November 19, 2008
The Progress of the Financial Crisis in One Picture: Mortgages, Flight to Safety, Credit Lock
Markus Brunnermeier provides an excellent summary graph of the financial crisis, told in "spreads".
Figure 3 from Brunnermeier (2008): Interest Rate Spreads. The top panel shows the LIBOR-OIS spread (dark shaded area). The TED spread (LIBOR minus the Treasury bill rate) is given by the sum of two shaded areas. It also captures the fact that Treasury bonds are especially sought-after collateral in times of crisis. The top panel also shows the ABCP rate minus OIS spread, while the lower panel depicts the spread between mortgage backed repos and general collateral repos and the agency spread. Sources: Bloomberg, LehmanLive, and Federal Reserve Board.
An increase in mortgage delinquencies due to a nationwide decline in housing prices was the trigger for a full-blown liquidity crisis that emerged in 2007 and might well drag on over the next years. While each crisis has its own specificities, the current one has been surprisingly close to a "classical banking crisis". What is new about this crisis is the extent of securitization, which led to an opaque web of interconnected obligations. This paper outlined several amplification mechanisms that help explain the causes of the financial turmoil. These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too 36 interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account.
(As an aside, I'll observe that in this paper, Fannie and Freddie do not make appearances as "causes" of the crisis. I wonder who has an interest in pushing the view of Fannie and Freddie as betes noire. For more recent critiques of the "F&F caused it" meme, see ,  (h/t DeLong).)
Posted by Menzie Chinn at November 19, 2008 08:32 PMdigg this | reddit
I just read this article and it was very clear and interesting. I highly recommend it. I would also like to recommend this post which also deals with liquidity risk, which is mentioned in this paper as well:
Liquidity risk and the current crisis
Lasse Heje Pedersen
15 November 2008
Posted by: Don the libertarian Democrat at November 19, 2008 10:28 PM
Force managements to be accountable financially and legally and we have less incentives to take on unreasonable risks. Laws are broken because it has been an worthwhile exercise. Laws have been changed to encourage illegal and risky behavior. The market cannot be self-regulating if fixed.
Posted by: Kevin Cavanaugh at November 20, 2008 04:38 AM
As an aside, I'll observe that in this paper, Fannie and Freddie do not make appearances as "causes" of the crisis. I wonder who has an interest in pushing the view of Fannie and Freddie as betes noire.
I'll push it. Each one of the rationalizations of Fannie and Freddie that you linked started by saying sure, Fannie and Freddie could have had something to do with it but look at everyone else. Well, that is part of the problem. If you want to understand the problem you have to look at how the whole mess was intertwined not just look at everyone else. You can't separate Fannie and Freddie from everyone else because like an alcoholic family you had the alcoholics and you had the enablers. Fannie and Freddie appear to be both.
But Fannie and Freddie could not have worked their intoxication without the massive amounts of liquidity from the FED. Then on top of that you had congress and the bank regulatory agencies punshing banks if they did not make loans to bad risks and you get just what we have now, a credit crisis.
All Fannie and Freddie apologists seem to make a very concerted effort to step around the role of government in this whole mess especially congress. It is like there is a big pile of elephant manure in the middle of the living room and everyone is running around the pile trying to hang up airfresheners to eliminate the smell. What we need to do is get rid of the pile of manure.
Posted by: DickF at November 20, 2008 07:00 AM
Well, well. Brunnermeister
sounds like economists have started to understand what ecologists teach -- that a few big players can't make up a stable ecosystem, that stability comes from diversity and complexity, and that, as Ehrlich put it long ago, you can knock an awful lot of rivets out of an airframe before it falls out of the sky only if you've used a whole lot of them to begin with.
is a good bibliography; there are many more.
An ecology is certainly "an opaque web of interconnected obligations." It has "amplification mechanisms" that aren't apparent until some component is removed. It collapses if the top predator is taken out. It collapses if some parts are taken out, anywhere, and we don't easily know which ones are connected most closely or how long such events take.
