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Bloggingheads
04-06-2008, 09:32 PM

bjkeefe
04-07-2008, 11:46 AM
I know Dan is being a little ironic here (http://bloggingheads.tv/diavlogs/10023?in=23:14&out=23:28), but still, he gives voice to an awful lot of sad truth regarding the media in general, particularly the financial press.

Anyuser
04-07-2008, 07:46 PM
I would have enjoyed this more if the diavloggers had spent less time on financial porn and more time on policy questions. For example:

The current financial market fubar started about one year ago. How is it possible that events that some describe, perhaps hysterically, as taking us to a severe worldwide recession, were not foreseen or even understood by Alan Greenspan, Paul Bernacke, Henry Paulson, the former CEO of Merrill Lynch, the former CEO of Citibank, Robert Rubin, or Bear Stearns? When I say these people didnít understand the situation, Iím not being rhetorical: a number of these people expressly admitted that they didnít understand the ramifications of CDOs, CDSs, etc., and Bernackeís explanation for involving the Fed in the Bear Stearns meltdown was that the consequences to the economy were unforeseeable.

Why isnít the issuance and trade of these arcane instruments regulated? Commercial banks and public company securities are regulated to the nth degree. If investment banks and hedge funds can put the country in a recession, why shouldnít they be regulated, too? Commercial banks, through their investment bank sister companies, seem to be betting investor money on some of these unregulated deals, plus messing with their balance sheets through investment bank and hedge fund ďshadow banking.Ē Publicly-traded institutions trade in these deals, but theyíre impossible to evaluate on a balance sheet. Ratings companies canít rate them worth a damn, much less auditors. Iím given to understand that the value of debt obligations is replaced on balance sheets by credit default swaps, so that the holder of the debt obligations doesnít have to mark them to market, yet the creditworthiness of the sellers of CDSs is not regulated at all. There is a blog segment entitled ďWhat credit default swaps are (and why you need to know),Ē but CDSs werenít explained at all. Note: the market value of US treasuries is 4.4 trillion; the market value of mortgage securities is 7.1 trillion; the market value of the whole damn US stock market is 21.9 trillion; and the market value of the CDS market is, get this, 45.5 trillion. The one blogger would say, well, thatís the aggregate face value, but you gotta understand itís hedged within itself a zillion times over so that the real net exposure is a lot less. But whoís to know? See here (http://www.nytimes.com/2008/02/17/business/17swap.html?_r=2&st=cse&sq=credit+default+swaps&scp=1&oref=slogin&oref=slogin).

How much of the current uncertainty was cause by cheap Fed-supplied money, and to what extent does that cheap money benefit only Wall Street to the exclusion of the public? A CDS is an insurance policy in which the policy holder need not have an insurance interest in the property being insured. So Wall Street issues 45.5 trillion dollars worth of these gizmos and then enters into a gigantic clusterfuck with itself. As far as I can tell, the value of these things does not ďtrickle down,Ē so to speak, whatsoever. Economically (and morally, for me) trading in these things is absolutely no different than gambling in Vegas.

How is it possible that this country allowed Wall Street to corrupt the most sober element of national and personal economics and create, exploit, and pop the real estate bubble? The mortgage banks get beaucoup blame in the press (not that they deserve any slack at all), but I donít think Wall Street gets enough. Essentially, Wall Street said to commercial banks, weíll buy all the mortgages you can provide. Weíre not going to vet the things, and we donít care about your underwriting standards. Just feed us all the mortgages in the world, and weíll pay you a premium price. All the dumb Wall Street money made traditional mortgage lenders lose their mind, and consequently we got a housing bubble and a recession. Itís been estimated that being able to take home mortgages out of the commercial banking system and securitize them into global capital markets saves the American consumer $17 billion a year. Big deal. Iím sure the market in CDOs is vastly greater than that, and Iím also sure that the current recession will cost the American consumer much more than that. Furthermore, itís not clear to me (Iíve tried to find out), how the market of synthetic CDOs (made of up credit default swaps) compares to the market for ďrealĒ CDOs. A real CDO consists of real mortgages. Synthetic CDOs are just funny money.

What should the Congress do about this, if anything? Hillaryís suggestion that we freeze interest rates is so fucking stupid it doesnít deserve comment. McCain comes as close to making sense as anybody when he says screw the dumb banks, and screw the borrowers that took out dumb loans. What Iíd like to hear a prominent Senator or presidential candidate say is, screw Wall Street, screw investment banks, and screw hedge funds. I wouldnít mind seeing hedge funds and investment banks regulated basically to death. Investors should be motivated by regulation and tax policy to invest in the ďrealĒ economy, you know, the economy of products and services. As they say, there are those who wrest a living out of nature, and thatís called work. There are those who wrest a living out of those who wrest a living out of nature, and thatís called marketing. Then there are those who wrest a living out of those who wrest a living out of those who wrest a living out of nature, and thatís called finance.

