its actual value. The difference between the actual value and the price increase caused by people bidding up the asset is the bubble.

 

Usually, bubble give a false impression not just of the asset, but of the economy in general. You by an asset for a dollar. I buy it for two dollars. You buy it back from me for three dollars. I buy it back from you for four dollars, and so forth.On paper, it looks like we've made enormous profits, and one of holds a very valuable asset. In reality, nothing's really changed. But it sure looks good on paper.

 

Take the value of land in Tokyo, which at one point if I recall correctly was greater than the value of land in all of the United States. A few square feet might be worth millions of dollars. But the only people who bought and sold these were a few Japanese banks, who inflated the price when buying and selling to each other to make the prices seem gigantic. In fact, nobody outside of these banks were willing to buy this land for thousands of dollars per square foot, let alone millions. But because the banks didn't try to sell it to the public, the "market value" wasn't corrected.

 

Why did they do this? Well, it made the banks look very strong, with lots of assets, and plenty of collateral to cover bad loans. It also meant they could borrow fantastic amounts of money, enough to simply buy the World Trade Center and numerous other landmarks.

 

Unfortunately, as usual with loans, some went bad. And when some banks couldn't repay, their assets were seized, and they were forced to sell this amazingly valuable land. Which nobody wanted to buy at these insane prices. So the "market value" of the land plunged, which meant that all of the other banks suddenly didn't have any collateral to cover their loans, which meant either that they went under or they stopped giving out more loans. Net result- the Japanese economy crashed, and took over 15 years to recover.

 

Should the "I'll pay $1 billion dollars for your worthless land if you'll pay $1 billion for my worthless land" bankers be punished? Did they even break the law? I don't know.

 

In our case, real estate agents and banks were deliberately inflating real estate prices, by assessing houses much higher than they were actually worth and giving out loans to people who couldn't possibly pay them back. I don't think the result is going to be Stock Market 1929, in part because the global stock market had crashed about 1925 so nobody could buy up the discount stocks back then, while now the Saudis and Chinese (and others) will happily gobble up the cheap stuff once the markets stabilize a little. This looks to me more like Japan 1990. Serious financial 'malaise' but not a depression for the next decade or so.

[Winstonm]

2) What is too much leverage?

 

Leverage to the degree that it requires government bailouts if losses are incured. This is usually not caused by the degree of leverage, per se, but by the model used to establish the positions.

 

 

3) what is too little regulation?

 

Regulation that facillitates opacity instead of full disclosure, which would also include current GAAP that, for example, allows banks to count negative amortization of option-pay ARMs as earnings.

[Winstonm]

This looks to me more like Japan 1990.

 

It is an almost exact replica, including overpriced, overleveraged commercial real estate, undercapitalized banks, and reluctance of banks to assume losses.

[Al_U_Card]

Which means that the Dow will see under 10K again.....right? (Japan's SI having sunk almost 50%)

[mike777]

"....underline "irrational investor euphoria" as to me this is the base cause of excess in asset overvaluation, and not even the brightest among us is exempt from its affect....."

 

 

 

Again you guys want to regulate asset bubbles, assuming they exist, which is a big if. You want to regulate irrational investor euphoria?

 

 

Banks and financial institutions are already choking with regulation. They do not understand these vague rules as it is. This is nothing new. :) They all have legions of lawyers but it is still the blind leading the blind. This is nothing new.

 

I am not saying have zero regulation but you guys want even more. More regulation to stop, asset bubbles or too much leverage.

 

 

Let us go back to square one of the issue. The subprime mess. What is this?

 

As I understand it, hundreds of billions if not trillions of bucks, euros and other monies were lent to non prime borrowers. Who did the lending? People and instititutions from around the world who are the experts, the superexperts in the business. The very top banks and credit instituitions in the world.

 

Now hundreds of billions of these loans are being written off as worthless or worth alot less since they will not be repaid.

[hrothgar]

As I understand it, hundreds of billions if not trillions of bucks, euros and other monies were lent to non prime borrowers. Who did the lending? People and instititutions from around the world who are the experts, the superexperts in the business. The very top banks and credit instituitions in the world.

 

Now hundreds of billions of these loans are being written off as worthless or worth alot less since they will not be repaid.

From my perspective, there are two distinct issues that need to be considered here:

 

Issue 1 involves entities that invested in financial instruments whose value ultimately depended on packaged mortgages. Please recall that the upper level tranches of the CDOs were rated very highly by firms like Moody's and the like. Many of these CDOs (undeservedly) had AA or AAA rating. Accordingly, you had a number of fund managers who were supposed to be maintaining fairly conservative investment profiles got severely burned when the market went belly up.

 

There are a number of pension funds as well as state and local investment funds that have been severely burned by this whole situation. The Florida Local Government Investment Pool is getting a lot of coverage right now. For anyone who isn't aware, the investment pool placed a heavy bet on structured instruments backed by mortgages. The value of these assets collapsed, leading to a run on the investment pool. The pool has now suspended payments and a number of local communities have had a lot of their operating funds frozen. This has been covered in a number of places such as

 

http://www.cfo.com/article.cfm/10272724/c_10273009

 

What makes this really ugly is that there are some communities that contributed funds AFTER the melt down who have also had their assets frozen.