Applause. Now if the economists can _learn_ that they have learned this, they could save the world instead of investing it at high multiple leverage.
Posted by: Hank Roberts at November 20, 2008 07:38 AM
DickF: (1)The post was by Menzie Chinn, not JDH. (2) Thanks for providing your interesting perspective.
Hank Roberts: I think the idea that oligopolies or highly concentrated industries could exhibit unstable or suboptimal behavior has been around in economics for a long time. So I think your wholesale dismissal of economists in this regard is unjustified. I think Brunnermeier adds the idea of specific types of externalities; that idea too is not completely new to economists.
That being said, complexity does not guarantee stability. Given the right parameters, complex systems can exhibit deterministically chaotic behavior.
Posted by: Menzie Chinn at November 20, 2008 08:16 AM
I'm sorry Menzie. It was a slip of the finger.
Posted by: DickF at November 20, 2008 08:29 AM
Hank - I like the comparison of the economy as an ecological or biological system rather than a mechanical one that is easy to manipulate and control. But as Menzie pointed out, it is not a new idea.
Posted by: MikeR at November 20, 2008 02:34 PM
Displaying my ignorance, but what is the OIS, please?
Posted by: Barkley Rosser at November 20, 2008 11:14 PM
I will also push the Fannie and Freddie as causes issue. This post starts,
"An increase in mortgage delinquencies due to a nationwide decline in housing prices was the trigger for a full-blown liquidity crisis that emerged in 2007"
Why did housing prices decline. Simple shifts in supply or demand? I say it was excessive credit risk primarily caused by Fannie and Freddie's undue influence in this aspect of mortgage origination. The market was pushed unduly by their actions to the point past reasonable credit risk thereby prolonging and exacerbating the subsequent price correction. The risky nature of those marginal loans precipitated the liquidity crisis. The mark to market rule wiped out net worth almost overnight as the crisis unfolded. I further blame Franklin Raines, Barney Frank, and Chris Dodd as major political influences in those institutions taking on excessive risk and pushing it into Wall Street with an implicit government guarantee which we have just finished paying the tab for.
Posted by: Hitchhiker at November 21, 2008 07:04 AM
Interesting graph which takes one closer to understanding the causes of the current "difficulties". I don't think Fannie and Freddie are off the hook, however. Your link to an earlier post answers the wrong question. My understanding is that Fannie and Freddie do not originate loans, but were a major buyer and facilitator of the subprime industry. In a quick search I found this - "
Somebody didn't do their research. The GSE's (Fannie and Freddie) are the largest buyers and guarantors of private sector loans/MBS's.
The GSE's (Fannie and Freddie) bought 25.2% of the record $272.81 billion in subprime MBS sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, Md.-based publisher that covers the home loan industry. In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold. The existence of a large single buyer of such securities (especially one markets belived could not fail because of the GSE's Federal guarantee) enabled the subprime market to grow in the manner it did.
Private sector lenders do originate the loans, but they do so because Fannie and Freddie buy them. Fannie and Freddie created a huge demand for subprime loans, under pressure from Congressional Democrats and their CRA mission."
Am I wrong?
Posted by: Rich Berger at November 21, 2008 08:41 AM
I thank Minzie for another good post on the financial crisis. You have persuaded me that the CRA is at best a minute cause of the reduction of underwriting standards. As many of your readers, I still believe that the GSEs deserve blame and hopefully add a new argument. Not only were they politically flirtatious with both Republicans and Democrats, they seemed to use a carrot and stick approach with companies from whom they purchased mortgages. Firms that believed in the GSE mission or that risk from subprime lending was low grew under GSE sponsorship; those that did not stagnated. Individuals from these firms were promoted and retained their optimistic view.
