Good Fences

Living in a modern apartment complex in a big city usually means knowing little to nothing of the people around you. I have neighbors on both sides of me and all I know of them is tiny little stuff based on hearing their interactions in the hall as they and their guests enter and leave the apartments. And, of course, on the rare sound heard through the walls.

The sound heard through the walls is rare because the walls between apartments in my building are thick. Like slow-witted-cashier thick. Often you can clearly hear somebody's TV turned way up from the hallway but find only blissful silence once ensconced in your own living space.

So what have I learned about my neighbors? Odd things. I'll take the one I think is less interesting first.

The apartment to the East of mine is a large one-bedroom situated on the corner. I know this because I took a surreptitious look around when they left the door open when repairing it between tenants a couple of years ago. The fellow who lives there is a tall guy. He has a large dog (black lab, I think, though I'm terrible with dog-breeds). He has a standing order for two cases of the sports-sized Poland Springs bottled water, which appear outside his door in the early morning once a month.

He went to Ohio State and I think he has a job that allows him to work from home much of the time.

The Ohio State factoid I learned shortly after Georgetown beat UNC Vanderbilt (thanks for the reminder Bill) in the NCAA tournament the year before last. I had watched the game at home with a few friends and when Green sunk the game winning shot as the final seconds ticked off the clock there was an understandably boisterous celebration. Boisterous enough, I suppose, to actually penetrate the sound-suppressing walls that my apartment is blessed with. We later went on to beat UNC which meant we would next face Ohio State in the Final Four. The evening after that win I returned from work to find a note from my neighbor taped to my door congratulating me on Georgetown's win and wishing us luck against Ohio State signed "An Ohio State Alum" with his apt. number given.

The working from home I am hypothesizing based on the fact that he orders food in every night at roughly 6:30. As I get home in the 6-ish range this would imply that he either gets home just before me and immediately orders dinner or that he is just home all day. My rare experience with being home sick or otherwise during the week seems to confirm the home-all-day theory.

So that's my Eastward neighbor.

My Westward neighbor is, I am fairly certain, a prostitute. I'm not sure if she is the same woman who has lived there for the past two to three years or if she is of newer import. (I haven't actually seen her since I began to suspect her working-girl status.) However, she routinely receives many, many visitors in the evening. This alone is perhaps suspicious but not proof of working-girl status. Nor are the many candles she lights which I can see reflected in the windows of the building across the alleyway.

Last Tuesday evening, however, I ran into one of her visitors on the elevator. He was a 40-something guy, who I had never seen before, heading for my floor. Nothing suspicious in that, I haven't seen lots of folk who live on my floor. He was polite, holding the door for me as I was carrying armfuls of stuff. Getting off the elevator, he again held the door for me and followed me out.

He headed with me towards my door. There are three other doors in that direction: my Ohio State friend, the supposed-prostitute and a currently empty apartment. Getting close to my door, he was looking at the numbers and asked me if the prostitute's door was F. I acknowledged it was and bid him "have a good night" as I was just finishing opening my door and stepping inside. His reply "I'm working on it" drew my notice to the fact that he was carrying a bottle of wine in the bag from the wine store around the corner. Given that he was a 40-ish guy and she is (based on late-night comings and goings and the timber of her female friends voices) a 20-something, it seemed odd that they would be meeting up for a date. It seemed even odder when that date ended somewhat less than an hour later and he went on his merry way.

And that, dear friend, is why I am firmly convinced that my next-door neighbor is a prostitute.

It's in Belgium.

So a ways back, when the sun yet shone, before the dark times, before... The Bailout, I took a trip to Florida.

We took some Netflix with us. One of those movies was a little oddball comedy that had intrigued me since I had first seen its trailer but, like most movies, I never got around to seeing in the theater or in the first few months of its DVD release.

This was In Bruges.

I am happy to report that I enjoyed it. I should start by saying that I was surprised to even be intrigued by it way back at first viewing of the trailer as Colin Farrell has a long history of making awful, awful movies. Just awful. I'm not actually sure why he's a movie star because in addition to being awful, I'm under the impression that many of his movies don't make money.

You'd think that making bad, expensive, money-losing films would be a career-ender but the ways of Hollywood are mysterious indeed. Maybe I should get a job in that industry next, work my death-touch magic on those big bags of useless.

Anyways. In Bruges.

Very odd movie. Reminded me of a play in that it had very tight dialogue and a fairly intricately woven plot that didn't actually go very far but kept circling over on itself and putting in clever little references to earlier seemingly throw-away lines so that the whole thing ended up being very enjoyable indeed.

I should point out, before everyone goes rushing out to rent it on my good say-so, that it was a very dark and fairly violent comedy. I'm not sure that most people would like it. My girl, for example, was not as taken with it as I was, though she enjoyed it as well.

She particularly liked a certain line of Ralph Fiennes that was very reminscent of a joke I use far too often. If you know me you will likely recognize the joke when you see it in the movie. (Though his character is not using the line in a joking manner, it is clearly a joke in the overall movie.)

I give it three stars. Good flick.

Coherence. I think it's over-rated but who am I?

Here's a run-down of the AIG bailout that doesn't read like the ramblings of a drunkard sometime after 3 am. If you like that sort of thing.

Clearly, I prefer unfinished, multi-part ramblings that more than passingly resemble drunk-talk. Or else why would I keep posting them, right?

Oh, don't despair. I've got some words on old movies that I finally watched and crazy boring econ books I've recently read coming up too. It's just that I've been rather distracted by the tremulous fate of my company and the finance system more broadly of late.

Part 7: Everybody in the Pool!

