reckless loans

[Winstonm]

Sorry, but I can't leave this topic alone. Some of the proposals are downright silly, IMO.

 

It has been stated that the Fed will earn billions from buying MBS that no one else would buy. First off, if the products were worth all that much but could not get a bid, then it pretty much disproves the idea of an efficient market for MBS existed. And if there weren't any bids under the market, then it means that none of the solvent rational actors wanted to make the billions that the Fed is supposedly going to make.

 

Give me a break.

 

The computer models for these MBS were based on the assumption that real estate prices NEVER go down. Never? These brilliant chimps didn't even know their real estate history.

 

When foreclosures exceeded forecasts and real estate prices began to decline due to overcapacity, there was no efficient market with rational actors making rational choices - there was pure primate panic as margin calls went out forcing liquidation of non-liquid assets.

 

The Fed did not step in to make a profit but to create a market where none existed. The market had already set its price - pennies on the dollar - yet the Fed did not utilize market pricing and paid more. (And still now, mark-to-market accounting has been suspended so the still toxic crap on books that even the Fed wouldn't touch is marked-to-make-believe value.) So who was right, the market for pricing risk at pennies on the dollar or the Fed for ignoring market price?

[Al_U_Card]

[mike777]

thanks for the replies everyonemakes good points worth discussion.

 

 

Just to make clear efficient markets does not mean that markets/ a stock/bond/reckless loan is priced correctly. I think sometimes people confuse these two issues.

 

 

Just because a loan defaults does not mean it was a reckless loan.

[mike777]

side note I thought there was a very interesting article about Ted Turner and others and how, per the article, they built their fortune on minimizing risk.

 

 

I think I read it in the New Yorker magazine(non academic).

[helene_t]

thanks for the replies everyonemakes good points worth discussion.

 

Just to make clear efficient markets does not mean that markets/ a stock/bond/reckless loan is priced correctly. I  think sometimes people confuse these two issues.

 

Just because a loan defaults does not mean it was a reckless loan.

hmmmm ..... from http://en.wikipedia.org/wiki/Efficient-market_hypothesis:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.

 

(btw it is not "to know information", it is "to have information", I have corrected that)

[mike777]

thanks for the replies everyonemakes good points worth discussion.

 

Just to make clear efficient markets does not mean that markets/ a stock/bond/reckless loan is priced correctly. I  think sometimes people confuse these two issues.

 

Just because a loan defaults does not mean it was a reckless loan.

hmmmm ..... from http://en.wikipedia.org/wiki/Efficient-market_hypothesis:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.

 

(btw it is not "to know information", it is "to have information", I have corrected that)

yep.......this is often confused...see your quotes.........people do not understand what this means....

 

 

to put this simple......prices can be wrong...very wrong....

 

 

in this case.......mortgage insurance was priced wrong...very wrong..........but see other....

 

in this case....insurance was seen by super smart traders.....they arbitrage away...etc....

 

 

 

 

 

I just note...all traders were super smart, the very very best..........high IQ super IQ...

 

 

My point is ...these trades were not reckless.....wrong ..ok but not reckless

 

 

See my OP.....many smart people claim these trades were reckless! They may be right but proof it!

i mean the claim is not a few loans were reckless but all or almost all of them are.

[mike777]

Isn't it more likely that these smart people are right?

 

Are you suggesting that there was to much money around, so that save investments where all sold out. So the investors had to put their money to unsave investments?

typical this makes zero sense i mean have you read any phd economics...it seems no........your post makes zero sense.

 

you seem to claim investors/owners make nonsense loans so they can lose 100% of their money.

[mike777]

thanks for the replies everyonemakes good points worth discussion.

 

Just to make clear efficient markets does not mean that markets/ a stock/bond/reckless loan is priced correctly. I  think sometimes people confuse these two issues.

 

Just because a loan defaults does not mean it was a reckless loan.

hmmmm ..... from http://en.wikipedia.org/wiki/Efficient-market_hypothesis:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.

