» The F.A.Q.’s of Lehman and A.I.G. re: What the Hell Just Happened? from blivet 2.0
Seen over at both Rafe and Susan’s [via Megan McArdle] blogs:
In a guest post at the Freakonomics blog, economists Doug Diamond and Anil Kashyap explain the current financial crisis in FAQ form. For example, here’s the nut of the problem with ... [Read More]
So relating to politics... as someone who seems to have a bit of sense in these ever so partisan days... in your opinion, would either candidate actually be able to do much to fix this disaster? Or more specifically, would either of them be able to bring about whatever changes are necessary to recover and prep us to better handle these crises in the future?
Obviously there isn't a good way to know for sure since they are both spitting out garbage that is unoriginal and meant to make the other side look worse, but what are your opinions on this?
Megan: Thank you for the article link. They explain a lot, but they leave out what for me is the prime question:
What caused the subprime bubble? And did government (Republican deregulation or Democratic mortgage guarantees) make it worse?
Had a whistleblower stepped forward in 2001, or had oversight of Fannie and Freddie been increased, would we have seen this overvaluation of subprimes? Would the bubble have popped sooner, before it threatened to take down our entire economy?
That NY Times Freakanomics blog item was posted too early in the day to include commentary on what, potentially, could be the biggest news so far this week, word that the government is considering starting a fund to buy bad mortgage debt off the books of banks.
Wow, I thought this post was going to be about Congress's possible half a trillion dollar bailout. Just let that number set in a for a while; half a trillion dollars - at least!
Congratulations on getting pillow-fluffed by David Brooks in his latest column, not once but twice!
I love his conclusion:
"It’s just that there’s a big difference between dreaming of some ideal regulatory regime and actually putting one into practice. Everybody says we’re about to enter a new political era, rich in global financial regulation. The herd might just be wrong once again."
which means either (a) nothing or (b) the answer to the banking crisis is not more regulation or better regulation, it's little or no regulation at all!
Why are people so obsessed with arguing over counterfactuals e.g. would the crisis have occurred if step x had been taken back in 2005 or 2000 or 1995? All as a prelude to arguing that the Democrats would have screwed up just as bad. Well, maybe, maybe not. The only thing that's clear is that we'll never know. The rest is just ideology projected on an unknown world.
What just happened was banal protection. This is like a case study for Marx. He clearly had no idea what the dictatorship of the proletariat would look like but who could blame him. His predictions have been no worse than 99% of predictors.
Kudos to Peter Buxton for posing a straight-up (albeit not easy to answer) question without any tinge of ideological bias! My answer is that what played out here is really a fundamental market failure.
In an perfect world in which all costs are internalized, the market would force a business subject to risks to provision against to risks, charging customers slightly more and making slightly lower profits in order to save for day when the risky event occurs and needs to be paid for.
But for very low-probability, high-impact risks, the market doesn't enforce this discipline. On the contrary: a business that does not provision against such a risk will likely out-compete one that does long before the risky event occurs. A systematic jump in mortgage default rates caused by a widespread and significant fall in house prices is precisely such a low-probability, high-impact event, and by the time that it occured, pretty much only the businesses that had failed to provision against it were left, because they were the ones that in the long time before had been able to offer their customers lower mortgage rates and their stockholders higher profits.
One might think that government could have stepped in and forced businesses to deal with this risk. There are lots of regulations that could have done this: stronger capital requirements (provisioning), more stringent lending standards (risk reduction), not creating entities (the GSEs) that attempt to hide the default risk from those that fund mortgages. But in practice, no one in government had any interest in such regulation. The Republicans who might be willing to see the less creditworthy not get cheap mortgages were disinclined to regulate. And the Democrates who might be willing to regulate were disinclined to cut off the less creditworthy from cheap mortgages. The basic problem continued to lurk, through many Republican and Democratic administrations.
How is this possible? Did every single mammal in the United States-- including farm animals -- have a subprime mortgage?
