Everybody is trying to capsulize what caused this credit crisis, and both political sides are trying to minimize their role. Here are some simple facts.
In the 1990's some congresscritters, mostly Democrats, noticed that many inner city people could not qualify for mortgages because they could not provide a record of income sufficient to justify a mortgage. So they passed a law with some Republican votes requiring banks to provide so called "no document" mortgages without checking the borrowers income. Furthermore the law required Fannie Mae and Freddie Mac to buy those mortgages from the banks. A former law had established Fannie and Freddie as quasi arms of the government, which allowed them, in turn to borrow money from the Treasury and from others at lower interest rates than usually required for such things as mortgages. The Federal Government thus became sort of responsible for the debts of Fannie and Freddie.
If congress had just restricted such "no doc" mortgages to cheap housing in the inner cities all would have stayed manageable. But noooooooooo! The congresscritters, Democrats and Republicans, quickly figured that it would be unfair to only let poor people take advantage of the system like that - so they quickly raised the limit on such mortgages to middle class and even wealthy people. After that it became all the rage for banks to offer everybody who couldn't or didn't want to prove their income "no doc" mortgages.
As a result pretty soon banks were writing big mortgages on first homes and even on second and third, fourth and fifth home mortgages on a "no doc" basis. This all resulted in a very enjoyable party wherein folks were buying and selling homes like sausages, especially in Florida and California. If you doubt this you can turn on the TV and find a show called Flip That House which is all about how everybody can get rich by buying houses, fixing them up a bit and then selling them for big profits. Naturally all this game playing drove the price of housing up to the sky in the hot markets.
It all worked quite nicely while home prices continued to go up fast because people could take out a new mortgage to pay their old mortgage. But then in the early part of this decade the nasty old Grinches, like Warren Buffet, tried to spoil Christmas by pointing out the old Chinese proverb that "No tree grows to the sky."
So, in 2005, some congresscritters (mostly spoil sport Republicans this time, including John McCain) noticed that Fannie and Freddie were writing an awful lot of bad mortgages, and they were also fostering a market in blindingly complex bonds and betting pools called "derivatives" which were being sold and kept in bank and insurance company vaults as assets just as though they were real money. The Republicans were shouted down in 2005 because they were gutless wimps and because nobody wanted to leave off drinking the champagne and eating the caviar that came of writing and trading and betting on all these interesting new "derivatives" even though nobody could really understand them.
So there you have it. High finance in a few paragraphs. That is what brought us to where we are now, when even the smartest financial wizards don't know what those "derivatives" are worth, and when if the government doesn't bail out all the dumb banks and insurance companies the whole shebang will come apart.
As an aside, practically every well known congressman and senator except John McCain was on the Fannie and Freddie payroll to keep the party running as long as possible. And even McCain is not blameless because he should have shouted his concerns from the rooftops in 2005 instead of letting the Democrats kill the bill which would have at least moderated the crisis. But, of course, if he had done that he wouldn't have been able to run for president because nobody likes a Grinch. His opponent, Barack Obama, is trying his darndest to wriggle out of his share of responsibility for all of this, but that's pretty hard when it's a simple fact that he took the third biggest money envelope Fannie and Freddie handed out last year.
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6 comments:
Excellent synopsis of the situation. Thanks for explaining it so well!
They're using the phrase mark-to-market? Could you possibly explain that?
Thanks.
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Suppose you own a stock you bought for $10 per share, but in the stock market now it is only worth $5 per share if you were to sell it. Your historical "cost basis" is $10 per share; but if you're honest with yourself whe you add up your assets you "mark to market" by counting the stock as only being worth $5 per share.
Under old accounting rules banks and corporations could carry things on their books at their cost basis indefinitely as long as they intended to hold them to maturity. I think it was (and still is for some assets) a hangover from the days when it was hard to do all those calculations every quarter. Also, some things don't have highly liquid markets like the stock exchange, so to mark them to market you have to do a process to estimate what you would get if you sold them right now.
A couple of years ago, I think, the sacred college of accountants changed the rules - I think under prodding from congress or the SEC. As a result, when mortgages and those derivatives turned South the banks and insurance companies had to start reporting their assets at real value each quarter instead of at historical value.
This gets interesting because banks and insurers are required by regulations to keep a certain percentage of assets to back up their deposits and insurance policies. Also, the bond rating agencies rate their debt on how well their liabilities are covered by their assets.
So you get a double and triple whammy. The asset value goes down which leaves you with insufficient assets to support your liabilities. When you report that the regulators make you sell stock to build up more assets - that forces down the value of the stock. At the same time the bond rating agencies cut their ratings on your bonds, which forces you to pay out more interest and which also makes it harder for you to sell new bonds to replace the old ones which you are paying off as they mature.
Hence a company can look reasonably solid on the day before it reports quarterly results (or before the bad news leaks) and it is substantially bankrupt the day after.
And when that company fails it dumps all of it's mortgage and derivative assets onto the market, which drives their value down further, thus making other companies insolvent.
With derivatives it is even worse than with actual whole mortgages themselves because it can be hard to figure out who actually gets the house if the mortgage is foreclosed. So, the day before everybody panicked about a year ago the derivatives were worth real money and they had relatively liquid markets. The day after everybody panicked a lot of those derivatives became substantially worthless, or at least worth very little. Which gets me to the subject of the claims that there are no markets for such things - which is unadulterated bull.
