reckless loans

[kenberg]

Richard, I also offer my thanks for the investment example. I have felt I have a reasonable grasp of some of the push for bad loans: Here, sign up for this ARM, don't worry about the adjustable rates, the value of your house will go up and you can renegotiate. Oops. But the purchase of the bundles has remained a mystery. Presumably, or at least hopefully, the folks buying the bundles were not total idiots. Your example, basic though it may be, sheds some light on how this could come about.

 

Casinos get rich by running games with a positive, for them, mathematical expectation. But they are also smart enough to keep thie individual bets small enough and spread enough to give the probability laws the time needed to work their magic. If all of the wealth is clustered in one bet, a positive expectation would still make a professional very nervous.

[hrothgar]

Hi Ken

 

Couple points that are worth considering:

 

The senior tranches of Collateralized Debt Obligations were all rated to be equivalent to triple A. Most of folks who really got hammered were the ones who were following the safest / most conservative investment strategies.

 

Moreover, many of these same professionals decided to be even more paranoid: The bought insurance to protect themselves in case something did go wrong. Moreover, the all went out and bought insurance from a very large, very reliable insurance company (Aka AIG)

 

Sadly, one of the fundamental assumptions about the system proved to be wrong... All the brains in the world aren't going to help if you don't have an good idea what the covariance matrix looks like.

[kenberg]

It's been my claim for a long time that one of the benefits of being in mathematics is that you get a solid close up view of the limits of mathematics. And of logic. These tools are immensely valuable for reasoning your way from point A to point B. But are we at point A? Ah, that's another matter. Here is from the Wik on Black Scoles:

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is widely employed as a useful approximation, but proper application requires understanding its limitations – blindly following the model exposes the user to unexpected risk.

. The same can be said about many or all models I'm sure.

 

If If IF we can somehow keep the bets from clustering we will all be a lot safer.

[Al_U_Card]

So, the bookie laid the odds, our best friend had a tip, we borrowed from the mortgage to make the bet and.....They shoot horses, don't they?

 

I am still not quite clear on the money flow for the "re-imbursements". The conservative investors (with insurance too) got their money back?

[hrothgar]

I am still not quite clear on the money flow for the "re-imbursements". The conservative investors (with insurance too) got their money back?

In theory, the money should have come from AIG

 

In practice, AIG was severely over-leveraged so the Federal Reserve Bank had to step in...

[hotShot]

When a bookie estimates the odds wrong, he will either be broke paying his customers, or nobody takes his bet's. So he has a vital interest to get them right.

 

The important lecture from hrothgar's example is, that the creator of the security tranches, evaluates the risk, without taking any risk himself.

Anyone buying the insurance would have a lot of costs to do an accurate risk estimation himself.

So a sensible regulation would enforce that only XX% can be insured, the rest of the risk stays with the one originally giving the loan.

[hrothgar]

When a bookie estimates the odds wrong, he will either be broke paying his customers, or nobody takes his bet's. So he has a vital interest to get them right.

 

The important lecture from hrothgar's  example is, that the creator of the security tranches, evaluates the risk, without taking any risk himself.

Anyone buying the insurance would have a lot of costs to do an accurate risk estimation himself.

So a sensible regulation would enforce that only  XX% can be insured, the rest of the risk stays with the one originally giving the loan.

 

Personally, I don't see any reason why the entity that creates the CDOs should need to hold any of the resulting risk. As an analogy, we don't require that the individuals who own an exchange trade shares. You might want to make a case that mortgage lender's are legally barred from re-selling mortgages. This is a very different proposition (and would have enormous impact on interest rates and housing prices)

 

I think that the main structural flaws are

 

1. There isn't enough transparency in the system. All of these complex instruments were traded behind closed doors rather than on some kind of open exchange. As a result, it was impossible to determine the risk positions of individual actors.

 

2. Actors like AIG assumed WAY too much leverage

 

3. Individual actors became so large that there was no choice but to socialize the losses

[Winstonm]

When a bookie estimates the odds wrong, he will either be broke paying his customers, or nobody takes his bet's. So he has a vital interest to get them right.

 

The important lecture from hrothgar's  example is, that the creator of the security tranches, evaluates the risk, without taking any risk himself.

Anyone buying the insurance would have a lot of costs to do an accurate risk estimation himself.

So a sensible regulation would enforce that only  XX% can be insured, the rest of the risk stays with the one originally giving the loan.

 

Personally, I don't see any reason why the entity that creates the CDOs should need to hold any of the resulting risk. As an analogy, we don't require that the individuals who own an exchange trade shares. You might want to make a case that mortgage lender's are legally barred from re-selling mortgages. This is a very different proposition (and would have enormous impact on interest rates and housing prices)

 

I think that the main structural flaws are

 

1. There isn't enough transparency in the system. All of these complex instruments were traded behind closed doors rather than on some kind of open exchange. As a result, it was impossible to determine the risk positions of individual actors.