The Blame Fannie and Freddie arguments seem to have several flaws. Among them, it does not explain why underwriting standards fell at private firms outside the GSEs influence. Brunnermeirer offers a good explanation, “the transformation of the banking system from a traditional banking model, in which the issuing banks hold loans until they are repaid, to the “originate and distribute” banking model, in which loans are pooled, tranched and then resold caused a decline in lending standards.” Why did investors buy these toxic bonds? They measured risk incorrectly. For example, they assumed that price declines would be limited to regional markets. Nor do the flaws of the GSEs explain the international scope of the financial crisis. Brunnermeirer does. The same opaque financial instruments used here were used internationally.
I am looking forward to more enlightening posts.
Posted by: Brooks M. Wilson at November 21, 2008 11:07 AM
Didn't JDH apply some game theory to explain how the GSE's could have played a role? I remember Mark Thoma writing that it was the most convicing argument he had read about the GSE's having any blame. It was right after I had been convinced that they weren't by his posts on the matter.
Also someone posted a speech by GW where he said that we need more mortgages for the poor and then pressured the GSE's to do more. Apparently they couldn't make the loans directly but they started buying a lot of them.
Personally I've moved to the camp that says when a big asian savings glut flooded the market it was sort of like the bible verse my childhood minister used to quote- "new wine in old wine skins".
Posted by: oops at November 21, 2008 01:40 PM
Barkley Rosser: OIS stands for Overnight Indexed Swaps; see here for a definition.
Rich Berger and Hithchiker: Rather than repeating my previous explanations, I'll just reiterate that the vintages of mortgages going most rapidly into delinquency are those securitized in the years when F&F were most constrained in terms of what kind of loans they could securitize. That is clearly laid out in the graph in my betes noire post. Please re-inspect. I allow that F&F might have been important, and the most persuasive argument in this respect is by Jim Hamilton. But when credit cards and auto loans go south, will we also blame that on F&F? Hence, for me, I still look to insufficient regulation by OTS, OCC, and the Fed, along with overexpansionary monetary policy and a tax policy that provided excessive incentives for housing investment.
Posted by: Menzie Chinn at November 21, 2008 01:41 PM
If Fannie and Freddie were doing nothing especially risky, why are they where they are?
Your reply to this has been "lack of liquidity".
I take that to mean declining revenue generated by their defaulting assets is less than fixed expenses required by their liabilities at a time when their assets can not be easily sold.
But they didn't make any mistakes, it was just the bankers, right?
Posted by: Name at November 21, 2008 01:51 PM
Name: I'm not sure you're addressing the question to me; if you are, I'd say that it's primarily a problem that F&F were undercapitalized/overleveraged. It wasn't that the assets they had were particularly risky (that's been debunked), it's that conducting business with the equity ratios they had was risky.
Posted by: Menzie Chinn at November 21, 2008 03:24 PM
Yes, by 2006 F&F had cut back their purchase of subprime. But by then, an entire infrascture had been set up to feed the beast... brokers, originators like New Century and securitizers like Bear Stearns. By 2004 it was clear that these firms were taking excessive risks, but as long as they were making money, it did not matter. I went to Orange County in 2005 and visited with New Century, Impac, Aames, and Accredited. It reminded me of the tech bubble, you knew it woud crash, but you did not know when. I think Bert Ely was spot on with his book, "Nationalizing Mortgage Risk" back in 2000.
"In 2003, the two bought $81 billion in subprime securities. In 2004, they purchased $175 billion -- 44 percent of the market. In 2005, they bought $169 billion, or 33 percent. In 2006, they cut back to $90 billion, or 20 percent. Generally, Freddie purchased more than Fannie and relied more heavily on the securities to meet goals."
Posted by: MikeR at November 21, 2008 03:51 PM
Menzie, the Fannie/Freddie myth is being pushed by the innumerate, the kind of person who is unable to distinguish between a cash mountain and a molehill. Any connection to a particular ideology or political party is purely coincidental.
