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Tilting at Windmills

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December 6, 2007
By: Kevin Drum

THE AAA MELTDOWN....At the heart of the subprime mortgage debacle is a financial instrument called a Collateralized Debt Obligation, or CDO. A CDO is a collection of bonds that's divided into tranches and then sold to investors. Usually there's a AAA tranche at the top (very safe, very reliable) and a garbage tranche at the bottom (pay your money, take your chances). In the middle is a mezzanine tranche.

It's easy to understand why the garbage tranches have lost all their value: they're garbage. But why are the AAA tranches also losing value? Aren't the underlying securities still safe and reliable? Today, Steven Pearlstein puts in place a piece of the puzzle that I didn't know about before:

The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees....What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

So if this is right, then the reason that even AAA tranches are in such trouble is basically twofold:

  • A lot of the AAA debt isn't really AAA. It's mezzanine debt that the rocket scientists and the rating agencies conned everyone into believing was AAA.

  • The mortgage meltdown is so widespread that even the legitimate AAA stuff is taking a beating.

Put these two things together, and the average AAA tranche is overvalued by, say, 10-20%. Add in the usual Wall Street panic whenever something goes wrong, and buyers are demanding discounts of 20-30% or higher.

There's plenty more worth reading in Pearlstein's column. But here's the unsettling conclusion: "This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001."

Kevin Drum 6:18 PM Permalink | Trackbacks | Comments (63)

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And yet the usual gang of idiots from the real estate industry and the gummint are telling us that the worst is over and we can see a recovery soon into 2008.

Does anyone believe anything they say anymore?

Posted by: jprichva on December 6, 2007 at 6:22 PM | PERMALINK

OK, so suppose I agree with you that the economy's in dire dire trouble and we've only begun to scratch the surface of the downturn. Suppose I have some savings to invest for a 20-30 year time horizon (at least, until retirement).

What on earth should I do? Keep it in a money market account for a couple of years? Short stocks? Gold bullion? Mining shares? ARRRRRGH!!!

Official disclaimers that I should consult a financial professional are duly noted. (A little ironic, though, since they're the ones saying to just ride it out!)

Posted by: Philip the Equal Opportunity Cynic on December 6, 2007 at 6:32 PM | PERMALINK

That's because, last I read, a lot of the "AAA" stuff was actually not so AAA. This, again, is why the bond rating agencies should be answering as many questions from congress as any of the mortgage and commercial banking concerns. They probably bear the most responsibility for this mess because they were willing to make the assumption that the underlying sub-prime loans would be okay because housing prices were going to continue to rise. That or they just didn't give a shit.

Posted by: JeffII on December 6, 2007 at 6:33 PM | PERMALINK

OH YEA KEVIN, WHAT ABOUT WHITEWATER !!!!!!!!

Posted by: Al on December 6, 2007 at 6:34 PM | PERMALINK

@jprichva

Give those idiots a break -- at least some of them are trying to prevent a panic. And the costs of a panic would outweight the immediate pleasures of schadenfreude, jprichva.

Also -- I'm getting the idea that these CDO models assume that morgage defaults are independent of each other and that the rate of default is known and constant.

Is that true? Because if it is true, then they are basicly guaranteed to fail all at once.

Posted by: Adam on December 6, 2007 at 6:37 PM | PERMALINK

Add to this the fact that a lot of the funds who bought these instruments levered up a couple ten times, using similar "assets" as collateral.

Posted by: jhm on December 6, 2007 at 6:43 PM | PERMALINK

Last updated December 3, 2007 4:55 p.m. PT
Financial crisis back with a vengeance

By PAUL KRUGMAN
SYNDICATED COLUMNIST

NEW YORK -- The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.

How bad is it? Well, I've never seen financial insiders this spooked -- not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.

This time, market players seem truly horrified -- because they've suddenly realized that they don't understand the complex financial system they created.

Before I get to that, however, let's talk about what's happening right now.

Credit -- lending between market players -- is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about "liquidity," is an essential lubricant for the markets, and for the economy as a whole.

But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets -- such as the London market, in which banks lend to one another -- have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.

"What we are witnessing," says Bill Gross of the bond manager Pimco, "is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August."

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction -- and that will mean a recession, possibly a nasty one.

Behind the disappearance of liquidity lies a collapse of trust: Market players don't want to lend to one another because they're not sure they will be repaid.

In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble -- I mean, there wasn't even a glamorous new technology to justify claims that old rules no longer applied -- but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.

Thus, "super-senior" claims against subprime mortgages -- that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts -- have lost a third of their market value since July.