 

I expect to see similar stories emerging in a number of other states.

 

Personally I'm not sure how much sympathy I have for groups that hired poor fund managers. (I don't find any of this particularly surprising and folks should have learned something from Orange County) Even so, I wouldn't be surprised to see a bunch of lawsuits in the months ahead

 

Issue two involves lawsuits over predatory lending. My impression is that there were a number of abusive practices being perpetrated.

[mike777]

".....Issue two involves lawsuits over predatory lending. My impression is that there were a number of abusive practices being perpetrated."

 

 

Full disclosure, I and my immediate and extended family basically make our living

because these laws and regulations exist in the first place. When I hear the words, more regulation or better regulation or lawsuits, I think BONUS! :)

 

 

This sounds as if the current laws or regulations that already exist are not being properly followed. Not being followed by inst. that have legions of lawyers/compliance people hired to do nothing but know this stuff and enforce it.

 

I may have told this story before. I once interviewed to work for the SEC in Calif.

Boss after boss basically told me what they do.

They go around and find (audit) financial companies in noncomplaince. Year after year do they ever find even one company in full complaince? NO! Not even close.

 

Job security.

[Winstonm]

Let us go back to square one of the issue. The subprime mess. What is this?

 

It is an issue of insolvency - an inability to service debt with a corresponding inability to sell the asset at an amount that covers that debt.

 

But it is not only a subprime mess - it is a debt mess that extends into commercial real estate, credit cards, auto loans, as well as housing.

[Winstonm]

Richard,

 

Another compelling issue is the problem now facing the bond insurers like MBIA and ACA - there are billions of dollars of municipal bonds insured by these institutions whose own solvency is now being questioned.

 

ACA has already been downgraded and MBIA is on downgrade watch. As the bonds insured by these companies carry the same rating as the insurer, a downgrade below investment grade will cause a forced sale of these municipal bonds - which have historically been thought only a step below the safety of U.S. treasuries.

 

There is genuine systemic risk underlying this whole ordeal, and few seem to be aware of its existence.

[mike777]

Let us go back to square one of the issue. The subprime mess. What is this?

 

It is an issue of insolvency - an inability to service debt with a corresponding inability to sell the asset at an amount that covers that debt.

 

But it is not only a subprime mess - it is a debt mess that extends into commercial real estate, credit cards, auto loans, as well as housing.

Lets go back to before square one. :)

 

 

As I understand it, my local bank borrows one dollar from me when I put it into my checking account. (liability)

They then loan out ten dollars, yes ten, in long term loans based on my lonely one buck. (assets!)

Yes I am suggesting banks create money/assets.

 

Now I spend my one dollar in my checking account. In fact I sometimes overdraw my checking account. :) No problem so far.

 

Some people do not repay their loans.

 

 

You seem to think this whole system somehow may create a mess? I am shocked!

[Winstonm]

Let's go one step futher.

 

A customer deposits $100 into a bank checking account. The bank then deposits $10 with the Federal Reserve banks - the reserves - and can lend out 10X$90 or $900 dollars.

 

But instead of simply loaning $900, the bank takes that $900 loan and adds a bunch of other loans, packages them into bundles and sells the entired package of loans to a Wall Street bank for the cost of the loans + a fee. Now the bank has no liabilities against its $90 in assets, and is thus in a position to do the entire process all over again. (Yes, I am saying that securitization has effectively bypassed fractional reserve requirements.)

 

Meanwhile, the Wall Street bank takes the Residential Mortgage Backed Security it bought from the bank along with others it bought from other banks, takes out the riskiest part, the mezzanine tranches, and bundles all these mezzanine tranches into a whole new security, sliced into tranches based on which tranch gets paid first, and shows Moodys or S&P or Fitch this neat product that they in turn give their blessing to by rating this repackaged crap as AA because of faulty computer models that say that housing collateral value always goes up and never falls.

 

So now with their new AA rating on this boatload of *****, the Wall Street hucksters sell this Trojan Horse to investment firms all over the world.

 

Eventually, the crap loans and the golden loans are so comingled that no one has a clue where the good loans or the bad loans are, who holds risk and who doesn't, who can pay back the default insurance bought and who can't, and so everyone simply stops playing the game.

 

How can this simple concept ever cause a problem?

[mike777]

Let's go one step futher.

 

A customer deposits $100 into a bank checking account.  The bank then deposits $10 with the Federal Reserve banks - the reserves - and can lend out 10X$90 or $900 dollars. 

 

But instead of simply loaning $900, the bank takes that $900 loan and adds a bunch of other loans, packages them into bundles and sells the entired package of loans to a Wall Street bank for the cost of the loans + a fee.  Now the bank has no liabilities against its $90 in assets, and is thus in a position to do the entire process all over again. (Yes, I am saying that securitization has effectively bypassed fractional reserve requirements.)