 

2. Actors like AIG assumed WAY too much leverage

 

3. Individual actors became so large that there was no choice but to socialize the losses

Richard,

 

You are dead on accurate. There is nothing wrong with the products nor the sale of those products to thos who wish to increase yield and risk. The entire problem is lack of oversight which can be traced back to legislation Clinton signed but was endorsed by Robert Rubin to allow non-regulated OTC derivaties to be traded.

 

This allowed companies like Lehman Brothers and AIG to be undercapitalized for the risk the carried - and hence the losses were socialized, leading to more moral hazard.

[Winstonm]

It's been my claim for a long time that one of the benefits of being in mathematics is that you get a solid close up view of the limits of mathematics. And of logic. These tools are immensely valuable for reasoning your way from point A to point B. But are we at point A? Ah, that's another matter. Here is from the Wik on Black Scoles:

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is widely employed as a useful approximation, but proper application requires understanding its limitations – blindly following the model exposes the user to unexpected risk.

. The same can be said about many or all models I'm sure.

 

If If IF we can somehow keep the bets from clustering we will all be a lot safer.

The flaw in Black Sholes is when the Chimps panic - the model has us being able to sell out our positions, but in the real world there has to be a bid under the market for that to happen and in crashes and panics "it just ain't there".

[Winstonm]

Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck

 

This is where the efficient market hypothesis breaks down - although Richard points out that very few succeed, it is fact that there are some who do outperform the market for years and years. A handfull, but enough to be more than lucky.

 

Don't misunderstand me, I think the EMH is useful and correct most of the time - just not all of the time. There are periods of disequalibrium and during such times the markets reflect the disequalibrium and not efficiency.

[jdonn]

Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck

 

This is where the efficient market hypothesis breaks down - although Richard points out that very few succeed, it is fact that there are some who do outperform the market for years and years. A handfull, but enough to be more than lucky.

If enough people are playing the market then there will be a few such people through randomness. I don't know what convinces you its too many for it to be due to luck.

 

Also the assumpion that each person only uses information that the market already knows is not necessarily true. I don't thik any of what you say disproves the "theory" you quote.

[Winstonm]

Here is another example (IMHO) of Efficient Market Theory failure.

 

From Wired Magazine artile on David Li. http://www.wired.com/techbiz/it/magazine/1...currentPage=all

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

 

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

 

 

If you're an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream—interest payments or insurance payments—and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly. Though credit default swaps were relatively new when Li's paper came out, they soon became a bigger and more liquid market than the bonds on which they were based.

 

When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice. If it did, then there was a strong correlation between Alice's and Britney's default risks, as priced by the market. Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

 

The problem with the model is that the market was wrong - it mispriced risk.

 

Disclaimer: Richard is the expert in this field and I am an amateur. However, I believe Richard is smart enough to recognize that economics begins with assumptions that may not be 100% fact - however, those assumptions are necessary else no predictive value could be obtained. The only real contention I have is that at times both the Efficient Market Hypothesis and the concept of rational actors fail in combination to explain the disequalibrium that occurs prior to debt-deflation events such as the Great Depression, Japan's Lost Decade, and the present Great Recession in the US.

[Winstonm]

Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck

 

This is where the efficient market hypothesis breaks down - although Richard points out that very few succeed, it is fact that there are some who do outperform the market for years and years. A handfull, but enough to be more than lucky.

If enough people are playing the market then there will be a few such people through randomness. I don't know what convinces you its too many for it to be due to luck.

 

Also the assumpion that each person only uses information that the market already knows is not necessarily true. I don't thik any of what you say disproves the "theory" you quote.

The efficient market hypothesis states that it is impossible to outperform the market for any length of time. I am simply saying there are some people who have done so over great lengths of time, regardless of what the EMH says is impossible.

 

How you chose to interpret that data is up to you.

[mike777]

Actually the emt does not say that, but I agree these finance theories can be confusing.

 

 

We can only hope for more transparency but as many have said that must be the way to go.

 

 

In any event I posted this thread to get people thinking that maybe most of these loans were not reckless, they may have been, but lets just not assume they were.

 

 

 

As a side note if as Winston post suggests the market mispriced risk, mispriced it in a gross manner, how can we do better? How can we take advantage of it?