I called 25 friends tonight. NONE of them had a subprime mortgage.
My (extremely simplified)understanding is that all the big investment banks and finance houses, used subprimes (and leveraged the shit out of them) as collateral in an attempt to make money elsewhere, spreading it throughout the system.
The blame for this belongs to all America; from the average Joe who lived well beyond his/her means, to the greed of Wall Street which attempted to profit from this using/promoting criminally laxed lending standards and irresponsible leveraging of such risky assets.
So, supposedly, this SEC rule change (which put America in line with EU regulations, so surprisingly multilateral for the Bush administration!) changed the necessary reserves for bigger investment houses, thus dooming them no matter what they did. Hmmm.
So, uh… why did Fannie and Freddie implode? They weren't investment houses. See, I've been reading around the web but frankly, it seems most people are talking out their sphincters.
Yeah regulations aren't the answer. Right. You see, I've done research into it, and I can give you a list of reasons why it's a bad idea.
And I have all these economists who, granted, didn't see this entire financial collapse coming, who tell me regulations are a bad idea. So they must be.
And the Iraq War was a good idea. Really. I've done research and I know it is. Because you see we have all of these foreign policy experts with all these reasons, but no evidence, for why it's a good idea.
Give me a break.
The American people need to quit trying to OVERTHINK everything. I've never seen so many people who are so sure they're so smart be wrong SO OFTEN.
Let me save you the time and effort. You're not that smart. Neither am I, neither is David Brooks and certainly neither are all of the bone-headed economists who were ALL FOR these sub-prime loans until they stopped working.
It ain't that hard. Vote the Party in, out. Period. The American people's refusal to just accept what's right in front of their nose: The Republicans have ruined the economy, they have no idea what they're doing, they have no ideas they won't reverse themselves on (John McCain and de-regulation, anyone?) in five minutes flat and they need to be voted out of office.
Four years in the wilderness will do them some good. Heck they need to think about what exactly it is they stand for since it sure ain't small government or fiscal responsibility anymore.
If you vote for McCain, by any rationalization, after this you're insane. Make fun of me if you want. We said the same thing about Bush 4 years ago. Everyone rationalized that vote too. Look where it got us.
Do you really want to try that AGAIN? Please don't rationalize that either, it's a simple yes or no question.
You have 2 options:
1) Keep going in the same direction we have been going
They violated their charters and tried making money off the entire scheme, just like everybody else. From the article Megan linked to above: They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages.
Also conveniently left out of every discussion is the fact that we would never have been in this mess if Gramm-Leach-Bliley wouldn't have been proposed let alone passed. Prior to that banks weren't trying to offer investment, commerical AND insurance services.
But in the continuing refusal to ever blame anyone for anything, even if it is their fault, people are trying to do logical contortions around this fact as well.
Gee that makes sense. I understand it. Hence there must be something wrong with it! I refuse to believe it!
"Also conveniently left out of every discussion is the fact that we would never have been in this mess if Gramm-Leach-Bliley wouldn't have been proposed let alone passed. Prior to that banks weren't trying to offer investment, commerical AND insurance services."
How does that explain the collapse of Bear Stearns and Lehman, two stand-alone investment banks, and the hearty survival of JP Morgan Chase and other combined commercial banks/investment banks? If anything, it seems that G-L-B gave us more stable financial institutions, since the ones that combined after the law was passed have held up better than the independent investment banks.
Also, Glass-Steagall did nothing to prevent banks from dabbling in all sorts of toxic investments during the last credit/real estate bust in 1990-1991.
Commodities bubble. Cheap money seeking unreasonably high returns, first in .com's then in real estate. When those looked to risky, confused investors ran stuffed the money into commodities. This just caused inflation, real returns and incomes went down (previously, before gas prices went up, inflation was low and primarily was focussed on the rich), but people had the same old large debts.
