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.