So now we've got lots and lots of marginal people getting mortgages that they prob. shouldn't have, structured in ways that make it very unlikely that they'll be able to pay them off -- partly because of wide-eyed optimism and hopeful thinking on the part of the government, mortgage lenders and the people themselves and partly because of fraud by mortgage applicants and sellers. Regardless, everybody's fine so long as housing prices keep going up...

Then you have all of these mortgages gathered together into massive mortgage backed securities. These have been given quality ratings by the rating agencies -- partly because of fraud-ish greed on the part of the raters and securitizers and partly because, with housing prices going up, they don't look that risky. And so long as housing prices keep going up, they won't be that risky.

Everybody see where the problem is? Everything is predicated on housing prices going up. But that is predicated on an ever expanding group of people to buy these houses. But we've already come up with shady mortgage structures and tossed out the standards just to get to this point. Where are the buyers going to come from to continue propping up these prices?

The answer, of course, was nowhere. And thus housing prices stalled and declined. And, suddenly, these people who took out the ARM and other loans with payments that jump are facing high new rates and a house that's worth less than they borrowed to buy it. And, of course, it's a chain reaction of sorts. A foreclosure in the neighborhood lowers housing prices which traps still further people in the same boat.

So that's what's going on in the neighborhoods. Bad things. People not being able to afford their payments. People watching their house's value decline precipitously.

But what's going on down the line with the securities backed by all these mortgages? Also bad things.

See, for years companies were making a killing on these things. So, naturally, more and more companies got in on the game. They would buy these mortgage backed securities to hold for themselves. Which means that on their balance sheets, they would have an asset that was backed by all of these securities. And that asset would have a value. So what's the value of that asset? Simple, it's whatever you can sell if for.

Perhaps a bit of accounting arcana? You see, financial firms these days are required to use what's called "mark-to-market" accounting. This basically means that all of the various stuff (stocks, bods, mortgage securities, other derivatives, whatever) that comprises the assets of the firm must be valued each day at whatever they would be worth if you sold them all immediately.

Ordinarily this is not a problem. But it can set up nasty chain-reactions if there's a panic. So when the housing market stalled out, suddenly all these billions and billions of dollars of mortgage backed securities didn't look so hot. So lots of firms became eager to get them off the books. So they started selling them. A lot of them. All at once.

As I think most people can guess, when everyone tries to sell the same thing at once, the price crashes. And so the price of these things cratered. But, again, the firms have to record the value of these things as if they were selling them today. So when the price crashes, the value you record also plummets.

Which means, suddenly, you are not holding as many assets as you thought you were. Which can cause all kinds of problems. The credit rating agencies, yes, those same agencies that told you this garbage was AAA-rated, might look at your newly weakened balance sheet and slash your credit rating. Which would then cause all the firms you do business with to ask for more collateral. Which means you need to come up with money fast. But, since your credit rating has been slashed, it's harder for you to borrow at just the time you most need to. So you might well go under.

This is all much more likely to happen if you happen to be a highly leveraged firm -- which all of the investment banks were. Leveraging is a fun and useful concept but I won't get into it here. Just to say that it's been at the heart of every financial collapse, prob. in history. As with everything else, this does not mean it's a bad thing. After all, the internal combustion engine has been at the heart of every traffic disaster and it is a wonderful thing.

At any rate, this is roughly the position that Bear Sterns found itself in. It was facing bankruptcy because the value of the mortgage backed securities that it was holding were plummeting because everybody was selling them and nobody was buying them.

So why was it saved by the Fed? Simple, the Fed gambled that if it could prevent Bear from going under suddenly, it might nip this whole thing in the bud. You see, if Bear had dropped suddenly into bankruptcy, all of its assets would be sold off very, very cheaply. Which would mean that all of the other investment banks holding those assets (we're primarily still thinking of the huge mortgage-backed positions these banks held) would also have to value them at the very cheap price. Which would put more of them into the same boat as Bear, just as surely as a domino knocking down another domino.

Ignoring, for the moment, the Fannie and Freddie stuff, the very same thing played out later with Lehman and AIG. Lehman was allowed to go under because the Fed saw that their bet on Bear hadn't worked and decided they needed to let somebody fail to remind the market that there's no such thing as a free lunch. But this decision ended up having precisely the effect that they were hoping to avoid with Bear: Lehman's bankruptcy meant that their mortgage-backed securities book was suddenly valued much lower.

AIG had a sizable book of similar assets whose value was thus immediately slashed. But it also was among the largest writers of "credit default swaps" (CDS), which basically functioned like insurance on these mortgage backed securities: that is, other firms would enter into a CDS with AIG that basically stated if the value of the mortgage backed securities the firm was holding dropped, AIG would make up some of the difference.

So two things happened so far as AIG was concerned when Lehman failed: its own book of mortgage backed securities was suddenly slashed in value and the potential costs of honoring all of those CDS's suddenly became much higher, at least as of the current valuation. (Again with the "mark-to-market" stuff.)

This did not sink them. What did was that with these developments and probably fearing that their reputations had been harmed by having their fingerprints all over these sub-prime mortgages securities the big three rating agencies decided to get tough. So they immediately threatened to downgrade AIG's credit, which meant that AIG would have to immediately come up with a lot of money. And come up with that money in a market that was skittish and using a credit rating that was lower. Not possible, AIG would go bankrupt trying.