But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn't supposed to have tens of billions of dollars in subprime exposure; it did. Florida's Local Government Investment Pool, which acts as a bank for the state's school districts, was supposed to be risk-free; it wasn't (and now schools don't have the money to pay teachers).

How did things get so opaque? The answer is "financial innovation" -- two words that should, from now on, strike fear into investors' hearts.

OK, to be fair, some kinds of financial innovation are good. I don't want to go back to the days when checking accounts didn't pay interest and you couldn't withdraw cash on weekends.

But the innovations of recent years -- the alphabet soup of CDOs and SIVs, RMBS and ABCP -- were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead -- aside from making their creators a lot of money, which they didn't have to repay when it all went bust -- was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: Policymakers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, a member of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation -- but added, "I don't think we'd want it the other way around." Is that your final answer, Mr. Secretary?

Now, Paulson's new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won't make more than a small dent in the subprime problem.

The bottom line is that policymakers left the financial industry free to innovate -- and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

Posted by: JeffII on December 6, 2007 at 6:43 PM | PERMALINK

But Wall St is soaring because:

a) they think the economy is doing fine!
b) AND they think they'll get another big interest rate cut!

How delusional can you get?

Posted by: Speed on December 6, 2007 at 6:43 PM | PERMALINK

Yup, they blended turds and chocolate into a cake and sold it at the full chocolate cake price.

Made trillions.

Human greed being what it is, they finally sold so many turdcakes the market couldn't absorb any more.

Now nobody knows just how many of the cakes have turds in 'em... or even which ones they are!

Hey, anyone wanna buy a cake? Cheap?
Hmmm....no takers.

Posted by: Buford on December 6, 2007 at 6:45 PM | PERMALINK

"This may not be 1929..."

Then again. . .

Posted by: Will Divide on December 6, 2007 at 6:46 PM | PERMALINK

Ah, Kevin, don't you know that we are a special nation that can keep living beyond our means forever, and other countries will gladly live in poverty so that we can keep buying big-screen TVs and McMansions, and starve themselves so we can put corn into our gas tanks? It is God's will! America is his chosen country!

Posted by: Conservatroll on December 6, 2007 at 6:46 PM | PERMALINK

"A lot of the AAA debt isn't really AAA. It's mezzanine debt that the rocket scientists and the rating agencies conned everyone into believing was AAA."

This isn't exactly right. CDOs of mezzanine tranches are what they are rated -- just like CDOs of individual debt obligations. It's just that the rocket scientists miscalculated how many mezzanine and junk tranches of those mezzanine CDOs would be needed to absorb losses before they hit the senior tranches.

Same thing could easily happen with the senior tranches of plain vanilla CDOs. It doesn't mean they aren't AAA like they've been rated.

Posted by: Joe on December 6, 2007 at 6:56 PM | PERMALINK

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees.

Finally someone mentions where at least some of the missing billions went to. More often than not, the business articles tell us that we're supposed to believe that all these billions just disappear into the air. But turn the page and you see how they are magically transformed into record bonuses, obscene compensation, and countless stock options, while the Style section details all the bigger and better mansions and yachts it all buys. When the scoundrels create the laws and run the agencies, criminal enterprises by any definition become perfectly legal, and even tax-free. That's the Bush GOP mission that was actually accomplished.

Posted by: R. Porrofatto on December 6, 2007 at 7:08 PM | PERMALINK

OK, so suppose I agree with you that the economy's in dire dire trouble and we've only begun to scratch the surface of the downturn. Suppose I have some savings to invest for a 20-30 year time horizon (at least, until retirement).

If you have a 20-30 year time horizon, what do you care what the market's doing now (barring, of course, total economic meltdown, and if that happens we've all got worse problems)?

Just keep saving and investing but make sure you're properly diversified among (i) equities, bonds, cash, and hard assets (i.e. real estate, precious metals, etc.) and (ii) within equities, between US (both large and small cap), international developed and emerging markets. Make sure your asset allocation has enough components that aren't in sync, so when one part zigs the other part can zag. Then sit back and wait for 20 years.

Posted by: Stefan on December 6, 2007 at 7:08 PM | PERMALINK

The firm that did the study (naturally, there's no way to look at the assumptions, etc.) is certainly on the front lines.
Eidesis Capital's flagship....suffered a 6.93% net loss last month and is now down 35.17% for the year....managing partner declined to comment. Um, yeah, what's to say?

Was that a study or a letter to the fund's participants?

Posted by: TJM on December 6, 2007 at 7:08 PM | PERMALINK

How delusional can you get? Posted by: Speed

Exceptionally delusional, when you live quarter-to-quarter.