More seriously, this is a classic example of constructing a myth around a political necessity. Regulating Fannie/Freddie was literally the ONLY issue on which McCain had done ANYTHING pro-regulatory. What he did was laughable: he issued a statement saying he wanted more regulation and that he would support a bill that was so bad that the Republicans could not pass it when they controlled Congress and the Presidency.
One can find many agencies and persons to blame in the mortgage crisis, but it took an almost superhuman capacity to lie with a straight face for McCain to try to pass off Fannie/Freddie as the culprits and McCain as the hero.
Posted by: Charles at November 21, 2008 08:04 PM
MikeR: A plausible argument, but not falsifiable. Can one prove that, had F&F not been in the market, then these profit maximizing private (non-GSE) wouldn't had entered into the lucrative market? I doubt it -- American financial firms seemed to be quite resourceful at finding ways of making money and building up contingent liabilities. Hence, I'm not convinced, and go back to my vintages argument.
Posted by: Menzie Chinn at November 21, 2008 09:14 PM
"I'd say that it's primarily a problem that F&F were undercapitalized/overleveraged. It wasn't that the assets they had were particularly risky (that's been debunked), it's that conducting business with the equity ratios they had was risky."
That's some spin; now we're parsing the bad management?
Freddie and Fannie increased their holdings of MBSs the securities. That led to F/F becoming highly levered. This was a bad move made by bad management.
Why not go back to the days where banks hold loans that they originated themselves?
People do not deserve a house be given to them; one must work for things in life. Bring back the twenty percent down payment.
Why not put the responsibility back on the shoulders of the person taking out the mortgage instead of moving that responsibility on the plate of the taxpayer?
Posted by: Babinich at November 22, 2008 03:32 AM
There is blame to go around for this mess and, I agree that the easy money policy of the Fed contributed. Who regulated F&F? It certainly wasn't the OTS, OCC, or the Fed. Who regulated the private mortgage companies?
I spent some time in the mortgage business. In 2006, it was still possible to get a zero down loan with a 580 fico score. Practically nobody ever put any money down. I am talking not even closing costs or anything. Just sign and move in. Made possible by unscrupulous realtors and originators trying to put deals together and enabled by lax underwriting standards. Did F&F single handedly cause the crisis? No but, in apportioning the blame, I sincerely believe they should get more than anyone else and the politicians covering for them.
Once a bank gets into trouble, they stop making auto loans and credit card loans also. Lending stops until they recapitalize. So what. It was a typical bubble but, one that should have burst earlier with less cost and economic impact except for the actions of F&F which pushed the bubble higher and made the subsequent bursting even more painful. Lending decisions became politicized and that will always lead to failure.
The scenario went something like: Blacks are disproportionally underrepresented in home ownership. This is due to being disproportionally poorer and less creditworthy. Answer. Lower lending standards through influence at F&F. As long as values kept increasing forever, no problem.
Posted by: Hitchhiker at November 22, 2008 11:54 AM
The role of Fannie Mae as a causal factor in creating the sub prime mortgage problem does need to be sorted out.
First, begin with why the issue is so emotional to so many people? Ans. because it has political implications.
Republicans historically defend financial interests. Democrats historically defend poor people.
Democrats say the deregulation urge, made popular by Ronald Reagan and his acolytes, is the root cause. An independent observer would conclude that it could not have happened without the deregulation laws passed by and supported by both parties. But the intellectual empedus came from the Republicans.
Democrats in Congress supported and encouraged Fannie Mae to go all out to enter the sub prime market - primarily to get more poor people into home ownership.
The most intriguing untested hypothesis that I encountered was the argument that Countrywide Federal also pushed Fannie Mae to buy up subprime mortgages by threatening to take their business directly to Wall Street firms that were securitizing mortgages, thus making Fannie Mae a minor player. If that threat happened, it would be like waving a red flag in front of a bull. If it happened, too bad Mr. Mudd, the Fannie Mae CEO at the time did not resist being pushed around. Apparently, he liked having a larger and more profitable company.