I also have a suspision that lots of hedgefunds have been closing or haven't been very active (I think as a result of possible regulation/oversight and bad PR). I think maybe they were previously covering the unusual insturements the large banks were holding, but when hedging declined, lower liquidity maybe made the big banks positions look riskier.
In my opinion, this whole mess was created by the biggest financial ponzi scheme in American history. All parties were complicit in this: The finance houses, the American consumer, the US govt (they promoted the shit out of this - both parties), foreign treasuries, etc.
Technology and new investment tools simply made it easier to hide and keep the scam going on for many, many years.
I called 25 friends tonight. NONE of them had a subprime mortgage.
Somewhere around 40% of people with mortgages don't even know what type they have. Unless they have a mortgage where they fully documented their income, assets and down payment that falls into the category the media now calls "subprime" When you receive a home loan for 9-10 times your income with zero down it's not a prime loan.
I called 25 friends tonight. NONE of them had a subprime mortgage.
My point is, even if 50% of mort\gages were subprime -- or 75% -- and, lets say 25% of those have declared banruptcy; it doesn't come close to explaining how Freddie, Fannie, AIG, et al are going bankrupt.
So, it ain't subprime mortgage bankruptcy by goofy Americans causing the loss of trillions of dollars on Wall Street.
The key to performance seemed to be what the paper calls “conversation suppression,” i.e., knowing when to shut up: “Passengers talking to drivers made shorter utterances, had more frequent pauses and were more likely to be talking about the upcoming hazard than cellphone conversors.
Sometime we need to just shut up and let the drivers drive.
So, it ain't subprime mortgage bankruptcy by goofy Americans causing the loss of trillions of dollars on Wall Street.
When companies collateralize this debt to the tune of 30:1 (in some cases), it amplifies the subprime crisis well beyond the actual monetary value of the loans themselves.
nobluff, I agree with you a little, but you don't actually need defaults to cause problems, just the threat. And it's not limited to subprime. People who bought overvalued assets are paying large payments. When prices of consumables go up maybe income even goes down, all the sudden their expectations aren't being met and they are a lot more likely to default.
even if 50% of mort\gages were subprime -- or 75% -- and, lets say 25% of those have declared banruptcy; it doesn't come close to explaining how Freddie, Fannie, AIG, et al are going bankrupt.
A quick perusal of the US census "quickfacts" (at http://quickfacts.census.gov/qfd/states/00000.html ) shows that in 2006, there were 126 million housing units, w/ a 66% homeownership rate, and median price $120000. Of course a mean price would be more useful here, but with the assumption that median is the mean, we find that there is some $151 trillion in housing value.
$151 trillion is a lot of money. If you misestimate (because real estate ALWAYS GOES UP in the New Economy!) and buy $151T in mortgages for 10% more than they turn out to be worth, then you just lost $15 trillion. By comparison, the total assets of the GSEs, AIG, and Morgan was about 6.6T, according to the profs in the linked piece.
This account of events is astoundingly good, incredibly prompt and enviabbly brief.
What really puzzles me is the reluctance over 10 months or so to pay the market price for large chunks of necessary new capital. I hope Morgan Stanley have now signalled the end of that with their announcement of advanced negotiations for a large Chinese stake in the company.
And for those who find the profs from Megan's alma mater too advanced, some case studies:
READINGS FOR INFANT MBAS
1. Pity For The Bear
In the forest there was a very grumpy, very large Bear who was greedy for honey. One day he found two hollow trees full of honey. He reached for both, and both his paws got stuck in the hollow trees. Bear hides are tough, but the stings of hundreds and thousands of bees began to get through. The Great Spirit heard the Bear’s agony from afar and feared for the peace and order of the whole forest. The tribe of the JayPeeMs felt the Great Spirit’s trouble, and said “Oh Great Spiit we will put the Bear out of his agony to give peace to the forest, but it is a very great thing for a modest tribe to do. To undertake it we need a promise of your bounty so that we do not risk starving next winter”. So the Great Spirit promised the JayPeeMs his bounty should they need it; and when he finally approached found the camps of the JayPeeMs redolent with roasting bear meat; and the medicine man of the JayPeeMs dancing in the skin of the Bear.