For example, if you are a heavy hitter in equity or bond trading/sales or in M&A, anything less than a seven- or high six-figure year end bonus means you've got to pick up the slack real quick or you'll be let go.

At that level, people begin to lose perspective and develop a sense of entitlement. The downside (besides perhaps losing your soul) is that the burn out level is high. It's almost like pro athletes - get the big contract ASAP because the average career is 3-5 years depending on the sport. Same is true in trading - strictly a young man's game. Most firms need only so many managers, so you need to make your money fast before moving on to something else.

Posted by: JeffII on December 6, 2007 at 7:10 PM | PERMALINK

Yeah, but at least the Wall Street types who pulled this scam will lose their jobs and their multi-million dollar bonuses. Right??

Posted by: jb on December 6, 2007 at 7:10 PM | PERMALINK

Today I learned a new word: Tranch.

Today I learned a new concept: Mezzanine tranch.

Today I learned that selling my house two years ago for full value and renting dirt cheap was a GOOD IDEA!

Posted by: Howard on December 6, 2007 at 7:15 PM | PERMALINK

"...Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired..."

"Rinse, dry, repeat" a few times and you have the financial market equivalent of using centrifuges to enrich U235 to weapons-grade levels. It looks like they've finally done gone and modeled a financial neutron bomb -- the kind where when it detonates the people and the economy are all gone but the buildings and real estate will still remain. This is the equivalent of doubling-down at the roulette wheel whenever you've lost. They weren't even playing on a good, honest European wheel but one of those house-loaded monstrosities favored here in America.

Posted by: PrahaPartizan on December 6, 2007 at 7:18 PM | PERMALINK

Between this mortgage mess and the huge deficit the USA is running, the coming recession will be the worst economic collapse since 1929. Not as bad as the Great Depression, mind you, but worse than anything we've seen since.

Posted by: Chief on December 6, 2007 at 7:25 PM | PERMALINK

What's a C.D.O. ? [Cool interactive graphic]

Here's one that liquidates for 25 % of value

... Across the cash flow assets sold and credit default swaps terminated, we estimate, based on the values reported by the trustee, that the collateral in Adams Square Funding I Ltd. yielded, on average, the equivalent of a market value of less than 25% of par value.
Bloomberg is reporting (no link) that $165 million of debt, originally rated AAA will not be repaid.
From triple AAA to nothing. That is a deep cut.

Posted by: Mike on December 6, 2007 at 7:32 PM | PERMALINK

Not as bad as the Great Depression, mind you, but worse than anything we've seen since. Posted by: Chief

Let me guess, Chief, you're less than 30?

I'm far from sanguine about the financial problems we have right now, but things are very reminiscent of the 1980s. I was working in a savings and loan in 1983. Mortgage interest rates were over, as memory serves, 12% for a 30-year fixed loan. A couple years later, thanks to Reagan's defense build up and tax cuts, I was squealing for joy as I was being paid in yen. Then there was the S&L melt down (calling "Straight Talker" John McCain!").

We were in more-or-less the same position then with the Japanese that we find ourselves in with the Chinese today - both economies were overvalued. The difference, though, is that Japan was riding an RE and stock bubble, and the fucking Chinese won't let their currency float. Oh, that and the Japanese were, are ostensibly allies and not a police state.

In short, we're in for a bumpy couple of year economically, but extricating ourselves from Iraq is still the major challenge facing the country.

Posted by: JeffII on December 6, 2007 at 7:38 PM | PERMALINK

AAA-rated incest in the tranches: Remember, the ratings agencies like Moody's make their money from lending instittutions. Enough said?

And, JeffII, I'm not as sanguine as you, and I'm over 40.

This has the potential, at least, to be the most serious postwar economic problem we've had, IMO.

Posted by: SocraticGadfly on December 6, 2007 at 8:01 PM | PERMALINK

The 7/30/07 Hayman Subprime letter at FT Alphaville explained the whole rotten mess --

http://ftalphaville.ft.com/blog/2007/08/21/6727/the-full-subprime-letter-from-haymans-kyle-bass/

Shorter Kyle Bass -- Wall Street and the Bond Rating Agencies conspired to perpetrate a massive fraud on the world financial markets, by repackaging BBB and BBB- mezzanine CDOs tranches as AAA bonds.

The net result -- the credibility of Wall Street paper has been totally destroyed, and the entire global credit system has frozen up.

Posted by: -ck- on December 6, 2007 at 8:06 PM | PERMALINK

"Put these two things together, and the average AAA tranche is overvalued by, say, 10-20%. Add in the usual Wall Street panic whenever something goes wrong, and buyers are demanding discounts of 20-30% or higher."