[Winstonm]

Mike,

 

I believe risk - great risk - must be regulated else the greedy chimps let greed rather than rationality set their course AT TIMES. I personally believe a very great number of very smart people have judged the economic-theory elephant by feeling blindfolded only a portion of the body and describing it - from Chicago School and Monetarists to Keynesians to Austrians they all have a piece of the puzzle but no one yet has been able to piece it all together.

 

AIG should not have happened with active regulation and capital requirements along with transparency of the derivative products with which they were dealing.

 

At the same time, transparency would have helped the market price risk - still, that would never stop the chimps from AT TIMES letting greed get in the way of rationality and miallocating captal.

 

However, Ritholtz I think has it right for ultimate cause with his 3 main reasons.

[mike777]

I agree strongly that bank deposits should be regulated strongly.

 

 

As for AIG

 

I simplify but.....the regulated, heavily regulated old fashion insurance part seems to be fine.

 

 

The other part the london part was also regulated so why did it drive the whole company in ruin if even that part was regulated? As others have mentioned it took on alot more leverage but so what, I assume that was legal and that very very smart people knew that.

 

Let me put it this way, did smart very smart people bascially not know what that part of AIG was doing, in other words was it hidden, super hidden or in fact did these guys really know whatAIG was doing and not care?

[Winstonm]

Mike,

 

IMO, AIG put too much faith in ideology - they believed in market efficiency. They thought (IMO) they could forever make fortunes by selling Credit Default Swaps based on a faulty model that assumed that real estate values could not decline and the risk was correctly correlated. RE Did, Risk Didn't, AIG Done.

[mike777]

Mike,

 

IMO, AIG put too much faith in ideology - they believed in market efficiency.  They thought (IMO) they could forever make fortunes by selling Credit Default Swaps based on a faulty model that assumed that real estate values could not decline and the risk was correctly correlated.  RE Did, Risk Didn't, AIG Done.

ok...but:

1) that part was regulated

2) wall street non aig had alot of very very smart people...phd etc.

 

 

My point being everyone on wall street thought "negative carry" trades are sucker trades.

 

 

So IMO to call them "reckless" is not best.

[hotShot]

So IMO to call them "reckless" is not best.

What would you suggest? careless, frivolous

 

I think one problem was that the real estate bubble has been growing since the 50th.

That made it difficult to recognize it as a bubble and for many people involved in home loans, it was their life time experience that house prices can only go up.

But I know that European experts have discussed that bubble as close to the burst since about 10 years ago. So I don't think it was a big surprise for all.

 

I understand that mortgage rates in the US are adaptive, they change whenever the risk or the interest rates change. Around here they are usually fix for 5 or 10 years.

Someone with a job and a tight budget, who could pay with mortgage rates without a problem, can get into big trouble if some of his neighbors can pay their home loan, and their houses are sold below the former market value. Suddenly the risk for his mortgage grows, his rate is adapted and his budget explodes.

 

So I think adaptive rates destabilize the system.

[phil_20686]

Firstly, there was a supreme court decision that made it illegal (on grounds of inequality) in america for banks to lend on different terms to poor people and rich people. The government should have moved immeadeately to quash this or legislate around it. However, for whatever reason, they didnt, and thus banks who wished to make large loans and morgages on good terms to upper class and professional couples were forced to accumulate large amounts of bad debt from poor citizens who were likely to default

 

Sorry, but thhis is absolute unadultrated bullshit. Give me a cite. Better yet, give me lots and lots of cites where banks were FORCED by the government to make bad loans.

Sorry, you are basically right. I was way too strong in my assertion here.

 

I was referring to the changes in the CRA in 1989 (under the FIRREA). This gave advocacy groups the right to check up on banks lending outcomes (as opposed to policies), and to complain about it if the statistics showed that they weren't enforcing equality etc etc. Ben bertranke spoke about this and how it affected banks lending policies. In particular he emphasisesd how the CRA had been effective in increasing the amount of loans given to low credit households, and that each of its major revisions had made it yet more effective. This speech was from march 2007, before the crisis really hit, so its interesting, he notes that:

 

"access to credit in lower-income communities is obviously much greater today than when the CRA was enacted. This greater access has had tangible benefits, such as the increase in homeownership rates (Joint Center for Housing Studies, 2006). However, recent problems in mortgage markets illustrate that an underlying assumption of the CRA--that more lending equals better outcomes for local communities may not always hold.12 Whether, and if so, how to try to differentiate "good" from "bad" lending in the CRA context is an issue that is likely to challenge us for some time"

 

I wonder if he has a different opinion on that now :).

 

In short I think its clear that there was political and regulatory pressure to increase lending to low credit households. You can read all about it in frankly tedious detail here;

 

http://www.federalreserve.gov/newsevents/s...ke20070330a.htm

[shyams]

I'm not well informed so forgive me for asking. Is there any class action suit in the United States where sub-prime mortgage borrowers (esp. of the 2006-2008 vintage) have sued their mortgage arranger/(s) for mis-selling?

