They're doing better than the media in the US does with explaining the
details of the financial crisis. :|
prompts me to pass along this note that I received in response to a query to a
fairly savvy group of folks, wondering in part why Congress is bailing out Wall
St banks (and execs) instead of the taxpayers that are losing their homes:
-----
> I realize that "all" the CDOs are considered toxic because the
> bad mortgages are mixed with the good and it's impossible to
> discern what's what.
I think this is a bit of misinformation. CDOs are contracts just like anything
else, and in order to be legally enforceable, they have to be clear on the
details. What happened here was simple fraud: Ratings agencies were tricked
(willingly, I admit) into providing ratings for securities that represented the
best parts of multi-part pools coupled with historical evidence of the issuer.
If you take a pool and divide it into {risky-but-pays-higher-interest; medium
risk, average interest; lower risk, lower interest}, each piece should be rated
differently. Instead, the whole thing was presented to the ratings agencies as
"From an A+ bank" and the whole thing got rated accordingly. There's lots ot be
said about this, but let's just say that the ratings agencies got sloppy and
greedy themselves; can you say "conflict of interest" ...? Now, if you're a
money manager and you're offered three things, all rated the same, and one pays
a better interest rate, which one do you pick?
That's right: you pick the crap.
Say you're gonna get 40bp more, you want all you can get! You're like Delorean
in a drug deal. And if you're a $50k/yr "money manager" guy working for a
pension fund in Iowa, your boss says: you can't buy anything you don't
understand without buying insurance. So you price the insurance: top notch
rating? That'll cost you 5bp (oops, should have cost you 200bp! Cue AIG, also
not big on reading ...). Great, you're well on your way to being a super genius
and getting your wife a new car with your bonus this year.
So what's happened here? Well, I'll tell ya: it's got not so much to do with
"bad mortgages" or (as one of the candidates say) "irresponsible people who
bought more house than they could afford" ...
What happened to Lehman and Bear (and to a certain extent Merrill and Goldman
and Morgan) is they got extra greedy: if selling this crap is making money, I
want to produce and sell even more. And in order to sell stuff, you have to buy
stuff. But "stuff" in this case is pretty expensive, so you have to generate
cash -- and get your nominal overlord regulator (surprise! Paulson is a former
Goldman exec!) to give you the green light to lever it up to 30:1. And since
you're a top-rated investment bank (hey, we were down to only 5 from 10 a decade
earlier; who else are people with money going to go to?), you can borrow money
easily: you just print a bond, sign your name ("I'm Picasso!"), and some idiot
gives you $100M because your ratings are high (at least on certain parts of your
business, but where that money goes after it gets swallowed at the head is
anyone's guess [my money is 'closer to the tail'], because IBs don't have the
kind of regulatory transparency that, say, a commercial bank does) and now you
can find all those idiots listed by name on the roll call of "subordinated
Lehman bond holder" :-) ...
Also, "stuff" in this case is mortgages, to a limit. Fanny & Freddie have
nearly cornered this market: something north of 50% of all the mortgages in the
US have been bought or are guaranteed by them, so what do you do? Those
white-shoed guys are getting all the good mortgages. Ok, so let's set ourselves
up our own origination and distribution network, and buy mortgages from them.
Fanny & Freddie have slowly established requirements for "conforming" mortgages
over the years, and it gets better as they catch scammers[*], but if you can get
a conforming loan, things are pretty good for you. If you can't ... well,
there's plenty of people out there who will fudge, lie, cheat, steal ... all to
get you into your house. And then they would turn around and sell your mortgage
to guys like Lehman who would then build the pools. But you see, an investment
bank isn't in the business of originating loans: so they don't have standards
(high or otherwise). They are in the "cost-plus" world, where if something is
more expensive, you just mark it up: you live your life as a middle-man, and so
long as the other party pays, what do you care? And when you can't buy any more
mortgages, you start doing them for commercial real estate, an even more
notoriously volatile world, which you barely understand yourself, but it's:
product! product! product!
Now: it takes a while from the origination of the first mortgage in the pool to
the placement of the resulting CDO, so you've got carry risk: and that's where
it all fell apart. Normal underwriting takes on very little risk: many IPOs
these days deliver on the same day as the underwriting agreement is signed, and
it's not uncommon these days to not even get an underwriting agreement! This
was different. I understand that when the music stopped, Lehman was holding a
big pile of mortgage poop in their hands, but something like 4x that in
commercial real estate deals. And of course not all the CDO deals got done,
especially toward the end.
[*] The most recent change to the standards has been that loan-to-value has to
be calculated on the nominal lifetime APY rather than the initial one; that
change was only made less than a year ago, but at least it got made ...
It's not at all "impossible" to know what's in there: it's all very clear, if
you take the time to read it. But: who reads this kind of thing? This worked
to their advantage on the way up, but is working hard against them on the way
down: there's plenty of "good stuff" in there, still; but who would buy it
today? So you get these "no bid" markets where you just stop asking because you
don't want the mark-to-market price to slide any more ... because the ratings
agencies were catching up and lowering your ratings -- on bonds already issued!
oops! -- and so you had to raise cash to bolster your capital requirements ...
and then you circle the drain.
> Is that because bailing out individual taxpayers is bad, but
> it's OK to bail out wall street?
That's certainly part of it. But the key issue is that when you buy a CDO,
you're not buying the mortgages themselves: you're buying a synthetic cash-flow
that's based on the approximate cash-flow of the underlying mortgages; it's
*not* secured by the mortgages, it's secured by the issuer. In this case, it's
secured by a company that just went under. So even though only some of the
mortgages in the pool are going to not pay off, the guy who sold it to you isn't
going to pay off at all. Somewhere, there's residual cash-flow that will arrive
monthly into some trust account established as part of the liquidation
proceedings, but you can bet your ass that a) it's never going to be enough to
pay off everyone and b) you're not even close to the head of the line.
One question that comes up is: well where did all that money go? And the answer
is probably: a LOT of different places. It went to people who sold their houses
at the peak two years ago and downsized to Omaha from Manhattan Beach; it went
to lumber companies, Home Depot, and construction workers who built those
tract-home neighborhoods that are now sitting empty; it went to Las Vegas
casinos as people visited to celebrate their own little win in the rising market
over the last 5 years; and it went to IB bonus pools, staggering amounts of
money to the individuals who made this all up.
So: simply fixing the broken mortgages doesn't fix the trouble we're in.
Happy yet? :-)