AemJeff
04-07-2008, 09:34 PM
Why isnít the issuance and trade of these arcane instruments regulated? Commercial banks and public company securities are regulated to the nth degree. If investment banks and hedge funds can put the country in a recession, why shouldnít they be regulated, too?

Anyuser, I'm glad you weighed in, I was hoping for a more lively discussion related to this diavlog. I think your question here, is a damn good one. I only agree with the first part of the following, though:

McCain comes as close to making sense as anybody when he says screw the dumb banks, and screw the borrowers that took out dumb loans.

Some people did dumb things, some were given loans that the issuer was in a better position than they were to understand was a bad idea, others were plainly duped. I'd rather see the financial institutions take the majority of the damage - people applying for mortgages aren't financial experts, and often aren't accustomed to bargaining on this scale. I was in the refinance market last year and mortgage brokers were pulling tricks like agreeing to issue a fixed-rate loan and then faxing me paperwork for an ARM, for instance. (True story.) These folks have an advantage over consumers, on the whole, because the deals they're arranging are within their area of expertise, while people buying properties may be engaging in a transaction on this scale for the first (or only) time in their lives. Let the bankers worry that if they issue a really bad loan, there's a chance they'll have to eat it. Obviously I'm not talking about marginal cases, but I'm not talking only about clear cases of deceit, either.

Anyuser
04-07-2008, 11:03 PM
Some people did dumb things, some were given loans that the issuer was in a better position than they were to understand was a bad idea, others were plainly duped. I'd rather see the financial institutions take the majority of the damage - people applying for mortgages aren't financial experts, and often aren't accustomed to bargaining on this scale. I was in the refinance market last year and mortgage brokers were pulling tricks like agreeing to issue a fixed-rate loan and then faxing me paperwork for an ARM, for instance. (True story.) These folks have an advantage over consumers, on the whole, because the deals they're arranging are within their area of expertise, while people buying properties may be engaging in a transaction on this scale for the first (or only) time in their lives. Let the bankers worry that if they issue a really bad loan, there's a chance they'll have to eat it. Obviously I'm not talking about marginal cases, but I'm not talking only about clear cases of deceit, either.

It's hard for me to fully agree with you for the following reasons:

How do we distinguish between borrowers that deserve a break and those who don't? I understand a typical defaulting borrower to be one that employed the single most powerful force in the universe: wishful thinking. That borrower took out an ARM thinking, I'll be making more money 1/3/5 years from now when my rate resets, and my house will increase in value 5/10/15 percent in the meantime. That borrower wasn't necessarily dumb or duped, he or she was simply wrong. Why should that borrower be bailed out by the taxpayers or by resonsible borrowers (through higher interest rates)?

A phrase we hear a lot is "predatory lending." In the context of home loans, that phrase makes absolutely no sense to me. A predatory loan is one in which the lender would rather repo the collateral than have the loan repaid: a pawnshop loan, for example. A "subprime" loan by definition is a risky, that is under collateralized, loan. In a subprime deal the house seller got his purchase price, the buyer/lender got his fling in a house he really couldn't afford, and the only party that got royally, royally screwed was the lender. The rule of thumb is that a lender will recover 50% of its loan after a foreclosure. Exactly what is predatory about that? Repeat: the bank effectively gave the borrower hundreds of thousands of dollars, but the bank got only half back. What's the most vivid counterexample imaginable? A bank suckers some dumbass into an ARM, and the bank knows the borrower will never be able to afford the reset, so the snidely whiplash bank will repo the house? That simply doesn't jibe with reality. What would be the circumstances of a borrower that deserves a break? What would one look like? I suggest if you looked at 100 foreclosures you'd coming away thinking that 99 of the borrowers deserved no sympathy.

The real bad guys are long gone: the mortgage brokers. The had zero skin in the game. They could care less if a loan repaid or went bust. They made big, fat commissions for originating loans for the mortgage banks and the Wall Street buyers. Some loans paid higher commissions than others, I don't know why, and those were the loans the mortgage brokers steered their borrowers to. One would think that a good solid loan would earn a higher commission, but apparently that wasn't the case.

Another problem is that even if you could identify a lender that deserved to be held down and given a haircut, it's hard to get at that lender. Banks hate like death itself to repo real estate, and most likely would be eager to do a sensible workout. That's what it was like in the old days, when your local savings and loan held your mortgage for its own account. These days, maybe the borrower lied to the mortgage broker. Maybe the mortgage broker lied to the commercial bank. Maybe the institutional investor who securitized the mortgages could give a shit if the loans were decent. Maybe the ratings agencies are self-serving liars. Maybe the guy left holding the bag is some muncipal treasurer who thought he was buying AAA bonds. Putting aside whether the borrower deserves a workout, nobody in the trail of the mortgage has legal authority to negotiate or agree to a workout. Literally. This is one reason we're in financial straits today: there is no means for a workout. The bank that sends out mortgage statements is probably just a servicer for Wall Street investors. If you were to say to that bank, I have some temporary, ahem, cash flow problems and I need to work a deal with you, the bank would likely say, I'm not even authorized to discuss the topic with you.

