Bonus!

On the topic of the AIG bonuses, I understand and sympathize with the outrage but am very much on the side of respecting the sanctity of contracts and our system's (rather flimsily remaining, it seems at present) rules against bills of attainder(fn1) and the like. These are the kinds of things that our very civilization depends on and should not be trifled with no matter how vehement the popular outrage.

That said, the whole episode throws into stark relief an interesting problem with the way high-finance's compensation system is currently set up.

This piece in the NY Times presents the best (and, perhaps, only possible) defense of paying out the bonuses. In addition to sharing my respect for contracts, he points out that the problems these people are unwinding are tremendously complicated and since these folk built them, they know the details better than anyone and are in the best position to fix them. So you want to keep them around and thus will pay to do so.

Also, there is the possibility of other companies poaching these folk away precisely because of their familiarity with AIG's positions. Yes, they constructed the financial bomb that almost destroyed the financial world, but now there is good money to be made if you know which companies are counterparties to the mess. Basically, you could bet against the folk exposed to the bomb you built.

Can we see the problem here? If you are one of these geniuses of finance, every incentive you have is to make big, risky potential bombs. The bigger, the better. The riskier, the better. If everything goes well and it pays off, you become unfathomably rich. If everything goes wrong, then so long as it's big enough and complicated enough, you'll be paid handsomely to try to defuse it, because you were the one who built it. And if anyone should refuse to pay you to try to save them from the disaster you created, you can go and make a killing betting on it's blowing up.

Financial innovation can be a wonderful thing but so long as the entire system of rewards is set up so that those with the most skill and knowledge of complex finance can best maximize their earnings by creating massive potential financial catastrophes, we are going to continue to have massive financial catastrophes.(fn2)

I'm not sure what the solution is. Perhaps going back to something more like the old-school partner model might be beneficial, as then the folk responsible are not just playing with other people's money, but with their own and with their own name.

fn1: It occurs to me that folk might not be familiar with the term "bill of attainder". A bill of attainder is when you pass a law that directly targets an individual. Traditionally, they were used to punish or sentence to death without a trial. They are expressly forbidden in the US Constitution. My recollection is that they were only very rarely used even by the time of our split from England but still our founders felt it an important enough point to include in the constitution. Though with a "living constitution", perhaps our understanding of their prohibition has grown to include allowing them when we really, really want to get somebody without all the usual legal rigmarole.

fn2: Note that we will certainly have massive financial catastrophes either way, but without the poor incentive structure we will hopefully have fewer and, at the very least, can take consolation in that we weren't basically paying people to create them on purpose.

Pending...

My response to Salty Girl is still forthcoming, sorry it's been a busy week and I want to wait until I have a proper amount of time free to focus on it.

For now, I direct you to Arnold Kling's post comparing the forthcoming stimulus bill to the battle of the Somme as examples of colossally stupid decision making. It is a wonderful post.

His point at the end that, all things considered, he's happier watching the government make stupid decisions that merely wreck untold economic havoc rather than watching them make stupid decisions that cost thousands of young lives is well taken.

It could always be worse...

(I'm going to leave off my innate suspicion that if you wait long enough, it usually is.)

And another goes down?

To the extent that misery loves company (fn1), this speculation from a blogger at Portfolio (fn2) that Berkshire Hathaway could potentially face a ratings downgrade in sort of a cascade of self-fulfilling prophecies is excellent news for AIG. (fn3)

There's this interesting bit at the end:

On the other hand, I'm not comfortable with any company -- not even Berkshire Hathaway -- having a business model which requires a triple-A rating. Triple-A ratings should be the consequence of a company's profitability, not a cause of it. If Berkshire lost its triple-A and started playing on a level playing field with everybody else, that might be more sustainable, in the long term, than an attempt to shore up the triple-A at all costs. Certainly there's something very weird going on when CDSs are at 450bp and the credit is still triple-A: one or the other has to be wrong.

The last line is indisputably true: if two indicators are giving you radically different information, one of them is wrong. I could see arguments being made for either (briefly: irrationality in the market for CDS's mean they're wrong verses slowness of updates by the ratings agencies mean that they haven't reflected the most up-to-date information thus they're wrong).

But his overall point about not trusting business plans that rely on a AAA rating seems less obvious to me. I'm not sure it's wrong but it seems suspect. I'd have to think it through. Sadly, I don't have time to do that just now. But someday, someday...


(fn1) Not actually all that great an extent, in my experience. Though that could just be me, I'm not much of a people person at the best of times.

(fn2) Portfolio magazine, which I was only very dimly aware of just a couple of months ago, has crossed my radar many times recently. First, I saw their notice that they were cutting back and thought, "there's another magazine I don't read and never will". But then a friend called my attention to Michael Lewis's excellent piece on the Great Collapse, mere days after that I ran across this older but interesting piece on the troubles facing the traditionally technologically savvy and recession proof(ish) porn industry, and now this fun-filled guess at a potential calamity falling on Berkshire. They're on a roll!

(fn3) As you'll recall from previous posts (if, that is, you like long, rambling discourses...) it was a ratings downgrade that felled AIG.

A Winner!

Sorry for the light posting, I've been up to my eyeballs with work and packing and the like.

But I did want to call attention to the fact that today's 3:00 Dive left the Dow closed below 8,000 for the first time in five years.

Whoever had "Nov. 19" in the "when will the Dow close below 8,000" pool, you can collect your winnings from the man selling pencils on the corner.

I'll tumble for ya... I'll tumble for ya...

So the Dow is down again today, nearly 8%.

We are living in utter chaos. Up 11% Monday, steady Tues, down 8% Wed. Madness.

What I'm wondering now is how long it takes until this fades into the background and is no longer panic inducing?

I'm paying, perhaps, particular attention, over and above my usual, due to the limbo my various housing situations are in. (fn1) So maybe the dread pit in my stomach that has lived there almost continuously for the last couple of months is just my own unique cross to bear. But I think not.

On the other hand, if there's anything I feel certain of about Human Nature it is humanity's nearly inexhaustible capacity to become used to anything. So now I'm wondering how long it is until chaotic markets and an impending economic collapse just becomes "the way it is" and is no more bother than any other ongoing tragedy of our world.

Honestly, if it goes like this much longer, a collapse will be a relief if only as an end to the anticipation.

(fn1) It's a long, long story. Suffice to say we're now moving on a rental as negotiations seem to have reached the end on the place we couldn't buy. "What negotiations?", you might be asking if you'd heard about our board rejection. That, dear friends, is why it's a long, long story. But for now, at least, I theoretically am moving on two fronts. And the market is tumbling. (fn2) And my stomach is not loving life.

(fn2) The word "tumble" always puts me in mind of the Boy George song "I'll tumble for you". Good song.

U.S. as banana republic...

Kind of hard to argue with, lately...

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...

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.)

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