2. The Land of Lehman
King Richard the Full-Dressed looked out over the land of Lehman, and saw that beyond the borders of its rich and smiling valleys there were other untended valleys which could swell the revenues and glory of the land of Lehman. So he sent out his soldiers and peasants to occupy and cultivate these rich valley lands.
And the nomad tribes said “Aha! King Richard’s troops are spread thin, and our spies report that his reserves are few. Let us raid the riches of the land of Lehman.” And the word spread amongst the nomads. Day by day more of them troubled the borders of the land of Lehman. And King Richard’s reserves became very, very few.
But lo, an Eastern prince with a strong army appeared ready to aid King Richard. For his aid, he asked half of the land of Lehman. King Richard replied “Welcome are you, and you shall be well rewarded; but half the land of Lehman I will grant to no man!”. At nightfall, the Eastern prince folded his tents and marched away.
On the morning’s morning, the land of Lehman was no more.
3. Rancho AIG
Many and varied are its beasts, and endless are the acres of Rancho AIG. But its straw bosses heard of a Really Sure and Certain thing. There was a race that they could bet on known as the “Super Senior CDS Regulatory Handicap” in which it was Really Sure and Certain that their horse would always win. And sure enough for many months, every time the race was run their horse won. So they bet the Ranch on the race, and did not lay off their bet. And as with every Really Sure and Certain thing since time began, they lost the Ranch
Peter Buxton says: So, uh… why did Fannie and Freddie implode? They weren't investment houses.
I would argue that they were, in effect, investment houses. They had effectively made a massive bet that the default rate of their mortgage portfolio would not significantly increase. They were able to make money off that bet for a long time, by borrowing money at a rate that presupposed there was no mortgage default risk and loaning it at a rate that did take into account mortgage default risk. But when the default rate of their motgage portfolio did significantly increase, that bet went south.
David Wright: I would argue that they were, in effect, investment houses. They had effectively made a massive bet that the default rate of their mortgage portfolio would not significantly increase.
Yes, if I understand it, FNMA (calling it by its anthropomorphic diminutive is making me ill) started (1996?) to hold onto the bundled mortgage securities they used to sell. This was used as collateral for very favorable loans (as a GSE) which were used to buy more mortgages.
So, did FNMA lose the price feedback it used to get from sales? Was that a factor?
Tyler: So, uh… why did Fannie and Freddie implode? They violated their charters and tried making money off the entire scheme, just like everybody else.
Yes, I got that. I was pointing out the flaw in the post I linked to: that the SEC had changed no rules for FNMA, they simply got greedy and started misbehaving. Also, three investment houses went down, but two didn't. (Knock wood.)
It reminds me of Futurama: "Oh, the fools! If only they'd built it with 6,001 hulls! When will they learn?" Or, to quote the science fiction great: "It's tough making things foolproof because fools are so ingenious."
I've been in and out of the mortgage business for more than a couple of decades, and it has certainly appeared to me that, overwhelmingly, the direction that Fannie and Freddie have moved in, in terms of underwriting, has been in one direction; towards more laxity. The indulgence in "subprimes" was merely the endpoint of a long trend.
Why would anyone be surprised that entities which had the advantage of an implied taxpayer guarantee for the paper they bought and sold, and a charter from Congress to expand homeownership, would eventually engage in ridiculous practices?
So relating to politics... as someone who seems to have a bit of sense in these ever so partisan days... in your opinion, would either candidate actually be able to do much to fix this disaster? Or more specifically, would either of them be able to bring about whatever changes are necessary to recover and prep us to better handle these crises in the future?