My conclusion is that Fannie Mae made mistakes but the biggest mistake was to believe that deregulation would be good for the U.S. taxpayer.
Posted by: ReformerRay at November 22, 2008 01:38 PM
impetus - not empedus
Posted by: ReformerRay at November 22, 2008 01:47 PM
Babinich: You state: "Why not go back to the days where banks hold loans that they originated themselves?" I think this is an interesting thought experiment; I'd like to think about what this would mean for all sectors where securitization has occurred -- credit cards, auto loans, student loans, etc. Once you think about this, you understand why I still think the problem of securitization and agency (in terms of asymmetric information) problems are much more profound and pervasive than just an issue of F&F securitization and subprime/Alt-A.
Posted by: Menzie Chinn at November 22, 2008 02:41 PM
Is securitization a virus that is loose and cannot be contained or stopped? What laws could be passed that would eliminate or reduce the prevalence of securitization?
Posted by: W. Raymond Mills at November 23, 2008 02:59 PM
Babinich, suppose that you are a businessman in a business that normally has a 3% default rate. You set aside reserves for 4%. A recession comes along and defaults actually hit 4.5%. Are you:
The Fannie/Freddie story is very much like that. They bought loans that originators like Their management was not great. But compared to the rest of the industry, they were squeaky clean. If they had properly capitalized, their stock would be low, but they'd still be private.
Hitchiker should consider that George W. Bush himself was pushing home loans to minorities. The theory of the Ownership Society was that owning a home is an investment. Buying one lowers a family's cost structure and allows them to escape poverty. Once they've paid it off, it facilitates saving.
It's a theory that most middle class families subscribe to. And it turns out that minorities did not do too badly with their home loans--at least if they were of the CRA-related kind, because those have to go through banks, and banks are regulated. The category that is in worst shape among Fannie Mae's loans are the Alt-As, not the subprimes. Even among subprimes, many are not necessarily loans to minorities or even to poor people. Many of them are probably difficult to distinguish from Alt-As.
But none of what Fannie Mae is holding looks like the garbage that Countrywide and other unregulated shadow bank lenders were cranking out.
Reformer Ray, the reason that the mortgage crisis irritates me is that there are so many lies that have been put out about it. This nation is not in trouble because of ideology but because of dishonesty. Before forming an opinion about it, I listened to a lot of experts. I've been writing about it for about two years. That doesn't make my opinion right, but it does make it informed. On the other hand, there are a lot of people who form their opinions by listening to Rush Limbaugh, who is probably one of the most ignorant men in media. There are plenty of uncertainties about the mortage crisis about which informed people of different ideology could make a case. But lies, and in the case of John McCain knowing lies, are dishonorable and contemptible.
W. Raymond Mills, securitization has been around for a very long time. It was pioneered by Lew Ranieri. I suggest going to C-Span and listening to Ranieri explain the pluses and minuses.
I think it's pretty clear that as long as the securities created are transparent and easy to unravel, they are not a problem. The problem with complex CDOs is that if a giant komodo dragon eats Pittsburgh, no one knows what happens to the value of ABX-HE-AAA- 07-2 Without that knowledge, the markets are driven by speculation and fear and cannot reach equilibrium.
The issue is generically called "transparency," and this is a good example of why it's good.
Posted by: Charles at November 23, 2008 05:24 PM
"The Fannie/Freddie story is very much like that. They bought loans that originators like Their management was not great. But compared to the rest of the industry, they were squeaky clean. If they had properly capitalized, their stock would be low, but they'd still be private."
First off, please define 'private' as you use it in this passage.
What was the relationship between Freddie Mac's CEO and Freddie Mac's Chief Risk Officer? Was the CEO warned by the CRO about the quality of the loans?
It sure looks as if these were bad loans taken on at a point in time where the real estate bubble was about to burst.
So where are we? Bad loans, bad management decisions about taking on these loans, and a failure to secure the capital to take on these bad loans.