So in theory, I could find my own mortgage, and buy it back at a 30% discount?

Oh please oh please oh please oh please.

Posted by: anonymous on December 6, 2007 at 8:16 PM | PERMALINK

Thank you for joining us Kevin. Every reputable (bearish) economic blog out there has been saying this for almost two years now.

The scary part is that this is just the start. When you look at the big picture, you will notice that relatively little defaults have happened so far. The peak of the subprime resets are next year.

And subprime is nothing compared to the option ARMs. Those suckers are nuclear bombs waiting to detonate, and they don't reset for another year. Furthermore, every single one of those option ARMs is considered "prime".

There will be some major bank failures before this is all over. Betting money is currently against Washington Mutual surviving this ordeal.

Posted by: Walker on December 6, 2007 at 8:19 PM | PERMALINK

Walker's right. Jim Jubak and Bill Fleckenstein over at MSN have been very good on this; Mish's blog, if you can get past some of his hard-core libertarian thought, is also good.

And, if WaMu does implode, then, yes, this is officially the worst financial issue since WWII.

Posted by: SocraticGadfly on December 6, 2007 at 8:49 PM | PERMALINK

Well, for us over-50 types there's the 1970's stagflation. A Dow Jones/S&P500 drop of 50% in 1974-5, inflation kicked off by the first oil shock, and a whole wave of graduating baby boomers with no jobs and hordes yet behind us coming along in their turn. And just when we seemed to be recovering from that, another oil shock, real levels of inflation (none of that 3-4% stuff that had Nixon so panicked), and a 13% first mortgage to buy a house (the second mortgage was 20% till the parents came through with a family loan at only 10%). So, yeah, it could be worse.

Posted by: lahke on December 6, 2007 at 8:49 PM | PERMALINK

Shorter Pearlstein, last graf:

The Fed's gonna create another bubble to avoid facing this one.

Posted by: SocraticGadfly on December 6, 2007 at 8:57 PM | PERMALINK

Ah, Kevin.

Kevin (aka Captain Obvious) fills us in on some earth-shaking news: in market economies, sometimes some people do bad things. Wow. Notice, however, that he offers no prescritptions for this problem.

Stay tuned for when Captain Obvious tells us that maybe not all Iraqis are on our side, or that Social Security is in crisis.

Posted by: egbert on December 6, 2007 at 9:00 PM | PERMALINK

Mike, that CDO graphic was awesome. I was just not getting how AAA rated investments could pay nothing - after all most people are still paying their mortgages! But those CDOs are made up of the junk mortgage backed securities from all over the country. It's fine of just Florida or just New York has a bunch of foreclosures. But when it's all over the country . . .

Posted by: Emma Anne on December 6, 2007 at 9:57 PM | PERMALINK

Philip, I am white knuckling it along with you. But what is really pissing me off is worrying about my parents, who don't have decades to make up losses, and might find out their "safe" investments are really basement tranches or something. Grrr.

Posted by: Emma Anne on December 6, 2007 at 9:59 PM | PERMALINK

it gets worse. Those tranches derived from the A & B pieces of the initial CDOs are, as you said, recombined and sold on the market as new securities (CDOs in their own right), from which yet another layer of CDOS are constructed from the A&B pieces of those (secondary) CDOs.

Remember that CDOs are structured from CMOs (collateralized mortgage obligations) which ultimately represent actual mortgages that (in most cases) John and Jane Q. Public borrow against to buy their homes. So for every one mortgage, once tied into a wider portfolio and sliced into these tranches and securitized (and then re-securitized, rinse, repeat), you could be looking at two, three, many securities purchased by investors.

when this all shakes out, we'll look back on the blood-soaked news of today as the bright point.

Posted by: mitch on December 6, 2007 at 10:31 PM | PERMALINK

I'm just sorry that I have lived to see an age in which I have to know what a tranche is.

Posted by: DrBB on December 6, 2007 at 10:37 PM | PERMALINK

C'mon people, Larry Kudlow says its Goldilocks 2.0. Join the party!

Posted by: Jim on December 6, 2007 at 10:38 PM | PERMALINK

However you cut the financing, it should have been obvious that when the pump was primed with historically low interest rates these rates would go up quite a bit.

Posted by: Luther on December 6, 2007 at 10:42 PM | PERMALINK

SocraticGadfly: Walker's right. Jim Jubak and Bill Fleckenstein over at MSN have been very good on this; Mish's blog ...

Who is actually surprised by this debacle?