Obviously there isn't a good way to know for sure since they are both spitting out garbage that is unoriginal and meant to make the other side look worse, but what are your opinions on this?
Megan: Thank you for the article link. They explain a lot, but they leave out what for me is the prime question:
What caused the subprime bubble? And did government (Republican deregulation or Democratic mortgage guarantees) make it worse?
Had a whistleblower stepped forward in 2001, or had oversight of Fannie and Freddie been increased, would we have seen this overvaluation of subprimes? Would the bubble have popped sooner, before it threatened to take down our entire economy?
That NY Times Freakanomics blog item was posted too early in the day to include commentary on what, potentially, could be the biggest news so far this week, word that the government is considering starting a fund to buy bad mortgage debt off the books of banks.
Peter Buxton, I'm not sure if Megan linked to it earlier this week, but Tyler Cowen's piece in Sunday's NY Times is worth reading, Economic View: Too Few Regulations? No, Just Ineffective Ones.
Is that the biggest news of the day? Or will it be the outright ban on short selling of stocks?
Say goodbye to the derivatives market.
Wow, I thought this post was going to be about Congress's possible half a trillion dollar bailout. Just let that number set in a for a while; half a trillion dollars - at least!
I think Ron Paul's head just exploded...
Fannie, Freddie, Merrill, AIG, and just about everyone else in the entire financial universe is being undone by subprime mortgages.
The dollars involved are in the many trillions.
How is this possible? Did every single mammal in the United States-- including farm animals -- have a subprime mortgage?
I called 25 friends tonight. NONE of them had a subprime mortgage.
What's up with that?
Congratulations on getting pillow-fluffed by David Brooks in his latest column, not once but twice!
I love his conclusion:
"It’s just that there’s a big difference between dreaming of some ideal regulatory regime and actually putting one into practice. Everybody says we’re about to enter a new political era, rich in global financial regulation. The herd might just be wrong once again."
which means either (a) nothing or (b) the answer to the banking crisis is not more regulation or better regulation, it's little or no regulation at all!
Why are people so obsessed with arguing over counterfactuals e.g. would the crisis have occurred if step x had been taken back in 2005 or 2000 or 1995? All as a prelude to arguing that the Democrats would have screwed up just as bad. Well, maybe, maybe not. The only thing that's clear is that we'll never know. The rest is just ideology projected on an unknown world.
What just happened was banal protection. This is like a case study for Marx. He clearly had no idea what the dictatorship of the proletariat would look like but who could blame him. His predictions have been no worse than 99% of predictors.
Kudos to Peter Buxton for posing a straight-up (albeit not easy to answer) question without any tinge of ideological bias! My answer is that what played out here is really a fundamental market failure.
In an perfect world in which all costs are internalized, the market would force a business subject to risks to provision against to risks, charging customers slightly more and making slightly lower profits in order to save for day when the risky event occurs and needs to be paid for.
But for very low-probability, high-impact risks, the market doesn't enforce this discipline. On the contrary: a business that does not provision against such a risk will likely out-compete one that does long before the risky event occurs. A systematic jump in mortgage default rates caused by a widespread and significant fall in house prices is precisely such a low-probability, high-impact event, and by the time that it occured, pretty much only the businesses that had failed to provision against it were left, because they were the ones that in the long time before had been able to offer their customers lower mortgage rates and their stockholders higher profits.
One might think that government could have stepped in and forced businesses to deal with this risk. There are lots of regulations that could have done this: stronger capital requirements (provisioning), more stringent lending standards (risk reduction), not creating entities (the GSEs) that attempt to hide the default risk from those that fund mortgages. But in practice, no one in government had any interest in such regulation. The Republicans who might be willing to see the less creditworthy not get cheap mortgages were disinclined to regulate. And the Democrates who might be willing to regulate were disinclined to cut off the less creditworthy from cheap mortgages. The basic problem continued to lurk, through many Republican and Democratic administrations.