So why did the Fed save AIG? Precisely because of all of those CDS's. You see, all of the banks with large amounts of these mortgage backed securities could avoid valuing them super-low so long as they had these CDS's on them. Going back to the insurance analogy, they could say: "Yes, we have these mortgage backed securities that are collapsing in value. Last year they were worth $100B now they're worth only $35B. But! We have agreements with AIG that limit our losses to $30B, so we are valuing them at $70B." But if AIG goes away, all of a sudden the full loss has to be recognized. Pushing all of those banks closer to the edge, if not over it.

The thing with Fannie and Freddie is a whole other kettle of fish so even though it took place in between the Bear bailout and the Lehman/AIG fiasco, I'll deal with it separately later...

The Great Collapse Part 6: Living on a Prayer...

Everybody have a good weekend? Good. Me too. Everybody forget where we were in the story of the Great Collapse? Good. Me too. So perhaps a recap...

In Part 1, we gave the thumbnail version that the collapse was primarily predicated by the Housing Bubble. We talked a bit about what a bubble is and what the characteristics of that bubble were. We only just mentioned that the Federal government was interested in more people buying houses but didn't go into great detail about the various players and reasons for the decade-long run-up in housing. Perhaps we'll discuss that in Part 6.

In Part 2, we took a stroll down memory lane and talked a bit about what a mortgage is and how they traditionally worked. That led us to...

Part 3, where we looked at the dawn of Fannie Mae and Freddie Mac and the government getting into the mortgage market in a huge way. But that was only the prelude to the real fun which was...

Part 4 where we look at the development of mortgage securitization and the enormous new pools of money that opened to the mortgage market. But to sell to those new investors you'd need someone to sign off on the quality of your mortgage backed products which got us to the first of the serious problems which was discussed in...

Part 5, where we looked at the conflict of interest driving the ratings agencies to rate these sub-prime-backed mortgage securities perhaps more highly than an objective rater might.

So. Now we're all caught up. So how on Earth did we get to the point where there were so many sub-prime mortgages getting balled up to sell? Well, this is kind of back to the housing bubble story but now that we know how things flow, we can kind of get into details.

There are a lot of groups involved and interested in increasing home ownership. Or maybe not even home-ownership, but just mortgage buying.

First, you've got the government. The rate of home-ownership in the United States had been stuck for years at about 64% or so. This was considered awful. So the Clinton and Bush administrations took it upon themselves to increase this. And they did. All the way up to about 68% or so. Of course, unless human nature is changing or the nature of the economy is changing, all you are doing there is letting people who are increasingly less capable of exhibiting the financial restraint and intelligence that dealing with a mortgage and home-ownership requires, have to deal with it.

Second, you've got ordinary people who watch home-prices go up and up and want in. Perhaps you also have people who watch rents (especially on the low end) go up and up and want out. Of course, people who are having to deal with the low-end of the rental market are prob. not ideal candidates for the trials and tribulations of home-ownership, but we'll ignore that for the moment. (Lord knows everybody ignored it during the bubble...)

Third, you've got people who sell mortgages for a living. They like nothing better than selling more and more of them.

Higher-up on the food chain, you've got the guys packaging and selling mortgage backed securities. More mortgages equals more securities equals more money. Yay!

So how does this play out in the real world? This is going to sound mean, but not everybody is cut-out for home-ownership. Certainly not everybody is cut out for it at any time. It takes a level of financial responsibility and, yes, intelligence that not everybody possesses and maybe even not everybody can possess.

So what this means is that you have some people who are solid locks. Rich, organized, smart, whatever, they are good to go with buying houses. As you head away from these rock-solid people, you go through people who are increasingly less solid purchasers and eventually you get to the 64% level that we've been at historically. At this level, not everyone is a rock-solid purchaser. There were defaults, there were foreclosures, just not a huge, huge amount. In fact, there were a pretty steady and stable amount.

As you push beyond that threshold, you are asking people who are less and less ready for the enormous responsibilities of home-ownership to step up. Ordinarily, the institutions that put up the money for these mortgages would balk at selling to them. But with the government breathing down your neck to increase your rate of mortgages to "disadvantaged" or other groups, maybe you're willing to chance it. When you can easily sell those mortgages off, you're much more likely to chance it. When it seems like a safe bet because house prices are going up, it becomes a lock! Best case scenario, these marginal people manage to keep the mortgage current. Worst case, they refinance with a new mortgage after their house goes up in value or you foreclose and sell the house for more than the loan. No problem.

So as the mortgage sellers dip further and further into the group of people that are prob. not in the position to responsibly handle a mortgage and as housing prices go up and up, you need to start throwing your lending standards out the window.

Traditionally, you needed 20% down to get a mortgage. And it had to be your money. This serves as a kind of test right there, because it takes a fair amount of financial planning and responsibility to get 20% of the value of a house saved up. Second, traditionally all of your financials had to be verified and documented. You had to prove that you actually made enough money to make the loan payments. And what's more, those loan payments couldn't be more than 30-36% of your pay. You couldn't, for example, have a mortgage payment that would eat up 50% or more of your pay.

All of these fairly sensible qualifications became more and more ignored as the bubble grew. People started taking out loans for the 20%, in effect borrowing the full value of their house. Thus they had no equity and even a slight price decline would mean their mortgage was more than the house it bought. Banks stopped verifying incomes and other financial documentation with anything like the diligence they should have.

Even still, you probably couldn't get enough people to take these loans. They would still be too expensive. So you start coming up with different structures. Interest only, wherein you pay only interest for the first so many years, thus lowering the payments. Or even, negative amortizations. Under these loans, you are actually increasing the amount you are borrowing for the first several years. You are, in effect, slowly going more and more in debt to the bank.