Seems to me that bad is bad no matter the metric.
Posted by: Babinich at November 23, 2008 05:57 PM
"I still think the problem of securitization and agency (in terms of asymmetric information) problems are much more profound and pervasive..."
I really think it comes down to excess risk taking. I don't think the opaque securities are a problem in and of themselves. The agency problem has been around longer than securitization and investors should have known about it. Investors should have required a bigger risk premium when buying them, forcing issuers to offer more information in order to get a better price.
Brunnermeier seems to blame securitization, but he also says it was regulatory and ratings arbitrage, this implies that it was not de-regulation which casused the problem, but too much ill conceived regulation.
If F&F did not have the implied gov garuantee, their cost of capital would have been higher.
As Barney Frank said, investors were too willing to roll the dice.
"House Financial Services Committee hearing, Sept. 25, 2003:
Rep. Frank: I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing."
Posted by: MikeR at November 24, 2008 07:02 AM
"I think it's pretty clear that as long as the securities created are transparent and easy to unravel, they are not a problem."
I'll take your word for it. Next question. Why were so many of theme lacking these characteristics? Did the desire to pass off risky securities as risk-free encourage what happened?
Question remains. If Securitization can be useful, under certain conditions, what laws would insure that secruritization will take place ONLY under the right condtions?
Posted by: W. Raymond Mills at November 24, 2008 07:25 AM
Babinich asks, "First off, please define 'private' as you use it in this passage."
Um. They were listed on the stock exchange.
Babinich also asks, "What was the relationship between Freddie Mac's CEO and Freddie Mac's Chief Risk Officer? Was the CEO warned by the CRO about the quality of the loans?"
Neither of us knows. What you are suggesting is criminal conspiracy to defraud shareholders. If that were true, it should be prosecuted. But courts require a little thing called "evidence." And making allegations without evidence is what I would call "slander." Or "libel" since we're in the print medium.
W. Raymond Mills asks, "Why were so many of theme [CDOs] lacking these characteristics [transparency and ease of unraveling[? Did the desire to pass off risky securities as risk-free encourage what happened?... If Securitization can be useful, under certain conditions, what laws would insure that secruritization will take place ONLY under the right condtions?
Basically, companies are being pressed to make profits that are simply not realistic. Since any scheme to exceed the realistic level that is doomed to fail and also transparent will not be pursued, that means that any doomed plan must also be opaque. In the case of CDOs, what was opaque was risk. So, certainly there was a desire to sell the securities and they were sold only by blurring issues of risk. The level of volition in it is debatable.
Legally, the only changes necessary are to limit the use of derivatives. Complex derivatives are obviously problematic. Using derivatives to gamble is asking for trouble. Only businesses that are genuinely buying insurance should be allowed to use them, and they probably should be packaged as insurance to force them under that regulatory tent.
But a much bigger change is needed. American business has been getting more and more corrupt. The fundamental cause for it is, in my opinion, a decline in job security. People who are fearful for their jobs are not inclined to blow the whistle. Similarly, excessive executive compensation has created perverse incentives. We need to change our system of business to emphasize integrity.
Posted by: Charles at November 25, 2008 07:36 AM
Thanks for the clarification on OIS.