With the way I follow business news, I probably would have learned about the stock market crash by 1930, or 1931 at the latest. I'd never heard of CDO's or tranches until they hit the headlines, and yet I'm not in the least surprised.

What I did know is that the house I bought in 1999 nearly doubled in "value", but yet it was same house in the same neighborhood. Thanks in large part to our trade deficit, and China's financing of it, the US was awash in cash. It wasn't being put into productive investments (if your house doubles in price, it doesn't mean that anything was produced). When there is lots of cash around, people are so desperate to invest it that they'll loan it to just about anybody for just about anything (think petrodollars in the 1970's). Eventually the party has to end though - what a surprise.

Pssst ... I hear tulip bulbs are a good investment.

Posted by: alex on December 6, 2007 at 10:43 PM | PERMALINK

mitch: Those tranches derived from the A & B pieces of the initial CDOs are, as you said, recombined and sold on the market as new securities (CDOs in their own right), from which yet another layer of CDOS are constructed from the A&B pieces of those (secondary) CDOs.

Charles Ponzi is dead, but the spirit of his work lives on.

Posted by: alex on December 6, 2007 at 10:52 PM | PERMALINK

Republican presidential contender Fred Thompson drew his line in the sand, issuing a statement saying: "The accuracy of the latest NIE on Iran should be received with a good deal of skepticism. Our intelligence community has often underestimated the intentions of adversaries, including Saddam Hussein's Iraq and North Korea."

Posted by: billy on December 6, 2007 at 11:19 PM | PERMALINK

Hey!!! That's not the rocket scientists! It's the propeller heads.

You gotta get your geeks in alignment.

Posted by: pjcamp on December 6, 2007 at 11:33 PM | PERMALINK

What rotten Monday morning quarterbacking.

Good writing is not telling, but showing. "May not be 1929 blah blah blah". What the article does show is all procedural, nothing substantive.

Posted by: Bob M on December 6, 2007 at 11:45 PM | PERMALINK

From a friend that works at Citigroup:

One of the CFOs explained in a large "all-hands" meeting. "We didn't make mortgage loans to buyers; we made them to real estate. If the buyer defaulted after six months the value of the real estate would be more than the value of the original mortgage, plus Citi would have the cash flow from the payments the buyer did make. It was based on risk assessment, not credit worthiness."

Citibank thought they couldn't lose either way...of course that model assumed the value of the property would always increase.

Idiots! "Those that don't study history are doomed to repeat it."

Posted by: Ex - Republican Yankee on December 7, 2007 at 12:04 AM | PERMALINK

My experience with Fitch & S&P & Moody's is not that they are sleazy or incompetent. However, CDO's and structured products got VERY attractive when Greenspan kept rates ridiculously low (2002-4), and they got VERY complicated when enormous $$ (ie, pension funds) began to flow into them. With the enormous inflow came enormous fees for the issuers. As a result of all of the above, it became not terribly difficult for the structured products engineers to fog the eyes of the raters during day long meetings that determined the final ratings.

Posted by: marty on December 7, 2007 at 1:10 AM | PERMALINK

it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

Including the current meltdown, this makes three out of four which occurred when the President was named George Bush, and four out of four which occurred when the President was a Republican. Hmmm...

Posted by: jimBOB on December 7, 2007 at 3:01 AM | PERMALINK

Whether deliberately or otherwise, we have a suppression of financial market memory. Certainly not all those in position of influence and control, whether at the Fed, Treasury Department, or at finacial institutions, etc., are so young to have forgotten the Junk Bond and Savings & Loans debacles, let alone the dot-com bubble. Now this predictable event.

What they all have in common is ideology in pursuit of the chimera of the free and self-regulating, self-correcting market. Never happened, never will. Whether you idealogues want to believe it or not, capitalism as so far practised has never worked that way; left to itself it booms and busts, which the concensus has come to agree is no way to manage an economy.

All these events followed on loosening of regulation, oversight and control, a failure to apply judgement and prudence, both of which used to be valued in the financial sector. You know, risk managemnent and all that?

And why? Greed. The pursuit of personal, not shareholder wealth.

If you don't know who Michael Milliken was, or about all the 80s Reagan banking de-regulation that might be part of the problem.

This latest one, the Federal Reserve was definintely asleep at the switch. The greed shown the last few years throws Milliken's $300 million (or whatever it was) into the shadows.

Millikin went to prison.

The problem here is that those who made obscene profits walk away after, basically, conning investors while regulators slept or turned a blind eye.

That's where the injustice lies. And that's what is galling. It's the same with these CEOs who don't just underperform but actually destroy shareholder capital yet walk away with, even, hundreds of millions of dollars.