Or the famous Adjustable Rate Mortgages (ARM), these start off with a very low rate for a few years but then "adjust" to the market, which means the rate skyrockets. So unless the person's income skyrockets with it (unlikely, again we're dealing with the more marginal housing market participants here) they will have to refinance or sell the house. And there is often a penalty for refinancing or selling under these more "exotic" (read: "shady") loans.

So that's how people who prob. shouldn't have been taking mortgages were able to take out mortgages. And why they would take out mortgages that were structured in ways that made them riskier than traditional 30-year fixed rate mortgages.

Then these "sub-prime" mortgages would get balled together and taken to the rating agencies to get the stamp of approval and then sold off into the market.

And here's where it gets really, really fun...

Oh the Times we live with...

Yet another great one from the NY Times. This was in a front-page article on Saturday about the bailout plan. Sorry, I guess that should be Bailout Plan. So long as we're giving the Treasury Secretary $700B to play with and specifically saying there will be no oversight, we should probably capitalize, yes?

At any rate. In the course of giving a thumbnail description of where we are in the crisis, they mention "a mysterious colossus named the American Insurance Group."

Mysterious indeed as its name is actually the American International Group. To know that, of course, you'd have to have some kind of super powers. Well, that or 0.18 seconds and access to Google... Or, you know, just be marginally aware of the past week's biggest news. Whatever.

Honestly, the state of the Times these days is just embarrassing. I know they've been facing cutbacks but is firing all the copy-editors really the way to go?

The Great Collapse Part 5: Rate me, do it again and again, C'mon and rate me...

Alrighty then. We now have most of the basic pieces we're going to need to start constructing the financial shenanigans that got us to where we are. So now we start slotting them into place.

Last time, we looked at how Solomon had the revolutionary idea of slicing mortgage bundles into tranches in order to create more appetizing investments out of them.

But if I am an investor, how do I know which bonds are the good ones? And when Solomon or whoever wants to start selling pieces of one of these tranches (or, if I'm running a massive investment fund, perhaps the whole tranche all at once) how can I tell how good it is?

One way would be to do some heavy research myself. This would be costly and time-consuming. So, the market being what it is, a long time ago some folk had the bright idea to do the heavy research for you and publish lists of the results. Literally just lists of possible bonds and a rating for them, based on the research and opinion of these rating agencies.

These people were named things like Moody and Poor. The firms they started are still around, Moody's, Standard & Poor's and the other one are the big three. Yes, I could look up a reminder of the other one's name, but in groups of three isn't there always an "other one"? Like with the three tenors, or the three stooges, or whatever? (OK, fine. It's Fitch. Are you happy now? Fascist.)

So the big three rating agencies rate stuff. Companies, mostly. Which, in practice, means rating their bonds. Meaning rating how likely they are to pay off their obligations. They give grades like "AAA" or "AA-" or the like. So then investors looking to buy them know what an appropriate amount of interest might be.

Also, when making financial contracts between corporations, lots of times you'll have certain things be contingent on the credit ratings of the parties. Things like how much collateral you want to hold for them. In an insurance contract, say, for a large deductible policy, the insurance company often puts out the money for the deductible and then collects it back from the company later. Which means that the insurance company really wants to be sure the company will be able to pay. So they'll ask to hold some funds up front and the amount of funds will be highly determined by the company's credit rating by one of the big three. (This, too, will be very important towards the end of our saga.)

So the folk creating these tranches of securitized mortgages had the rating agencies rate them so they could sell them. And here, ladies and gentlemen, is a first part of the problem. The rating agencies are private companies trying to make money. They are also officially recognized by the government for their rating of companies. These two roles can be in conflict with each other. And were.

When these i-bankers started coming in with their snappy new tranche structures to be rated, the rating agencies charge them for the service. Obv. the banks are interested in better ratings. In theory, the rating agencies are interested in protecting their reputation for impartial ratings and doing a good job and all that. But they are also interested in money. Who's to say if you start rating a bank's mortgage securities too harshly they won't stop coming to you? Maybe they go to one of the other two rating agencies and you're left out in the dark.

So there's an incentive to rate them quickly and highly. (An excellent article on the rating of the sub-prime bundles by Moody's appeared in the NY Time's Magazine a while back.)

Once the i-bank has the rating on the mortgage backed security, they skip merrily off to market them to whoever is interested in that rating of debt.

Which would be fine if these things had been properly rated and were made up of standard mortgages taken out by qualified people.

But why would there be mortgages taken out by unqualified people? And who would try to sell bundles of questionable mortgages? These, dear friend, are questions for the next segment...

(To fully understand the title of this post it may be necessary to listen to the song "Rape Me" by Nirvana and also understand how vile I find the role of the rating agencies in this whole mess.)

Tragically Amazing Photos

Some amazing photos of the devastation of Ike.

The Great Collapse Part 4: Tranche Warfare

So yes. The 80's brought the computing revolution and in few places was the computer more revolutionary than in the world of finance. The level of analysis that computing unlocked truly revolutionized every aspect of finance. This is why there was a relative explosion of new techniques and financial products in the 80's. But for our purposes here, we're primarily concerned with one: mortgage securitization. (By the by, everything I relate here is from memory of the book Liar's Poker by Michael Lewis. It's good, as is most of his writing.)

As we learned in the last installment, Fannie and Freddie with their quasi-government status were kind of the be-all, end-all of what the suits call "the secondary mortgage market". (The primary market would be somebody getting a mortgage. When the bank sells it off so it can be bundled and sold to someone else, that's the secondary market. Something else that might come up in our wonderful tour of The Great Collapse is the tertiary market. This would be where groups of those bundles of mortgages are put together into their own little investment vehicles. Oh yes, never underestimate how many times you can sell the same product if you're clever about it.)