Posted by: Barkley Rosser at November 25, 2008 11:43 AM
Charles said: "I think it's pretty clear that as long as the securities created are transparent and easy to unravel, they are not a problem. The problem with complex CDOs is that if a giant komodo dragon eats Pittsburgh, no one knows what happens to the value of ABX-HE-AAA- 07-2 Without that knowledge, the markets are driven by speculation and fear and cannot reach equilibrium. "
Well, ABX.HE AAA 2007-2 is backed by 20 AAA ABS tranches; they in turn were backed by 78,712 mortgages totalling ~$1.4B at securitization. There are 62,530 mortgages remaining in the pools backing this ABX issue. At securitization, the pools contained 329 mortgages in the Pittsburgh, PA CBSA; currently 292 of those remain in the pools (have not paid down, etc), with an aggregate balance of $27,216,205.78 as of the October remits. (256 of those mortgages are current or 30 days late.) Assuming that consumption by Komodo dragon would be an insured event (i.e.: neither an act of God nor war, etc), and that the properties are insured, the ABS deals underlying this ABX would see the full principal prepaid within the next month or so; as all the underlying deals are currently sequential and at the top of their respective structures (I believe but didn't check: shame on me), this full amount would be distributed as a principal paydown to the AAA tranches. In the context of the ABX.HE AAA 2007-2, this would be a paydown of 2.1984% of any outstanding position (direction of payment would depend on whether you are long or short), cash settle. (If we were doing this for real, we would put a little more effort into the analysis: timing, a haircut for insurance, etc.; however, I'm not willing to spend more than 10 mins on this at present....)
So yes, I agree: transparency is a Good Thing, as this example amply illustrates.
Of course, it also illustrates that one man's transparency is another's opacity: I'm a professional in this business (on the buy side), and I have the tool$ needed to do this sort of analysis. Just because you don't have the tools doesn't mean they don't exist, or that the information doesn't exist, or that the investments aren't transparent.
It's time for the media to stop with this whole 'CDOs aren't transparent' nonsense.
Posted by: Dr. D at November 25, 2008 02:55 PM
Dr. D, I am impressed by your demonstration. Thank you.
I don't think it changes the reality that buyers can't be found for many securities. Full transparency has to do with precise definition of the quality of the mortgages contained in a CDO. To do the kind of securitization the industry did, it would have had to have well-defined standards that would not have varied between originators. It probably would have needed more precise subclassifications. It would have needed the tools to expeditiously renegotiate the terms of individual mortgages on default. These are all elements of transparency. Ultimately transparency means that buyers know the risk they are incurring. While you elegantly demonstrated that there was lots of information available about the securities, it's abundantly clear that it wasn't of the right kind-- and sufficiently clear to buyers-- to prevent a crisis of confidence.
By the way, komodo dragons are not large enough by many orders of magnitude to eat cities. It was a trick question.
Posted by: Charles at November 26, 2008 08:14 PM
With all due respect, you are well outside of your aparent expertise here. As an active investor in this market, I can tell you that we, and other dilligent investors who were willing to spend the money and effort, have enough information to fully re-underwrite each and every mortgage backing a CDO, if we chose to do so. In fact, no such extreme measures are necessary; all that is needed is a thorough analysis of the risk factors in the pool(s). The fact that we have been able to form portfolios with vastly better performance than alternate approaches has been ample demonstration of the sufficiency of information and transparency in this market.
The unfortunate fact is that many/most investors in CDOs and ABS securities simply bought on the basis of the rating -- and, having placed full faith and trust in the rating and the rating agencies, saw that trust completely trampled with the mass haphazard downgrade actions.
The situation now is a complex one: we have a multitude of AAA and formerly-AAA securities trading at 40 cents, even though these securities are all fully performing (no writedowns, no shortfalls); indeed, there is no rational scenario that results in a dollar of loss! Yet for a bank that bought such a security with 4 cents of capital, the impact has been severe -- and many are trying desperately to hold the positions (consuming vast quantites of capital) in the fully rational belief of substantial write-ups in the not distant future (these are short tenor securities). But on the flip side, the mortgage market stagnation and the inconsistent actions of the government are feeding the uncertainty and continue placing extraordinary pressure on housing, thus keeping all outside money out of this market as well.
In short, transparency is not the problem, and never was (for those few market participants who made the requisite investmets); instead, we have a crisis that looks every bit as if it was manufactured.
It is most interesting to me that no one has been pointing out the principal agent problem inherent in assigning and maintaining credit ratings on securities....