I, for instance, have always been very ready to offer a nickel per billion dollars worth of derivatives at face value even though I know relatively little about how to value them. I'm sure you would offer a dime; and someone else might well offer a dollar. But nobody is comfortable valuing many of those derivatives at any reasonable percentage of their face value.
Guys like Warren Buffet have the smarts and the financial analysis staff to evaluate such things but they're looking for bargains. If you check out the terms of Buffet's deal of the other day with Goldman Sachs, or whoever it was, you'll get a sense of the kind of deal that folks with serious amounts of ready cash want in such a market.
Thank you for explaining it so thoroughly. I really want to understand exactly what it is that is bringing our economy to its knees, which means that I need to go beyond the basics.
I'm having a little trouble wrapping my head around the concept of derivatives; but from what you've written, I get the impression that you're really not supposed to understand them. :)
I see you've figured out how to post an image. The famous cowboy hat picture. It looks like Santa brought you the whole enchilada...even chaps. You lucky kid.
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Derivatives - don't take this definition to the bank or think it is complete.
A company writes 100 mortgages on homes. In the old, old days it would simply put those mortgages in the paper vault and collect the interest each month until the mortgages were paid off. If one or two or ten defaulted it would foreclose on them and then sell the houses.
In the medium old days it packaged the mortgages together and broke them into two components. One component would be a bond entitling the holder to receive the interest paid on the mortgages less a servicing charge, and the final payoff when the mortgages were paid off. The bank would keep the actual documents and service the loans in return for the service charge. The bank would also sell the foreclosed houses and give the net money to the bondholder. Thus there were two derivatives - a bond and a servicing portfolio.
In the modern new age the bank packages up the 100 mortgages and issues ten bonds. The first best "tranch" entitled the holder to the first one tenth of the interest paid. The second best tranch entitled the holder to the second one tenth of the interest paid. And so forth - until you get down to the tenth tranch whose holder only got his full interest payments if every single homeowner stayed current with his monthly payments. Finally the bank sells a long term bond entitling the holder to receive the payoff amounts on all the mortgages. And the bank establishes a servicing portfolio on those mortgages which it also sells to another bank. Now the issuing bank has sold off everything to twelve different parties. The quality of those "derivatives" ranges from AAA to CCC because it's almost certain that ten percent of the homeowners will pay off their mortgages faithfully, and it's also almost certain that at least some of the homeowners will fail to pay off their mortgages faithfully.
Then the real fun starts when a mortgage insurance company issues an insurance policy guaranteeing to cover any shortfall in the interest payments on all or any one of those tranches. This two can be sold as a bond of sorts. It is a second iteration derivative.
Another popular gambit is to take tranch 5 from residential mortgage portfolio X and combine it with tranch 5 from commercial mortgage portfolio Y and sell that as a bond because residential and commercial mortgages have different risk characteristics, so the combination of them has less portfolio risk than either one.
So now the single package of 100 mortgages is represented by as many as twenty or thirty separate little bonds in the marketplace, each of which has different and complex risk characteristics. And, as is usual, some of the paperwork on some of the mortgages turns out to be faulty when someone goes to foreclose on one of them which goes bad, which immediately makes all the derivatives on those mortgages suspect in the market. Or throw in a real wildcard and have it revealed that one of the loan officers who wrote some of those loans had a habit of helping people to lie on their applications and of falsifying required documents. . .
Years after those mortgages were issued it can take the equivalent of a Sherlock Holmes to track down all the paperwork and actually figure out who owes what to whom. Which adds another wrinkle, because it's expensive to hire Sherlock Holmes to research such things, and the cost has to be apportioned among all the hundred entities which now own the various derivatives, each one of which can sue if they feel wronged. Get the lawyers involved at $500 per hour and suddenly any given tranch is worthless or worse - because some incurance company may have guaranteed the portfolio against legal problems and sold that guarantee as a bond.
I may be exaggerating just a bit. . . but not much.
Thank you again.
I've read it a few times--each time with a slightly better understanding; and I will continue to read it until it all sinks in.
The one thing I do understand is that derivatives make a real mess of things. I also get the feeling that all of this is done with the intention of creating confusion.
"The one thing I do understand is that derivatives make a real mess of things. I also get the feeling that all of this is done with the intention of creating confusion."
Don't let my cynical style infect you too completely with real cynicism. Derivatives also greatly lubricated the international financial system by making all sorts of transactions and investment decisions possible. And there are legitimate reasons why one investor only wants completely secure interest and is willing to take a very low rate of return in exchange for it; while another investor is willing to take less secure interest at a higher level of risk. So you can charge less interest on the overall mortgage (or make more profit on the same interest level) by cutting the mortgages up.
There are also legitimate portfolia management reasons why combining two derivatives from two separate mortgage portfolios can result in less risk than the risk of either portfolio.
That said, there's no question that the next time some smart guy offers a derivative it will get a lot more scrutiny. But they won't go away. My guess is that in ten or twenty years derivatives will be more regularized and will be seen just like junk bonds, which were also considered pure scams when first invented and promoted. In that case Michael Millken went to jail on mostly trumped up charges, but really because he invented them and someone had to take the fall when a lot of them collapsed in the 1980's and hurt people who didn't take the care to understand their risks.
Meanwhile, all of this should be just entertainment fluff to ordinary people (of which I'm one), who should have all or almost all of their investments in well diversified no load common stock mutual funds and government bonds or well diversified bond funds. And those only after having six months of living expenses in the bank.
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