 

(btw it is not "to know information", it is "to have information", I have corrected that)

I understand this is confusing but .........in fact there are 3 versions of this theory...not one....

 

in any case.......there is the discussion that prices reflect all known information or that they reflect it correctly......

 

 

for sake of this thread....I concede...that credit default swaps reflected all known information...........there was no secret...double secret unknown information........if we discuss in general wall street traders...management

 

 

I mentioned.......ethical....etc issues regarding FNMA i hope... i did here.

 

 

I hope I discussed FNMA in other threads.....1) I love super love FNMA 2) after 30 years I sold....and told all other to sell.......FNMA seem to take on insane risk...but I may be wrong......in general I own FNMA since it gets to print money......super cheap money.....at posters expense....

[hotShot]

Isn't it more likely that these smart people are right?

 

Are you suggesting that there was to much money around, so that save investments where all sold out. So the investors had to put their money to unsave investments?

typical this makes zero sense i mean have you read any phd economics...it seems no........your post makes zero sense.

 

you seem to claim investors/owners make nonsense loans so they can lose 100% of their money.

Remember your post was:

 

I keep hearing from very smart people that the entire usa system almost fell apart because of reckless lending.

 

 

On the face of it this seems nuts.

 

I think these very smart people need to stop and think deeper, much deeper.

 

Most of us assumed that you where disputing that lending was the major reason.

 

Your posts now seem to the suggest that you are disputing "reckless".

 

For most people I know buying a house is a once a lifetime action.

While I expect banks to deal with loans on a daily basis.

Since their customers are so inexperienced, while banks are experts, the banks have to take more responsibility in that deal. And they have to take the bigger part of the blame, if repaying the loan fails. Reckless or even irresponsible seem to properly describe some of the loans given. If the bank clerks get a bonus fee for every loan contract he makes, they might be tempted to resolve the clashing interests of their customers, the bank and their own, in their own favor.

[mike777]

Isn't it more likely that these smart people are right?

 

Are you suggesting that there was to much money around, so that save investments where all sold out. So the investors had to put their money to unsave investments?

typical this makes zero sense i mean have you read any phd economics...it seems no........your post makes zero sense.

 

you seem to claim investors/owners make nonsense loans so they can lose 100% of their money.

Remember your post was:

 

I keep hearing from very smart people that the entire usa system almost fell apart because of reckless lending.

 

 

On the face of it this seems nuts.

 

I think these very smart people need to stop and think deeper, much deeper.

 

Most of us assumed that you where disputing that lending was the major reason.

 

Your posts now seem to the suggest that you are disputing "reckless".

 

For most people I know buying a house is a once a lifetime action.

While I expect banks to deal with loans on a daily basis.

Since their customers are so inexperienced, while banks are experts, the banks have to take more responsibility in that deal. And they have to take the bigger part of the blame, if repaying the loan fails. Reckless or even irresponsible seem to properly describe some of the loans given. If the bank clerks get a bonus fee for every loan contract he makes, they might be tempted to resolve the clashing interests of their customers, the bank and their own, in their own favor.

so you suggest that owners want to make reckless loans..

 

I mean......lots of owners and lots of top management and lots of loan officers and lots of those who borrow.......I mean all of them thousands and thousands over years want to make reckless loans.....and .........regulators do not care?....is that what you say? or other?

 

I mean you may be correct but please say so....

 

 

1) owners of banks...loan reckess

2) management loan reckless

3_ loan officers loan reckless

4) borrowers reckless

5) government...lots of government....reckless.l....

 

so how does more laws help?????

[hotShot]

I mean you may be correct but please say so....

 

 

1) owners of banks...loan reckess

2) management loan reckless

3_ loan officers loan reckless

4) borrowers reckless

5) government...lots of government....reckless.l....

 

so how does more laws help?????