 

A cursory review of this thread indicates most of the discussion is focused on the impact of the sub-prime crisis on the banks, the tax-payers, AIG, the US Govt etc. What about the sub-prime borrowers who got a raw deal because they walked into a mortgage with limited knowledge, were (possibly) mis-sold, and probably continue to bear a lot of burden due to their investments into the housing sector.

[phil_20686]

Let's talk about SIVs - Special Investment Vehicles that the banks were using to move risk off balance sheet and minimize capital requirements.  Banks were indeed buying toxic assets - and foreclosures are only a part of the problem as the value of the undlying collateral dropping also affects the quality and value of the loan, which is why there has been so much discussion about "keeping people in their homes" - it is to support housing prices for the collateral value, not to be a good guy and let someone have a home.

I think you are making an error here. The point is that provided that the loan is paid back then the bank makes a lot of money from it. It only loses money if the load payer defaults, and there is not enough collateral. So the drop in house prices does represent a loss in value for the loan as it increases the risk. The problem is, that the market does not know how many current loan holders are likely to default. They want to keep them in their houses in teh ope that they will get a job and eventually repay the loan. Before they thought they knew the risk, but now that they ahve been burned they are in general more risk averse and their uncertainty of the risk is causing them to take a very pessimistic view. (..As you would say, I do not think they are behaving rationally...)

 

This is why I think the fed will make money from its toxic assets, as provided that the ecomomy stabllises in the reasonably near future the number of defaults will decrease. Morgages are incredibly profitable. A 25 year morgage is typically makes the bank a real term gain of 50% on its original loan, provided it is paid back. We are currently pricing them with a high risk of default because of the current climate, just as we were pricing them based on an extremely low risk of default suring the good times. As robert pointed out, the risk of default is not independent, and just as the defaults started all in a wave, they will probably stop all at once too. Obviously, the only true measure of the "risk" will come with hindsight in 25 years when we know how many actually did default, and that will tell us how we should be pricing them now.

[phil_20686]

So I think adaptive rates destabilize the system.

I dont knwo if i agree or disagree with this system.

 

It definately does mean that when conditions are bad the interest rates on teh laons goo up which combined with the economic climate means that people will tend to default all at once. After all, if you lose your job in the recession you are basically bound to default unless you planned savings for just such an eventuality, but adaptive rates mean that when people are losing the jobs so that the risk on the loans is higher they put up the price so now even some poeople who dont lose their jobs will default. On the other hand, the system is extra stable sureing the good times as prices are lower. Fixed price simply distribute your risk premium across the cycle, instead of concentrating it during the high risk periods.

 

On the other hand, if you get an adaptive rate suring the good times then you are probably more stable as you get to pay of more of the capital so that reduces the banks exposure, particularly if you reach the point where value of house > value of loan even in teh event of a drop in house prices (say when half yoru loan has been paid of or so) then the bank is risk free on this loan even in the down turn.

 

I have no way to evaluate which is better in a long term average. Since many banks offer both I would assume that the banks think they have equal merit, as if one was manifestly less risky it would be significantly cheaper. (assuming EMH of course).

[phil_20686]

So IMO to call them "reckless" is not best.

What would you suggest? careless, frivolous

 

I think one problem was that the real estate bubble has been growing since the 50th.

That made it difficult to recognize it as a bubble.

Lets be clear, only part of the growth in housing prices has been due to the bubble effect. Part has been due to generally increased wealth that meant people are prepared to pay more for their house. Particularly important has been the shifts int eh labour market, as more and more women have entered the labour market house prices have been driven up by the prevalence of families with two earners, resulting in a huge (marginal) increase in disposable income. It was always going to be impossible to seperate these effects from any bubble effects until the bubble ended.

[phil_20686]

I'm not well informed so forgive me for asking. Is there any class action suit in the United States where sub-prime mortgage borrowers (esp. of the 2006-2008 vintage) have sued their mortgage arranger/(s) for mis-selling?

 

A cursory review of this thread indicates most of the discussion is focused on the impact of the sub-prime crisis on the banks, the tax-payers, AIG, the US Govt etc. What about the sub-prime borrowers who got a raw deal because they walked into a mortgage with limited knowledge, were (possibly) mis-sold, and probably continue to bear a lot of burden due to their investments into the housing sector.

EH not as far as i know. There was on test case in britian where apparently the bank hadn't drawn up a contract properly, but I don';t knwow what happened in the end. There is no real evidence (as far as I know) that the banks tries to missell, more that the people buying the morgages underestimateed the risks.