What's not obscene with this picture?

Crude and inept as the "relief" the idiot son has signed on to, it certainly hasn't extended to punishing those who created the problem.

Posted by: notthere on December 7, 2007 at 3:37 AM | PERMALINK

For whomever in the financial industry came up with the idea that averaging the averages of the average would result in anything else but regression to the mean, here is a website they should review before even being allow to program an abacus.

Posted by: Kenny on December 7, 2007 at 3:54 AM | PERMALINK

What about all the investors in these tranches? They bought on the assumption that all these balloon interest rates would, indeed balloon, inflating the value of their investment. I can just see them rubbing their hands in ancitipation.

Now that interest rates will be frozen on some mortgages there is the strong liklihood that President Bush's actions will be challenged in court by the investors.

This situation is going to turn into a financial fiasco. It simultaneously shows the problems of unfettered, capitalistic greed and government attempts to mitigate the effects of that greed.

Couldn't happen to a more deserving Administration. Unfortunately it will impact us all.

Posted by: pj in jesusland on December 7, 2007 at 4:04 AM | PERMALINK

Explanation of why CDO AAA is not so AAA.

http://www.portfolio.com/interactive-features/2007/12/cdo

Posted by: JLS on December 7, 2007 at 4:13 AM | PERMALINK

I need some expert financial advice. As an n00b outsider, how often do I need to read things like this and when can I point to the various layers of taking a commission, downplaying the risk and selling on the investment before I can start pointing out it looks like a pyramid scheme?

      the govt. bailout will safe us
    its all AAA, just look at the model*
   CDO`s are less risky than their parts
  mortgage backed securities, great FICOs 
 these sub-primes are not really sub prime
nah subprime loans are not that risky at all

Anyway here is the wikipedia definition of a pyramid scheme:A pyramid scheme is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, usually without any product or service being delivered. It has been known to come under many guises.

Here is some telltale signs, also from wikipedia:

  • A highly excited sales pitch (sometimes including props and/or hand-puppets).
  • Little to no information offered about the company unless an investor purchases the products and becomes a participant.
  • Vaguely phrased promises of limitless income potential.
  • No product, or a product being sold at a price ridiculously in excess of its real market value. As with the company, the product is vaguely described.
  • An income stream that chiefly depends on the commissions earned by enrolling new members or the purchase by members of products for their own use rather than sales to customers who are not participants in the scheme.
  • A tendency for only the early investors/joiners to make any real income.
  • Assurances that it is perfectly legal to participate.

Just for the record, I did not write a single line of that article.

If you believe the economy is going great and are a big GOP donor, then I want you to invest in CDO`s.

*) Ignore the climate models because they are just models, follow the investment risk models!

Posted by: rt on December 7, 2007 at 6:26 AM | PERMALINK

Remember George W. Bush, a few years back, crowing about "the highest rate of home ownership in history"?

Now you know why.

Posted by: The Conservative Deflator on December 7, 2007 at 6:33 AM | PERMALINK

Schadenfreude aside, there's a good reason to lay the blame for this debacle squarely at the feet of the modern Republican Party and its ideology of wealth without pain. Supply-side economic theory, the denial of the common good from ideologues like Milton Friedman and Ayn Rand, and the econo-porn of think-and-grow-rich wealth hustlers have created the ideal political environment for these Ponzi schemes to flourish.

As Alan Greenspan so nobly exemplifies, not one of these hustlers will apologize. They'll blame imperfect humans for marring perfect capitalism. If we were only purer! It's a lot like Ron Paul's presidential campaign, which in turn is eerily reminiscent of Trotsky's lament that REAL Communism was never tried. Ideologues never run out of excuses. Because bromides often substitute for logic and rigorous argument, our political discourse ends up sounding like a debate between a cheerleader and a skater dude.

In a nutshell, why George Bush is president, Pat Roberston is rich, and Larry Craig is happily married.

Posted by: walt on December 7, 2007 at 7:46 AM | PERMALINK

I take offense to describing charletans as "rocket scientists." The rockets, I'll point out, actually do go up as they are supposed to.

Okay, well, the space shuttle has had it's problems, but that's because the of the rocket scientists' supervisers playing politics with the safety analysis.

Posted by: Ben V-L on December 7, 2007 at 8:47 AM | PERMALINK

Ah, we see the Reagan-worshipping Republican war on market and banking regulations delivering its inevitale result.

Handy how they could forget why those regulations were imposed in the first place.

George Santayana smiles and nods.

Posted by: CN on December 7, 2007 at 9:58 AM | PERMALINK

Establish a Federal 'Credit' Insurance Corp.