Posted by: Dr.D at November 29, 2008 10:40 AM
This is not to discount what you're saying, namely that you think you know the quality of mortgages and what the securities formed from them are worth. But the fact that you cannot sell these securities is evidence enough that buyers do not believe they have enough information. And, to be clear, I think that people like Lew Ranieri know what they're talking about. To me, you're just some guy on the Internet.
It's ridiculous to even suggest that this was a manufactured crisis, unless one wants to count the veneration of larceny that permeated the "conservative" movement as an organized system. The regulatory system and ratings agencies were subverted. The origination system was filled with fraudulence. The government's power in the secondary market was piratized. A half million people of Lilliputian morals pushed and tugged at capitalism until at last they killed it. That could be, I suppose, called "manufacturing."
Any human system is based on trust. Destroying trust is the most expensive vanity of all. Would-be Masters of the Universe learn this lesson again and again, at our expense, alas, and hopefully at theirs.
Posted by: Charles at November 30, 2008 11:06 PM
First, thanks for sharing your relative lack of background and expertise; of course, I continue to be amazed at this modern internet phenomena of how random people with no related experience or education are suddenly experts in some technical subject area given that they have read, rehashed, and regurgitated the writings and opinions of others. Sure, I too am just another guy on the internet; but in contrast to you, I'm a guy with access to full details on all the mortgages backing just about every ABS and CDO, and I have been actively transacting in this market for over 20 years. Thanks for playing.
Second, regardless what you may have assumed, read, or heard, this market is transacting; it is just a lot smaller than when normally functioning. Thus, my firm has been active both buying and selling -- so please don't fabricate things like "the fact that you cannot sell these securities." I may be relatively anonymous here, but that doesn't grant you any right to libel/slander me or my firm.
Third, you are assuming that buyers and sellers fail to meet for one and only one reason, lack of information (which aparently equals lack of transparency in your world view). Unfortunately, the world is not nearly so simple; there is also the matter of funding the trades -- on both sides of the trade -- as well as balance sheet and tax considerations. In short, all of these are major issues right now, with the foremost actually being liquidity and balance sheet implications -- not transparancy/information -- according to people actually in this business. There is also grave uncertainty about the 900 lb gorilla in the room -- the US Government -- and what it will do with mortgages, housing, banking, etc: depending on course of action, the outcome for investors could vary widely! Thus, all of these have combined to greatly chill this market and impede the entry of new capital, thus in turn greatly exacerbating the housing market problem.
Of course, with your lack of experience and knowledge, you fail to see how this crisis compares to other prior situations, particularly with respect to structured finance: in short, there was no reason this crisis had to develop like this; the housing bubble could have been defused at a moderate and reasonable pace. But the unprecedented withdrawl of mortgage availability (ostensibly in the interest of 'protecting' subprime borrowers: I hope they appreciate the 'help') combined with the haphazard ratings downgrades (the world never contemplated a situation where a security was given a defaulted rating yet has not suffered a dollar of writedown or shortfall) together have caused a liquidity trap for housing itself and thus brought on a crisis that may have no possible solution save the nationalization of the entire financial industry. If your goal was socializing the US, you couldn't come up with a better plan of action. Hmmmmm.
Posted by: Dr. D at December 2, 2008 06:52 AM
I can only shake my head by how people take offense when none was offered... and play lawyer when it's pretty clear they have no law license. Nor even a first year course in business law.
But I guess I'd be thin-skinned if I were in the position of saying that things are hunky-dory in the CDO business.
The fact remains that numerous non-anonymous experts in finance have stated that the primary problem is transparency. I provided links to prove that. Someone who was confident of his knowledge would concede the fact and would concede that, because he has chosen to post anonymously, his claims carry zero weight of authority.
You argue that the primary causes of the failure of CDOs to transact freely are liquidity, balance sheet considerations, and tax considerations, in roughly that order. Fine. That's a point of view. Feel free to support it with links to documents, speeches, etc. That will persuade much faster than prickly responses.
Posted by: Charles at December 3, 2008 01:06 PM