Well, in the 80's the relatively staid bond-trading business was about to really hit its stride when it applied the new computing power at its finger-tips. See, different bonds have different interest rates. The riskier something is, the higher the rate, as I mentioned previously.

But there's a bit more to it than that. Obviously, if whoever gave you the bond doesn't go out of business, then you just get the higher rate, even if they are very risky. The reason it gets the higher rate is because some of them go out of business and then you get no money. Safer bonds are less likely to do this, so you're more likely to actually collect your lower interest payments through the life of the bond.

Fine and dandy. But there's another wrinkle. Not everybody is interested in risk. Some pretty big players, pension funds and the like, are -- in theory at least -- looking for safe, predictable returns. They are not interested in the higher interest rates if they come with higher risk of no payments as well, which they do.

The problem with mortgages is that you can't tell which ones are the risky ones. Oh sure, you can kind of tell, some people get higher rates because they seem less financially responsible, but from an investor's point of view buying a big pool of, say, 1000 mortgages, the risk is that you can't tell which ones are going to refinance and pay off early. You can't tell which ones are going to go into default. So the solution had traditionally been to have Fannie, with it's huge resources and quasi-governmental nature, take care of it.

The genius idea that these fellows at Solomon had, was that if you organized the mortgages correctly, you could get a much better idea of the risk involved in the pool. And with the rise of computers, tracking the level of detail necessary was suddenly possible.

Basically it works like this. Say you have 1000 mortgages that you're going to sell. You can look at history and know that, say, ultimately 3% of those will go into default, 10% of them will get paid off early, that kind of thing. The problem is that you don't know which will. But what if you slice it up specifically by when they pay-off.

So say you slice into three pieces (tranches, they're called, which is where my very clever title for this post came from), and as mortgages get paid off or go into default, you put them in the 3rd piece until that piece is full of bad mortgages then -- and only then! -- does the second piece see its first bad mortgage and they all go there until that piece is full of bad mortgages and finally they'll start going in the first piece.

What this means is now that first piece is looking pretty good. The only way it gets hit with pre-paid or bad mortgages is if the total rate of them rises above 66.7%, which historically is just about impossible. The second tranche is less safe, but still very safe, since it only gets hit if the mortgages that drop out rise above 33.3%, still a pretty high number. That last tranche, on the other hand, is basically a junk bond: very risky. It's likely to see a significant portion of its constituent loans go bad.

So why is this helpful? Because now you can market those safe pieces to investors who are only interested in very safe investments. Like, say, massive pension funds and the like. It unlocks a whole new class of potential investor and, as we know from our basic economics, an increase in demand means an increase in price. So there's now a premium to be made in selling these things.

What does this mean over all? Well, for one thing, it means that Fannie and Freddie are no longer the only game in town for the secondary mortgage market. It means that there are even more outlets for banks to get mortgages off their books, which means an even more expanded ability to write mortgages.

And it means that investors who are looking for relatively safe investments are now also players in the mortgage market.

But this, I'm sure you're saying, doesn't sound like a disaster at all! It sounds like unmitigated goodness: the kind of sweetness and light that we all wish peppered our days eternally.

Perhaps, but just wait until we put it together with the housing bubble and give everybody involved some serious incentives to keep pumping the bubble up...

The Great Collapse Part 3: Fannie, Freddie and the Gang

So... Where were we? Ah yes. Fannie. Government trying to increase home-ownership and ease the limitations of a fragmented banking system. Right, on with the show...


Fannie Mae was originally owned outright by the government but was eventually spun off into a sort of quasi-governmental limbo known as "government sponsored entity". (This, too, will feature heavily in later parts of the story...) What being a GSE meant is that although it was technically a separate and private organization, because it had been founded by the government and was theoretically doing things the government wanted done it was assumed by most people that it was implicitly backed by the government. This allowed it to borrow money using the government's good credit.

(The U.S. Government is considered the safest thing to lend money to in the world, ever. The rate they borrow money at is used as the "risk free rate" in financial calculations. This was the result of a long history of always, always paying off our debts that dates back all the way to the very founding of the country when the government, changing from the Articles of Confederation to our current constitutional order decided to honor the obligations of the previous government. Well over 200 years of never missing a payment puts you in very rarefied company, financially speaking. Anyways...)

So. What was Fannie established to do? Simple, it was established to buy mortgages from the various little banks to get them off the banks books. Once it bought a mortgage from a bank, the bank, in effect, had just been repaid and could go about putting out another mortgage, thereby dramatically increasing the availability of mortgages.

How did it do this? Well, originally it did it straight out with the government's money. Later it would do it with borrowed money. Ultimately, it would sell these mortgages to investors. The problem, from an investor's point of view, with buying a mortgage is the risk that the person stops paying the mortgage. Or pays it off early with a refinance or the like. When an investor is buying some form of debt, they like to know that the stream of payments is going to be there.

So what Fannie would do is kind of insure the stream of payments. First, they were buying a huge amount of mortgages, the vast majority of which would never have any problems. So when Fannie sold a pool of mortgages to investors, they would kind of stay as the middle men, taking in the payments, skimming some off to use as a reserve for the payments that don't get made, and giving the rest, as agreed, to the investors.

This is a sort of proto-form of mortgage securitization, which will be the fun and exciting topic of our next part.

All-in-all this government started buying-of-mortgages scheme was probably a good thing at the time because capital markets had not yet developed the kind of sophistication needed to provide that kind of service on their own.