2006 Wall Street bonuses; $25 Billion. 2007 Sub prime losses: $25 billion.

As the big boys on Wall Street direct trillions in capital flows to derivatives, rank speculation and the latest hot packaged products like sub-prime mortgages they whet their beaks, like the mob, at every turn.
Why not place a one one hundreth of a per cent insurance hold-back fee on these flows to fund the financial and social dislocation costs caused by the the financial industry's recurring greed driven excesses?
It would be a manifest boon to American workers who toil at multiple jobs to create this capital and certainly smooth out a glaring, recurring economic pratfall.
The banks and major financial institutions go on binges as a matter of their nature. REITS, Latin American lending, S&Ls;, hi-tech bubble and now sub prime loans have each wiped out an enormous amount of the financial industry’s equity capital. To rebuild equity, subsequent financial instruments such as car loans, mortgages and credit cards must carry higher profit margins. Thus Jane and John Doe have to pay a penalty to rebuild this equity base.
We know these binges occur and have a deposit insurance mechanism in place (the Federal Deposit Insurance Corp -FDIC) which forces the bankers to set aside emergency money so that the deposit base of banks and their customers will not evaporate.
Likewise we need a Federal Credit Insurance Corp so that when these binges wipe out financial equity there is a source of credit (i.e.loans) available.
Banks do two things. They hold deposits and they offer loans. We insure that these bingers will not take American’s deposits with them as they go bust from time to time. Why not extract a minuscule fee from each credit offering in order that the availability of credit will not be so totally hemorrhaged as to affect gross interest rates, the dollar’s standing, the GNP, prices and inflation?

Posted by: cognitorex on December 7, 2007 at 10:47 AM | PERMALINK

Good stuff and commentary about all this at Brad DeLong (no surprise):
http://delong.typepad.com/sdj/2007/12/tanta-of-calcul.html

Posted by: Neil B. on December 7, 2007 at 11:27 AM | PERMALINK

It was based on risk assessment, not credit worthiness." Posted by: Ex - Republican Yankee

Gee, I wonder how many eyes were rolling and jaws dropped in that meeting. CFO ran the meeting, huh? Your friend sure he wasn't the manager of the Department of Redundancy Department? How does one separate credit worthiness from risk? Fucking morons.

Posted by: JeffII on December 7, 2007 at 11:38 AM | PERMALINK

Kevin,

The basic problem here is that the bankers, when they created these tranches, expected that not all borrowers would default at the same time (in other words they expected the default risk to be idiosyncratic and therefore diversifiable) while, ex post, the borrowers all started defaulting at the same time (the risk turned out to be syatematic and non-diversifiable). If the borrowers all did not default at the same time then the risk of default by borrowers in one part of the country would be offset by the payments of borrowers from another part of the country and the AAA CDO investors would still get paid. If borrowers in different part of the country all started defaulting at the same time then there is no offseting or diversification of the default risk. This is what happened here. Insurance companies use the same diversification idea when issuing policies.

The interesting question is whether the bankers underestimated the systematic component of this default risk given that the housing prices were too high. I also think a lot of the black-box models they use to value these securities do not adequately take into account the systematic risk which would lead to a higher risk premium for these securities.

Posted by: EP on December 7, 2007 at 12:42 PM | PERMALINK
How does one separate credit worthiness from risk? Fucking morons.

Well, first you're going to need a hat. Preferably one of those top hat types, or at least something with a fair volume and able to hold it's shape. Place it top down on a table, or stool or some such surface, so that the opening faces up.
Make sure there's nothing else in the hat, so as to keep the integrity of the process intact.
Then you wrap the credit-worthiness and risk into a regular white handkerchief and place it in the hat.
Next, youOHMYGOD-THEMULLAHSAREGONNAGETTHEBOMB!111!!!
Anyway, that's how it's done. Pretty simple really.

Posted by: kenga on December 7, 2007 at 12:56 PM | PERMALINK

The basic problem here is that the bankers, when they created these tranches, expected that not all borrowers would default at the same time (in other words they expected the default risk to be idiosyncratic and therefore diversifiable) while, . . . Posted by: EP

They wouldn't have needed to factor in a large number of "idiosyncratic" defaults if they'd lent money for housing the old fashion way. That being it based on credit worthiness.

However, no one should cry too much for those people going into foreclosure who knew full well that their interest rates would double or even triple X number of months down the road (many of whom should have been disqualified because of this).

Nor should anyone feel too badly about the percentage of people that got in this mess who came late to the "flipping" game. Like the day traders during the stock bubble, they were gambling but never really understood how the game was played.