How is this possible? Did every single mammal in the United States-- including farm animals -- have a subprime mortgage?
I called 25 friends tonight. NONE of them had a subprime mortgage.
My (extremely simplified)understanding is that all the big investment banks and finance houses, used subprimes (and leveraged the shit out of them) as collateral in an attempt to make money elsewhere, spreading it throughout the system.
The blame for this belongs to all America; from the average Joe who lived well beyond his/her means, to the greed of Wall Street which attempted to profit from this using/promoting criminally laxed lending standards and irresponsible leveraging of such risky assets.
Get mad, get really fucking mad.
David Wright: Kudos to Peter Buxton for posing a straight-up (albeit not easy to answer) question without any tinge of ideological bias!
Aw, shucks. :#)
So, Nassim Taleb's Black Swan was once again seen skulking around the crime scene, eh?
http://bigpicture.typepad.com/comments/2008/09/regulatory-exem.html
So, supposedly, this SEC rule change (which put America in line with EU regulations, so surprisingly multilateral for the Bush administration!) changed the necessary reserves for bigger investment houses, thus dooming them no matter what they did. Hmmm.
So, uh… why did Fannie and Freddie implode? They weren't investment houses. See, I've been reading around the web but frankly, it seems most people are talking out their sphincters.
Yeah regulations aren't the answer. Right. You see, I've done research into it, and I can give you a list of reasons why it's a bad idea.
And I have all these economists who, granted, didn't see this entire financial collapse coming, who tell me regulations are a bad idea. So they must be.
And the Iraq War was a good idea. Really. I've done research and I know it is. Because you see we have all of these foreign policy experts with all these reasons, but no evidence, for why it's a good idea.
Give me a break.
The American people need to quit trying to OVERTHINK everything. I've never seen so many people who are so sure they're so smart be wrong SO OFTEN.
Let me save you the time and effort. You're not that smart. Neither am I, neither is David Brooks and certainly neither are all of the bone-headed economists who were ALL FOR these sub-prime loans until they stopped working.
It ain't that hard. Vote the Party in, out. Period. The American people's refusal to just accept what's right in front of their nose: The Republicans have ruined the economy, they have no idea what they're doing, they have no ideas they won't reverse themselves on (John McCain and de-regulation, anyone?) in five minutes flat and they need to be voted out of office.
Four years in the wilderness will do them some good. Heck they need to think about what exactly it is they stand for since it sure ain't small government or fiscal responsibility anymore.
If you vote for McCain, by any rationalization, after this you're insane. Make fun of me if you want. We said the same thing about Bush 4 years ago. Everyone rationalized that vote too. Look where it got us.
Do you really want to try that AGAIN? Please don't rationalize that either, it's a simple yes or no question.
You have 2 options:
1) Keep going in the same direction we have been going
or
2) Change directions
Period.
So, uh… why did Fannie and Freddie implode?
They violated their charters and tried making money off the entire scheme, just like everybody else. From the article Megan linked to above: They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages.
Also conveniently left out of every discussion is the fact that we would never have been in this mess if Gramm-Leach-Bliley wouldn't have been proposed let alone passed. Prior to that banks weren't trying to offer investment, commerical AND insurance services.
But in the continuing refusal to ever blame anyone for anything, even if it is their fault, people are trying to do logical contortions around this fact as well.
Gee that makes sense. I understand it. Hence there must be something wrong with it! I refuse to believe it!
"Also conveniently left out of every discussion is the fact that we would never have been in this mess if Gramm-Leach-Bliley wouldn't have been proposed let alone passed. Prior to that banks weren't trying to offer investment, commerical AND insurance services."
How does that explain the collapse of Bear Stearns and Lehman, two stand-alone investment banks, and the hearty survival of JP Morgan Chase and other combined commercial banks/investment banks? If anything, it seems that G-L-B gave us more stable financial institutions, since the ones that combined after the law was passed have held up better than the independent investment banks.