Rushing though the history a bit, the government also founded Freddie Mac to do largely the same thing, on the theory that it was better to have some competition in the mortgage-buying games, to keep things relatively efficient.

So for a long time this was basically the state of mortgages. Small regional bank gives you a mortgage, they sell it to Fannie or Freddie and find somebody else to give a mortgage to. Fannie or Freddie sell pool it together, sell it off to investors and go buy some more mortgages. Wash, rinse, repeat.

Relatively simple. But then in the 80's some exciting stuff happens... Solomon Brothers (which was then an esteemed bond-trading house on Wall Street) invents mortgage securitization. What the hell is mortgage securitization? It is, finally, the fundamental reason for shit-storm in which we find ourselves. This does not mean it was a bad thing.

But it is a complicated thing so I'll give it it's own part, stay tuned for Part 4 of our little story...

The Great Collapse Part 2: Mortgages in a Nutshell

Hey, Hey Kids! Back for more? Yay! Hold on to your hats, because here's mortgages in a nutshell and the role they played in all this fun...

A mortgage, as we mentioned and you know if you're not currently brain-dead, is when you borrow money to buy a house. Houses cost a lot. So, unless you're rich, you have to borrow a lot. Generally, when people lend you a lot of money, they want to be extra sure their getting their money back.

Actually, this is a truism about lending money more generally (and will come up again later on in this wonderful story of The Great Collapse. I made that up, by the way, but you should use it. Really. It'll catch on.). When you lend money to someone, you're going to want to know how likely they are to pay it back. The more sure you are that they'll pay it back, the lower the interest rate you will charge them.

Anyhoo, way back in history, like 30 or 40 years ago or more, mortgages were sold by banks. And banks were heavily, heavily regulated. Many of these regulations kept banks from getting too large or doing too much competing with each other. The result of this was that most mortgages were sold to you by your local bank.

Having a small, local bank be your mortgage bank made that world different in a number of ways: for one thing, the banker was likely to know you personally. This had benefits and negatives. A benefit was that he wouldn't have to dig deep into your finances (well, lots of your finances were probably at his fingertips anyway as your one-and-only banker) for him to be confident that you were a worthy person to lend to. He knew you, so it was much more like lending to a friend. On the other hand, maybe he doesn't like you. Maybe he doesn't like you because you're black or a woman or beat him at golf too often. He doesn't have to loan to you even if you're otherwise a great risk.

The other thing about a small, local bank giving out mortgages is that it is small. That means it has limited funds to lend out. Often, in these primitive days, that bank would end up "servicing" the loan as well.

"Servicing" a loan is not the same thing as a prostitute "servicing" a client, though that distinction is often lost on those unfortunate enough to be foreclosed on. No, servicing a loan means you own the loan, you're the one getting the payments, it's effectively your money that was lent.

When a small bank keeps a loan on the books (services it) this can be a fairly significant amount of money for the bank. This severely limits the number of loans they can make.

The government saw this and saw that they wanted to promote home ownership. Why did they want to promote home ownership? Lots of reasons. Owning land is a part of the American Dream and has been a huge part of our national mythos since the very beginning. (Think of the indentured servants spending years as virtual slaves on the chance of getting their own farm someday.) Also, it's believed, with some evidence I think, that home-ownership is good for communities. People who own their living space tend to be more invested in their community: they'll be on local councils, they'll make sure the neighborhood is taken care of, in short, they care in a way that renters, on average, may not.

So. Wanting to increase home-ownership and seeing the limitations of the small-banking system in existence, the government created a new thing to fix the problem. The new thing eventually became Fannie Mae.

I was going to go on but this post is getting a bit long-winded. So I'll stop here and make the next part all about Fannie... sort of like a British porn-film, in a way.

The Great Collapse Part I: Housing Never Goes Down

So the whole crazy mess the financial system is in just now can largely be traced to the collapse of the housing bubble.

What, you might ask, is a housing bubble? Or maybe even just "what is a bubble"?

A bubble, dear friend, is when a market decides to go a little "irrationally exuberant" (in Alan Greenspan's memorable phrase, used to great effect as the title to Robert Shiller's book on the stock market bubble of the late 90's. I mention Shiller as he is the current expert on bubbles and because I had a conversation with him once when I was considering pursuing an Econ PhD. Then I remembered that I hate school. But he was still interesting to talk to.).

What this means is that whatever the focus of the bubble is: stocks, bonds, housing, famously, once, tulips; gets bid up. People start buying it not because they need it or because they feel it's worth the price they're paying but because they feel the price will continue to go up so they'll make money that way. And for a while, at least, they're right.

So. The housing bubble. What happened there? Basically, in much of the country, for a prolonged period of time, housing prices went up. And up. And up some more. They went up quickly. And then did it again. For years.

Over time, humans being what they are, this began to seem normal. If house prices go up 15% a year for 15 years, who's to say they won't just keep going up 15% a year forever?

Sensible people, that's who, but those are always in short supply and particularly so during bubbles and their inverse, panics. (Panic, by the way, often accompanies the collapse of a bubble, so expect to hear more about our old friend panic when we get to the later parts of this series...)

So where were we? Ah yes, otherwise sane-seeming people began to treat housing prices as if they were just going to keep going up forever. What happens when something's price goes up forever? All kinds of wonderful things, for the right people.

If you sell that thing, for example, it can be even easier to sell it. Because now you have a huge selling point: buy this thing now and reap the gains that are coming! The sooner you buy the more the gains!