Posted by: JeffII on December 7, 2007 at 12:58 PM | PERMALINK

Speaking as someone who almost got hired by Moody's to construct and rate these bloody things called CDOs, I can tell you the major major reason this whole thing happened:

"Gas molecules never panic and all stampede into the corner of a box. Humans often do."

My suspicion is that a lot of people working in quantitative finance happen to lie somewhere on the Asperger's Syndrom spectrum anyway and couldn't even stop to consider that humans and gas molecules act differently.

And believe it or not, I'm still getting ads for quantitative finance positions. Usually in Frankfurt....

Posted by: grumpy realist on December 7, 2007 at 2:05 PM | PERMALINK
A lot of the AAA debt isn't really AAA. It's mezzanine debt that the rocket scientists and the rating agencies conned everyone into believing was AAA.

It seems to me that the entire issue here is failure to correctly assess what risk is diversifiable within the universe of similar-type loans and what is not diversifiable, at least without mixing in different kinds of investments.

Deliberate dishonesty may have been involved, but it may just as well have been that the underlying dynamics are not easily quantified, and given different plausible scenarios, people tend to believe what is most attractive to believe. And, in the short term, the incautious were rewarded and the cautious punished, which reinforced the incautious approach.

Posted by: cmdicely on December 7, 2007 at 5:02 PM | PERMALINK

Deliberate dishonesty may have been involved, . . .

You ya think?

. . . but it may just as well have been that the underlying dynamics are not easily quantified, and given different plausible scenarios, people tend to believe what is most attractive to believe. And, in the short term, the incautious were rewarded and the cautious punished, which reinforced the incautious approach. Posted by: cmdicely

There were three plausible scenarios for the securities consisting, in part, of really crappy real estate loans bundled with the not so crappy real estate loans.

1) People who had barely sufficient income to qualify at low rates for borrowing (but couldn't afford a down payment) would miraculously triple their incomes in the space of 18-months so that they could just barely afford loans at 12%.

2) The Rapture would occur and then none of this would matter.

3) The most likely outcome, and what seems to be unfolding, is that the banks and mortgage companies would get bailed out to an extent by the federal government (or a foreign investor) and their executives and the executives at the bond rating agencies who aided and abetted the crime would all skate.

Ain't corporate welfare grand!

Posted by: JeffII on December 7, 2007 at 5:38 PM | PERMALINK

Read This!:

http://blogs.marketwatch.com/greenberg/2007/12/straight-talk-on-the-mortgage-mess-from-an-insider/

heres a small portion ..

-=snip=-
The ‘Pay-Option ARM implosion’ will carry on for a couple of years. In my opinion, this implosion will dwarf the ’sub-prime implosion’ because it cuts across all borrower types and all home values. Some of the most affluent areas in California contain the most Option ARMs due to the ability to buy a $1 million home with payments of a few thousand dollars per month. Wamu, Countrywide, Wachovia, IndyMac, Downey and Bear Stearns were/are among the largest Option ARM lenders. Option ARMs are literally worthless with no bids found for many months for these assets. These assets are almost guaranteed to blow up. 75% of Option ARM borrowers make the minimum monthly payment. Eighty percent-plus are stated income/asset. Average combined loan-to-value are at or above 90%. The majority done in the past few years have second mortgages behind them.

The clue to who will blow up first is each lenders ‘max neg potential’ allowance, which differs. The higher the allowance, the longer until the borrower gets the letter saying ‘you have reached your 110%, 115%, 125% etc maximum negative of your original loans balance so you cannot accrue any more negative and must pay a minimum of the interest only (or fully indexed payment in some cases). This payment rate could be as much as three times greater. They cannot refinance, of course, because the programs do not exist any longer to any great degree, the borrowers cannot qualify for other more conventional financing or values have dropped too much.

Also, the vast majority have second mortgages behind them putting them in a seriously upside down position in their home. If the first mortgage is at 115%, the second mortgage in many cases is at 100% at the time of origination — and values have dropped 10%-15% in states like California — many home owners could be upside down 20% minimum. This is a prime example of why these loans remain ‘no bid’ and will never have a bid. These also will require a workout. The big difference between these and sub-prime loans is at least with sub-prime loans, outstanding principal balances do not grow at a rate of up to 7% per year. Not considering every Option ARM a sub-prime loan is a mistake.
-=snip=-

theres far more info, and more in depth stuff in the comments .. [432 at the moment..]

Good luck, stay safe all! preserve what wealth you have!!

Posted by: 42Cliff on December 8, 2007 at 6:01 PM | PERMALINK




 

 

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