Lets start:

3) Yes they get a bonus for every loan, even a reckless one

4) perhaps, they want the loan, they probably don't know yet that it's reckless.

 

2) Well they invented these bundled loan papers to sell the reckless risk to others and made insurances.

 

1) They implemented a board of director, why should the do something themselves?

 

5) What do governments know about economics. For decades it was always, "less regulation", "we need less regulation", "let the market forces sort that out".

 

We'll perhaps we would have been better off, if we had the market forces take care of those banks.... Some people need to touch the hot oven to learn it's hot.

[kenberg]

I only have to look at my own behavior to be skeptical of theories based on rationality. I am not confessing to insanity, but rather to a limited interest in market research. Take, just for a moment, two pillars of advice for investors: 1. Investigate before you invest 2. Diversify. Uh huh. Maybe (but unlikely) I can work up the ambition to thoroughly investigate one or two companies before plunking down some cash for their stock but if I have to invest in fifteen or twent in order to diversify I will not be investigating all of them thoroughly. Warren Buffett I am not.

 

Now to apply this to housing. I will say how things were. I know we cannot live in tge past but we may be able to learn from it. I forst bought in 1970 or maybe 1971. Housing prices were risiong faster than me salary and savings, it was very frusgtrating, a friend bought a townhous and that seemed reasonable. As it happened, prices continued to rise and so it was a good investment but the important point is that if prices did not rise I was living in a townhouse that I could afford, as long as I kept my job. Job loss is of course possible and will always be an unforeseen disaster, but minus that development, I could pay my mortgage and, perhaps, later move to a house. This was a stable situation.

 

Somehow the situation became unstable. Maybe discussing "reckless" or "not reckless" is the wrong approach. Blaming or absolving from blame is important only in so far as it helps with the fix. I assume we could all agree on the word "unstable". Somehow it developed that my solution, buying a townhouse if you cannot afford a house, has come to be seen as asking too much of people. Everyone is entitled to a house, a big house in a good neighborhood with good schools and so on. And if a guy can't afford it, then the banks will lend him the money anyway. I confess I do not know exactly who to blame for this but it is clearly unsustainable. But while admitting I don't understand the details of what happened, it is not crazy to take the financiers to task for this. They are the professionals, and when things go to hell they are the ones who were supposed to be on watch. There might be many reasons for the Redskins having a disastrous season, but it's the caoch that gets fired. He was supposed to take care of this.

 

Bottom line: "The loans weren't reckless" won't cut it. The situation spun out of control and led to disaster. Of course I would listen to those who have lived their lives in the world of mortgages and finance, but "not our fault" is an insufficient response.

[Al_U_Card]

Tantamount to "I was only following orders."

 

The issue of being able to understand the full impact and import of the various derivatives begs the question:

 

"If it doesn't make sense to me, should I be putting my money in it?"

 

And this definitely applies to the regulatory bodies of the industry, most of all.

[Winstonm]

Good stuff today from Barry Ritholtz at The Big Picture:

 

They’re back!

 

The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred.  As the mid-term election approaches, we should expect to hear more from this crowd.

 

The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors

 

The causative reasons for the crisis according to Ritholtz.

 

) Ultra low rates;

2) Unregulated, non bank, subprime lenders;

3) Ratings agencies slapping AAA on junk paper.

 

Why are these “But Fors?” But for these things occurring, the crisis would not have happened:

 

-If it wasn’t for ultra low rates, the housing boom would likely have been much more modest; further, bond managers would not have been scrambling for yield, and searching for alternative products to low yielding Treasuries;

 

-If it wasn’t for the sub-prime lenders, the credit bubble would not have inflated; further, millions of unqualified borrowers would not have been able to purchase homes they could not afford;

 

-If it wasn’t for the ratings agency fraud, the enormous market for this high yielding junk paper — mislabeled as AAA — would not have existed; further, the primary purchasers were firms that were only permitted to buy investment grade bonds. No A+ or better rating, no sale.