People start buying into this logic and doing whatever they can to jump in. Or jump in again by buying second homes or other "investment property". Pretty soon, you have people buying and selling places without ever living them or, in some cases in condos in Florida that I know of specifically, even seeing them. You literally have new developments where the apartments are sold and resold multiple times before the building is finished and before any one moves in.

This, dear friend, is the equivalent of a market putting up a giant neon sign that flashes "BUBBLE!!" all day long but, again, in the heat of a bubble no one wants to pay attention to signs that it's a bubble. After all, everyone's making a killing and who wants to say it's over?

The point is, that a bubble can begin to drive increases in its own demand. People see people like them making money by flipping houses or stretching to buy a house just out of their means and they want in. When more people want in, that means you've got more people bidding, which means you've got rising prices. Wash, rinse, repeat.

But how can people afford to buy lots and lots of very expensive things like houses?

Well, how can anyone who's not filthy rich ever afford to buy expensive things like houses? You borrow the money!

When you borrow money to buy a house, as everyone knows, it's called a mortgage.

So stay tuned for part two, when we delve into the fascinating details of the mortgage market, including the magic of "mortgage securitization"...

No, really, it's fascinating. Of course, I read economic history for fun, so take that into consideration when I call something "fascinating".

What a week I'm having!

So yeah.

Just to put it out there:

There are better ways to start your work week than by reading in the NY Times that your company has 48 to 72 hours left unless it raises a massive amount of money. In a credit market that's collapsing.

I'll have lots and lots more to say about this. (Hey, if you're reading this and you have no idea what this whole mess is, give me a shout or stay tuned. I can explain it with wit and verve! Just ask my coworkers who I've been amusing/elucidating all day!)

For a tease, here's Hank Greenberg (the CEO who built AIG and was forced out during a trumped up accounting scandal pursued by that peach of a man Eliot Spitzer) writing to Robert Willumstad (the latest of our revolving door of CEOs after Hank left. Decent guy, but with a pretty hopeless mission.) on Monday. The day before we were bailed out (read: bought) by the Fed.

And here's my shorter version:

I hate you. You know this. But even aside from that, I've offered to help you. You've ignored me. You're going to lose the company you fucking moron. Take my fucking help.

Yours, Hank

Twitterpated!

Interesting article in the NY Times magazine this past weekend about the rise of Facebook and Twitter and that type of "Internet 2" stuff that ancient fogies like myself don't understand.

It almost made me see the appeal. Almost.

Apparently, signing onto these things lets you construct your own online identity. Okay, I knew that part of it but I just don't care about having much of an online identity. This is fine for old folk like me, but the article makes the point that for kids today an online identity is not optional. You will have one because most people you know will have one and if you don't participate, they construct yours for you in your absence. So I can see the appeal of the minimal policing of these things to make sure you're not being unfairly characterized by others.

But then there's Twitter. Twitter, if you're like me and only very passingly aware of it, is a service that lets you send out little "tweets", short text-message length updates on you: what you're doing, how you're feeling, what you're seeing, whatever. The article does a good job of explaining why one might want to watch a feed of these "tweets" from someone: it adds up, over time, to a good sense of their life. That is, the experience becomes sort of the 21st century version of the old days of being forced to live and work around the same people all of your life, you get a good sense of who they are, what they care about, how they live, etc.

The article does a less good job of explaining why on Earth someone would want to spend any part of their day texting the world that they "just made a sandwich" let alone why they would want to do it day after day*. I guess if you're getting a good buzz and sense of shared existence from reading other folks' tweets, you might develop the urge to "join the conversation" or whatnot. The article also tries to sell putting out tweets as a sort of chance to meditate on what you're doing, kind of take a meta-look at your own life. But I just can't see "I made a pastrami sandwich!" as any kind of worthwhile meditation on anything, deep as I find the cured meats to be.

So yeah. Interesting article, gave me a fleeting glimpse of insight into the world of those wacky kids whom I spend all my days yelling at to "Get off my lawn!"

*Yes, of course I am fully aware of the irony of someone who writes a blog questioning the desire of someone to shout into the ether. Perhaps these twitterers are as aware as I am that they are merely talking to themselves, as what they 'contribute' should not be read by anyone.**

** Note: I'm not actually talking about you, my loyal readers, who number somewhere between 1 and 4, given the day. You folk obviously appreciate my genius and can easily see the worthiness of my contributions here. I'm talking about all those people who don't read my fantastic rants.

Title Note: "twitterpated" is an actual word. It's a good word, one of my faves right up there with "canoodle", though unlike canoodle, you'll need a serious, serious dictionary, like the OED, to find the definition of twitterpated. Luckily, I have such a dictionary. Though not in online-linkable form, alas.

Basic Economics

So I read a bit on my Fla vacation of a week or so ago.

First, I finished Tom Sowell's Basic Economics.

It was quite good. I think I shall attempt to lend it to my more economically illiterate friends.

The basic tack he takes is to describe the workings of the economy in layman's terms and using approachable examples. He takes particular time in each chapter walking through common economic misperceptions explaining why they seem to make sense but then showing how when you fully think through their implications they are wrong. Indeed, he devotes an entire chapter to just these fallacies and has also published an entire separate book on the subject.

The main point that he repeatedly returns to is that to evaluate a policy it is important to not just look at its intended effects but also the incentives it will create and, if possible, the results in previous instances where the policy was attempted. (And history being as long and varied as it is, it's almost always possible. Despite popular belief to the contrary, there is precious little new under the sun, particularly when it comes to governmental action.)

The idea being that just because you have noble intentions and your policy seems straightforwardly directed to meeting them, it may well be creating incentives that will work in just the opposite direction. An example he uses is rent control (which is a subset of price controls more generally). It sounds like a great and simple idea: housing is too expensive, make it cheaper. That way poor people will be able to afford it.