Also, Glass-Steagall did nothing to prevent banks from dabbling in all sorts of toxic investments during the last credit/real estate bust in 1990-1991.
Commodities bubble. Cheap money seeking unreasonably high returns, first in .com's then in real estate. When those looked to risky, confused investors ran stuffed the money into commodities. This just caused inflation, real returns and incomes went down (previously, before gas prices went up, inflation was low and primarily was focussed on the rich), but people had the same old large debts.
I also have a suspision that lots of hedgefunds have been closing or haven't been very active (I think as a result of possible regulation/oversight and bad PR). I think maybe they were previously covering the unusual insturements the large banks were holding, but when hedging declined, lower liquidity maybe made the big banks positions look riskier.
In my opinion, this whole mess was created by the biggest financial ponzi scheme in American history. All parties were complicit in this: The finance houses, the American consumer, the US govt (they promoted the shit out of this - both parties), foreign treasuries, etc.
Technology and new investment tools simply made it easier to hide and keep the scam going on for many, many years.
We fucked ourselves...
I called 25 friends tonight. NONE of them had a subprime mortgage.
Somewhere around 40% of people with mortgages don't even know what type they have. Unless they have a mortgage where they fully documented their income, assets and down payment that falls into the category the media now calls "subprime" When you receive a home loan for 9-10 times your income with zero down it's not a prime loan.
I called 25 friends tonight. NONE of them had a subprime mortgage.
My point is, even if 50% of mort\gages were subprime -- or 75% -- and, lets say 25% of those have declared banruptcy; it doesn't come close to explaining how Freddie, Fannie, AIG, et al are going bankrupt.
So, it ain't subprime mortgage bankruptcy by goofy Americans causing the loss of trillions of dollars on Wall Street.
Not no way. Not no how.
I also think this is relevant to our current situation.
Sometime we need to just shut up and let the drivers drive.
So, it ain't subprime mortgage bankruptcy by goofy Americans causing the loss of trillions of dollars on Wall Street.
When companies collateralize this debt to the tune of 30:1 (in some cases), it amplifies the subprime crisis well beyond the actual monetary value of the loans themselves.
At least that's how I understand it...
nobluff, I agree with you a little, but you don't actually need defaults to cause problems, just the threat. And it's not limited to subprime. People who bought overvalued assets are paying large payments. When prices of consumables go up maybe income even goes down, all the sudden their expectations aren't being met and they are a lot more likely to default.
A quick perusal of the US census "quickfacts" (at http://quickfacts.census.gov/qfd/states/00000.html ) shows that in 2006, there were 126 million housing units, w/ a 66% homeownership rate, and median price $120000. Of course a mean price would be more useful here, but with the assumption that median is the mean, we find that there is some $151 trillion in housing value.
$151 trillion is a lot of money. If you misestimate (because real estate ALWAYS GOES UP in the New Economy!) and buy $151T in mortgages for 10% more than they turn out to be worth, then you just lost $15 trillion. By comparison, the total assets of the GSEs, AIG, and Morgan was about 6.6T, according to the profs in the linked piece.
Basically, I chalk it all up to lack of expansion of the energy supply, particularly oil.
This account of events is astoundingly good, incredibly prompt and enviabbly brief.
What really puzzles me is the reluctance over 10 months or so to pay the market price for large chunks of necessary new capital. I hope Morgan Stanley have now signalled the end of that with their announcement of advanced negotiations for a large Chinese stake in the company.