 

Hence, these factors are huge causative elements — BUT FOR them, there is no boom and bust, no crisis and collapse. Bond managers could not have owned all of these securitized sub-prime mortgages; the credit default swap market would have been much smaller, perhaps 1/10 its size; Sovereign wealth funds around the world could not have purchased all this bad paper; Iceland does not collapse. That is these are the big 3 — why I label them the prime cause of the crisis.

 

What happened at AIG?

 

Dinallo: What I Learned at the AIG Meltdown

 

 

1. Insurance policyholders at AIG were protected by reserves that each of the insurance companies are required to hold by state regulation;

 

2. Unregulated use of credit default swaps and other high-risk instruments by AIG Financial Products, [an unregulated] noninsurance unit with wildly insufficient reserves, caused AIG to stumble and threatened the financial system.

 

3. By September 2008 the Federal Reserve acted to protect the financial system from what it believed to be an imminent risk of catastrophic damage from AIG Financial Products;

 

4. In November 2008, when the Fed restructured its AIG financing, including the termination of tens of billions of credit default swaps and the widely criticized purchase (at par) of the underlying securities, the Fed had over $70 billion already at risk with AIG and was appropriately considering the value and operations of AIG’s insurance companies.

 

Dinallo further notes that “the essential lesson of AIG is the need to reform financial regulation.” Stating the obvious, he notes that “Financial institutions should be required to hold adequate reserves so they can deliver on their [derivative and swaps] guarantees.

 

Dinallo concludes: “Oh, and financial institutions should not be allowed to select their own regulator.”

[barmar]

Tantamount to "I was only following orders."

 

The issue of being able to understand the full impact and import of the various derivatives begs the question:

 

"If it doesn't make sense to me, should I be putting my money in it?"

 

And this definitely applies to the regulatory bodies of the industry, most of all.

That's like saying, "If I don't understand how a catalytic converter works, should I be driving?" The world has gotten too complicated for everyone to expect to understand everything that impacts them. So we defer to so-called "experts". If someone with lots of credentials in economics and finance tells me that CDS's are a reasonable investment, who am I to argue with them?

 

And it's not like the reckless advice was coming from one crackpot. Lots of Wall Street pros were promoting these financial instruments. There were some naysayers, but people are always more interested in looking for good deals than heeding warnings of doom and gloom. That's basic behavioral economics.

 

As I have before, I'll again recommend predictablyirrational.com.

[hrothgar]

MathWorks had its annual meeting today.

 

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.

Strangely enough, his comments didn't address many of the same themes...

[kenberg]

MathWorks had its annual meeting today.

 

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.

Strangely enough, his comments didn't address many of the same themes...

You could refer him to this thread to help him get up to speed. :D

[Winstonm]

I don't care who you are or who you think you are - making a 100% LTV loan to someone with no income, no job, and no assets and expecting the spread of the risk throughout the MBS to absolove you of risk and blame is not only stupid but reckless.

 

Making loans on homes without determining if the buyer had the capability to pay the mortgage payments was reckless. Making loans to people who could afford the interest-only payment but could not afford the reset payment was reckless.

 

Subprime lending from around 2006-2008 was clearly reckless. There should be serious jail time for the major offenders but I doubt there will be.

[Al_U_Card]

Subprime lending from around 2006-2008 was clearly reckless. There should be serious jail time for the major offenders but I doubt there will be.

When they say "Follow the money" it tends to show where the incrimination is and where the punishment should go.

 

In all of these "losses", where DID the money go?

[Winstonm]

MathWorks had its annual meeting today.

 

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.

Strangely enough, his comments didn't address many of the same themes...

Do you want my home number? :D

[hrothgar]

In all of these "losses", where DID the money go?

To folks holding the so-called toxic waste...