But what it does, in fact, is make it less attractive to build and maintain housing. Thus, over time, you get less housing and the housing you have falls into worse and worse states. Often very expensive housing is not covered under rent-control laws (the thinking being why try to keep costs down on mansions or whatever) this, of course, makes it more attractive to build luxury housing than affordable housing and so you get more and more luxury housing and less and less affordable housing, exactly the opposite of what you intended.

Prices, in general, are very important. They represent easily understandable information about reality. This is why attempts to change them without changing the underlying reality always cause unintended problems. To go back to the housing situation, high rents in an area are telling you that lots of people want to live in an area that does not have enough housing to fit them all. Artificially constraining the price of housing does not correct this imbalance: instead it exacerbates it by causing more people to try to live there because the price seems low, thus you end up with a housing shortage. Left alone, the high rents would be attractive to builders who would come in and build more housing, the greater housing would mean that there would be fewer people-per-place to bid it up and voila, cheaper housing. Now this might cause other issues that you are trying to avoid, like turning your sleepy town into Manhattan but life is all about trade offs.

In fact, if I could sum up the importance of economic thinking in a nutshell that would be it: that there are really no 'solutions.' Because we live in a reality of finite resources, there is only an endless set of trade offs.

At any rate. This book report got kind of off topic so I'll cut it here. Short version: well-written, useful book. I give it two snaps up in a circle.

Norks are weird

Article on "hidden majorities" of women and minorities

Here's an article on "hidden majorities" of women and minorities that brings up the constitution's 3/5's compromise. The author here doesn't explicitly get the point of the compromise wrong but the way she brings it up kind of hints to me that she's the type who would get it wrong. And since it's a huge pet peeve of mine, I'm going to explain it here.

So often people bring up the 3/5's compromise as a sign of how awful our founding fathers were. "Look," these types of people say, "they were such racists that they codified into law that black people were only worth 3/5's of a white man!"

This gets the point of the compromise precisely backwards. Setting aside the fact that the constitution quite purposefully never mentions race, the argument was about how much slaves would count when apportioning representation. That is, the constitution establishes that we will have a census and that our representatives in the House of Representatives will be apportioned among the states based on their share of population.

(At least that's how it is now. Originally, of course, the plan was to just add more Reps for new population, keeping the ratio of people-to-Rep constant at around 30,000. Now, the number of Reps is fixed at 435 and only the apportionment between states is adjusted to match population shifts.)

So given that you were going to be doling out Representatives based on population, you are naturally going to have more power going to states with higher populations. So how should slaves count? Under the deluded "How racist it is not to count them as full people!" argument, you would count them as one each. But given that they are owned by other people, all you are doing is increasing the power of the slave-holders. If you count them as less than one per slave, you are decreasing that power.

This is why it was the anti-slave Northern states that were arguing for not counting slaves at all -- not because they thought slaves weren't people but because they didn't want to give all that power to the slaveholders that they opposed. On the other side, you had the slave-holding states arguing that slaves should count as full people -- not because they thought of slaves as their equals but because they wanted more power. Thus the 3/5's compromise. The reason they were counted as less than a full person was due to the anti-slavery side.

God how I wish people would get this straight. Getting it wrong betrays not only an utter lack of knowledge about the constitutional creation process but also a pretty shaky grasp of the logic of political representation.

After bringing up the 3/5's compromise, the author goes on to say this:

Women were counted as zero-fifths -- at least symbolically -- unable to vote nationwide until 1920 with the passage of the 19th Amendment, behind Australia
and Canada and lots of other countries.

This is just plain idiotic. Slaves weren't allowed to vote either so by this logic the 3/5's compromise was really a 0/5's compromise! Yeah! Oh wait, no. This is just the author trying to be a little more clever than she is apparently capable of being.

I also don't particularly like the snide naming of a couple of countries and the "lots of other countries" that beat us to women's suffrage. Why not point out that "lots of other countries" still don't allow women to vote? Or have other basic rights? Or you could point out that Canada is currently engaged in a debate over whether they should have the right to free speech, a right that, if you lack it, makes voting largely irrelevant.

Yes we were slower to the punch on women's suffrage than some and eons ahead of most of the globe on that and so many other issues. It's a shame we weren't born perfect but then nobody is.

Fun with Perspective!

George Clooney seizes the rare opportunity to grab a giantess and make a wish!

All that glitters...

Fascinating Washington Post article about a Turkish immigrant millionaire's daughter's Sweet 16 bash.

Great quote from one attendee:

"Honestly, it's been challenging at times raising our daughter around all of this," says Melanie Braun, mother of Ayse's best friend Maddy. She gestures around the club. "It's not our lifestyle at all. But the Halacs are a wonderful family, very generous. I think Ahmet contributes to charities in Turkey, or something."

"Contributes to charities in Turkey or something". Priceless.

I also liked the bit about how Soulja Boy, one of the celebrity rappers paid to attend, was under the impression that it was a club appearance, not a private party. He charges more for private parties.

Easy Come, Easier Go...

Disturbing article about a Chase private banking client who had hundreds of thousands of dollars stolen from his account over a period of months.

The disturbing part is how easily it happened and, of course, if it can happen to uber-wealthy investor types being handled by the "Private Banking Group" (read: sycophants who will bend over backwards to retain the really, really rich clients) and they have little recourse, what does that say for us peons?

Still, I hope to someday be in a position to have $300,000 stolen from me in 15 months and not really notice that it's missing.