And for those who find the profs from Megan's alma mater too advanced, some case studies:
READINGS FOR INFANT MBAS
1. Pity For The Bear
In the forest there was a very grumpy, very large Bear who was greedy for honey. One day he found two hollow trees full of honey. He reached for both, and both his paws got stuck in the hollow trees. Bear hides are tough, but the stings of hundreds and thousands of bees began to get through. The Great Spirit heard the Bear’s agony from afar and feared for the peace and order of the whole forest. The tribe of the JayPeeMs felt the Great Spirit’s trouble, and said “Oh Great Spiit we will put the Bear out of his agony to give peace to the forest, but it is a very great thing for a modest tribe to do. To undertake it we need a promise of your bounty so that we do not risk starving next winter”. So the Great Spirit promised the JayPeeMs his bounty should they need it; and when he finally approached found the camps of the JayPeeMs redolent with roasting bear meat; and the medicine man of the JayPeeMs dancing in the skin of the Bear.
2. The Land of Lehman
King Richard the Full-Dressed looked out over the land of Lehman, and saw that beyond the borders of its rich and smiling valleys there were other untended valleys which could swell the revenues and glory of the land of Lehman. So he sent out his soldiers and peasants to occupy and cultivate these rich valley lands.
And the nomad tribes said “Aha! King Richard’s troops are spread thin, and our spies report that his reserves are few. Let us raid the riches of the land of Lehman.” And the word spread amongst the nomads. Day by day more of them troubled the borders of the land of Lehman. And King Richard’s reserves became very, very few.
But lo, an Eastern prince with a strong army appeared ready to aid King Richard. For his aid, he asked half of the land of Lehman. King Richard replied “Welcome are you, and you shall be well rewarded; but half the land of Lehman I will grant to no man!”. At nightfall, the Eastern prince folded his tents and marched away.
On the morning’s morning, the land of Lehman was no more.
3. Rancho AIG
Many and varied are its beasts, and endless are the acres of Rancho AIG. But its straw bosses heard of a Really Sure and Certain thing. There was a race that they could bet on known as the “Super Senior CDS Regulatory Handicap” in which it was Really Sure and Certain that their horse would always win. And sure enough for many months, every time the race was run their horse won. So they bet the Ranch on the race, and did not lay off their bet. And as with every Really Sure and Certain thing since time began, they lost the Ranch
Peter Buxton says: So, uh… why did Fannie and Freddie implode? They weren't investment houses.
I would argue that they were, in effect, investment houses. They had effectively made a massive bet that the default rate of their mortgage portfolio would not significantly increase. They were able to make money off that bet for a long time, by borrowing money at a rate that presupposed there was no mortgage default risk and loaning it at a rate that did take into account mortgage default risk. But when the default rate of their motgage portfolio did significantly increase, that bet went south.
David Wright: I would argue that they were, in effect, investment houses. They had effectively made a massive bet that the default rate of their mortgage portfolio would not significantly increase.
Yes, if I understand it, FNMA (calling it by its anthropomorphic diminutive is making me ill) started (1996?) to hold onto the bundled mortgage securities they used to sell. This was used as collateral for very favorable loans (as a GSE) which were used to buy more mortgages.
So, did FNMA lose the price feedback it used to get from sales? Was that a factor?
Tyler: So, uh… why did Fannie and Freddie implode?
They violated their charters and tried making money off the entire scheme, just like everybody else.
Yes, I got that. I was pointing out the flaw in the post I linked to: that the SEC had changed no rules for FNMA, they simply got greedy and started misbehaving. Also, three investment houses went down, but two didn't. (Knock wood.)
It reminds me of Futurama: "Oh, the fools! If only they'd built it with 6,001 hulls! When will they learn?" Or, to quote the science fiction great: "It's tough making things foolproof because fools are so ingenious."
I've been in and out of the mortgage business for more than a couple of decades, and it has certainly appeared to me that, overwhelmingly, the direction that Fannie and Freddie have moved in, in terms of underwriting, has been in one direction; towards more laxity. The indulgence in "subprimes" was merely the endpoint of a long trend.
Why would anyone be surprised that entities which had the advantage of an implied taxpayer guarantee for the paper they bought and sold, and a charter from Congress to expand homeownership, would eventually engage in ridiculous practices?