(Mainly hedge funds)

[hrothgar]

Here' an analogy that will help describe what happened to much of the wealth that was transfered:

 

Assume for the moment that you hold a pair of IOUs. Each IOU promises that the lender will pay you $100 in a years time. Each IOU has a 20% chance of default. To make life simple, I'm going to assume that you are risk neutral (you are indifferent between holding the IOU and holding $80). Furthermore, I'm going to also assume that the time value of money is zero (this is a simple example and I don't want to deal with discount rates). Last, but not least, I am going to assume that the pay off for the two IOUs is independent. The chance that one lender defaults is unrelated to the chance that the second lender defaults. (This is the big assumption. We're going to come back to this one in a bit)

 

You decide that you you're going to repackage those two IOUs and create a pair of securities that are backed by the IOU. The first security is the senior tranche from the two IOUs. The first security will pay

 

$100 if neither IOU defaults. (A 64% probability)

$100 if one IOU defaults but not the other. (A 32% chance)

$0 if both IOUs default (A 4% chance)

 

The second IOU will pay

 

$100 if neither IOU defaults (a 64% probability)

$0 if one IOU defaults but not the other. (A 32% chance)

$0 if both IOUs default (A 4% chance)

 

You go off and sell senior tranche for $96 and the junior tranche for $64...

 

The senior tranche is is a very secure asset. It gets purchased by banks and pension funds and other institutional investors that are required to purchase high grade securities.

 

The junior tranche is a very risky asset. It gets purchased by hedge funds and the like (folks who prefer to invest in risky assets)

 

Now, lets consider what happen if the payoff from the two assets isn't independent of one another: For simplicity, lets assume that the two assets become perfectly correlated. In this case,

 

The probability that neither IOU defaults increases to 80%

The probably that one IOU defaults but not the other drops to zero

The probability that both IOUs default increases to 20%

 

Lets consider what happens to the expect value of the two securities

 

The expected value of the senior tranche has just dropped from $96 to $80.

The expected value of the junior tranche has just risen from $64 to $80.

 

People who purchased the senior tranches got destroyed. People who purchased the junior tranches made out like bandits.

 

Now think of the IOUs as mortgages and ask yourself whether the assumption that the chance that multiple mortgages defaults are independent events.

 

This should give you a basic idea about what happened....

[helene_t]

Spot on, Richard. Very illustrative example.

 

I only have to look at my own behavior to be skeptical of theories based on rationality.

If you define the word "rational" in a sufficiently general way it becomes almost a tautology that we are all rational.

 

Say that I have a pile a donuts for lunch today. That sounds irrational given that I have low blood count, ought to be lose some weight, and since I didn't bring my toothbrush I shouldn't be eating sugary things at work. Besides, I could have found alternative food on the campus which is not just healthier but also cheaper and better tasting.

 

But obviously all that information wasn't available to me (I must temporarily have slipped the info that donuts don't contain much iron, for example) since otherwise I would have chosen some different food, wouldn't I? Maybe the info was available but it was a temporary lack of information processing skills. Maybe I was stressed and couldn't think so clearly. Well, information processing capabilities is just another scarce resource. Just like a house may collapse due to lack of good clay it may also collapse because of lack of architect's brain cells. Or lack of project developer's brain cells.

 

I think economics could be an interesting science if it were based on assumptions that could be tested. What occurred to me after I had been doing mathematical economics for a year was that the assumptions have no interpretation in terms of predicted observations. So I thought, if those theories haven't any practical use, why not study pure mathematics instead, that may be equally remote from the real world but at least I would get to do with some elegant theories. Anyway, I was too stupid for pure math so I decided to do neither, and specialize in engineering math instead.

 

To be fair, there are lots of good books that deal with economics at an academic level, making it intellectually satisfying and applicable at the same time. But this "physics envy" trend to axiomatize fields that just aren't even remotely ripe for axiomatizing ("economic man", "efficient market hypothesis" and similar nonsense), don't waste time on it.

[hotShot]

Great example, Richard!

[hrothgar]

Great example, Richard!

Wish I could claim that I came up with it myself...