 

Meanwhile, the Wall Street bank takes the Residential Mortgage Backed Security it bought from the bank along with others it bought from other banks, takes out the riskiest part, the mezzanine tranches, and bundles all these mezzanine tranches into a whole new security, sliced into tranches based on which tranch gets paid first, and shows Moodys or S&P or Fitch this neat product that they in turn give their blessing to by rating this repackaged crap as AA because of faulty computer models that say that housing collateral value always goes up and never falls.

 

So now with their new AA rating on this boatload of *****, the Wall Street hucksters sell this Trojan Horse to investment firms all over the world.

 

Eventually, the crap loans and the golden loans are so comingled that no one has a clue where the good loans or the bad loans are, who holds risk and who doesn't, who can pay back the default insurance bought and who can't, and so everyone simply stops playing the game.

 

How can this simple concept ever cause a problem?

hmm no.

 

 

the 100$ is a liability. Customer deposits are liabilities, not assets. :)

loans are assets, not liabilities...the bank sold assets. :)

 

They had a timing mismatch. The borrowed short term...and loaned out long term. Danger Danger.

 

to help solve the timing problem they sold the long term assets and got cash to pay off their liabilities when you write a check and demand your money back. :)

 

If you have no idea if you are buying crap loans(assets) or great loans(assets)..cool........may I sell you more please, sir?

 

If I know and you do not know, that is what makes markets. :) If you do not want to know, fair enough. If I lie, throw me in jail for fraud and no one will ever do business with me again..or maybe they will...cool.....

[Winstonm]

the 100$ is a liability.

loans are assets, not liabilities...the bank sold assets.

 

 

 

Thanks for the clarification, Mike.

 

But if it sold assets and kept the liability, isn't it still in position to make a new loan to balance the books?

 

They had a timing mismatch. The borrowed short term...and loaned out long term. Danger Danger.

 

Exactly. In fact, this - as I understand it - was Northern Rock's entire business model. Works O.K. as long as the collateral asset value is rising and the short term paper market is liquid - not so well, otherwise.

 

IMO, the whole fiasco had 3 problems:

1. The Greenspan-led Fed held rates too low for too long, causing an artificial demand based on mortgage rates that outstripped supply and thus caused an overheating of prices.

2. Loan originations were either non-regulated or poorly regulated to allow borderline criminal behavior.

3. The ratings agencies relied on flawed models as guides to rate CDOs and such.

 

Without these three occurences, the problem could not have grown out of control that I can see.

[mike777]

the 100$ is a liability.

loans are assets, not liabilities...the bank sold assets.

 

 

 

Thanks for the clarification, Mike.

 

But if it sold assets and kept the liability, isn't it still in position to make a new loan to balance the books?

hmm the books should always be in balance...hmmm always......that is why they have accountants to balance the books.

 

If your books are not in balance all the time that is hmm accounting fraud?

[jtfanclub]

Which means that the Dow will see under 10K again.....right? (Japan's SI having sunk almost 50%)

The "Dow" is an average of industrials, I don't expect it to drop quite that far. Close.

 

http://finance.yahoo.com/q/bc?t=5y&s=%5EDJ...5EIXIC&c=%5EDJI

 

Both the Down Jones Transportation and the NASDAQ more than doubled since 2003. Wouldn't surprise me a bid for them both to drop down to half their summer values.

 

S&P 500 and Dow Jones Industrials...maybe 70% of their current values.

[Winstonm]

the 100$ is a liability.

loans are assets, not liabilities...the bank sold assets.

 

 

 

Thanks for the clarification, Mike.

 

But if it sold assets and kept the liability, isn't it still in position to make a new loan to balance the books?

hmm the books should always be in balance...hmmm always......that is why they have accountants to balance the books.

 

If your books are not in balance all the time that is hmm accounting fraud?

Isn't this balancing of the books the very reason for the intrabank lending?

And if fellow banks are not willing to take your RMBS as collateral for an overnight loan.....?

[mike777]

1) If people will not loan me or my company money, ya I am in big trouble. In fact I am out of business until someone does. Here are the keys to the front door of the company. Good luck.

2) The broad USA stock market going down 50% sounds pretty bad to me. :)

3) Maybe I should buy bonds(mortgages) or real estate (houses)? Broad based commodities anyone? Of course demand(prices) may drop for some of these things also.

[hrothgar]

3) Maybe I should buy bonds(mortgages) or real estate (houses)? Broad based commodities anyone? Of course demand(prices) may drop for some of these things also.

I think that industrial commodities are going to go up, up, up...

 

Mining and petroleum companies if you're boring, metal futures if you're aggressive

 

Copper has really spiked over the past few years, however, I think that there is still upside.

[mike777]

Yes, the argument against commodities is that a worldwide..ok read china, industry recession occurs and demand tanks. Of course recessions do come and they do go...so :)

 

Billions still like to eat or keep warm or keep cool even in recessions. Babies are made...babies grow up....the world hopefully grows and does not, does not end in that big bang thingy.