I can't buy the proposition that the borrowers lacked information, either. The ungodliest complicated portion of a loan these days is the truth in lending paperwork. The interest reset and monthly debt service is spelled out in black in white. Wishful thinking makes borrowers illiterate.

A fix would be to force, by regulation, the mortgage originator to hold the first piece of the mortgage for its own account, and to comply with margin requirements for any purchaser of the mortgage. This would effectively prohibit banks from making dumb loans. Issuers of mortgage securities should also hold the first piece for their own account (this is often the case now, not by regulation, but because nobody would buy the piece of shit). Sellers of credit default swaps should have balance sheet requirements, should mark to market continuously, and comply with margin requirements when the obligations they're insuring go pear-shaped. Had these requirements been in place 3-4 years ago, we wouldn't have the problems we have now. In other words, the borrowers defaulting now never would have gotten the loans in the first place.

AemJeff
04-07-2008, 11:18 PM
Anyuser, I'm glad you weighed in, I was hoping for a more lively discussion related to this diavlog.

Damn - no slight intended toward Brendan. I mean I was hoping for a discussion on the merits of this particular diavlog; and Brendan's post was somewhat on the meta side.

Incompetence Dodger
04-08-2008, 12:14 AM
I worked in equity research for several Wall St firms in the 90s and earlier this decade (still do on contract, so I probably shouldn't name names, but big names, I assure you). I wasn't deep in the bowels, exactly, but I wasn't in the executive suite, either. Anybody who now says "gee, we didn't see it coming" is just full of it. Me and my colleagues saw it as far back as 2003. We didn't see the exact contours of the crack-up, of course, and being in research we didn't have first-hand knowledge of either the lending or credit derivatives markets. Nevertheless, we saw even then that the subprime/refi freight train and the ABS freight train were headed right for each other. And if us mid-level guys in research understood what was what (in a Rosencranz and Guildernstern fashion), you better believe the suits did too (we were all suits, but you know what I mean).

That the guys at the top knew what was happening and did nothing doesn't necessarily mean they're a bunch of crooks--the incentives were what they were, and there was absolutely no upside for any individual (person or institution) to do the right thing unilaterally. Your classic collective action problem. Basically I think they just had their fingers crossed, hoping their asses would be near a chair when the music stopped. I attribute my clarity at the time largely to the fact that being in research, my bonus was a fraction of my salary rather than a multiple, so my livelihood didn't depend on me not seeing what was in front of my face.

Anybody still confused about what's going on should go to subprimeprimer.com (mildly NSFW).

Anyuser, your policy recommendations are spot-on, although there's going to be a belling-the-cat problem. It's the separation of risk from reward that got us into this mess. Another way to say it is if you're going to look, walk, and quack like a bank or insurer, you're damn well going to have capital and reserve requirements. The only thing I would add is that SIVs and other balance sheet shenanigans have got to go.




A fix would be to force, by regulation, the mortgage originator to hold the first piece of the mortgage for its own account, and to comply with margin requirements for any purchaser of the mortgage. This would effectively prohibit banks from making dumb loans. Issuers of mortgage securities should also hold the first piece for their own account (this is often the case now, not by regulation, but because nobody would buy the piece of shit). Sellers of credit default swaps should have balance sheet requirements, should mark to market continuously, and comply with margin requirements when the obligations they're insuring go pear-shaped. Had these requirements been in place 3-4 years ago, we wouldn't have the problems we have now. In other words, the borrowers defaulting now never would have gotten the loans in the first place.

bjkeefe
04-08-2008, 01:02 AM
AemJeff:

... no slight intended toward Brendan.

None taken.

I thought I was going to have nothing to say about this diavlog, partly because I feel undereducated in this area, and mostly because Daniel Gross seems to bring about the same level of understanding to macroeconomics that Michael Goldfarb does to foreign policy. (Will no one rid me of these tiresome frat boys?) He did let slip that one moment of clarity, so I couldn't resist dingalinking to that.

It's a pity, because Duff really seems to have something to say. Imagine him with Krugman or Reich, if we could ever get either of those guys back. Or anybody else. I nominate Anyuser, if you'll excuse the lame double entendre.

On the issues themselves:

I am inclined to think that ordinary people getting hustled into bad mortgages deserve a little bit of help. I agree that there are plenty of people out there who were playing the real estate market like it was a short-term investment, and have no sympathy for them, and I agree that it would be impossible to separate these two types. Still, it does seem that some kind of temporary program to help people keep a roof over their heads, provided it is their sole domicile, is not unreasonable. I think I said what I had to say about this in the Reich diavlog thread.

I am also in favor of strengthening regulations for the future. Even though some horses have escaped, it still seems worth it to secure the barn. I'm sure there are others to be kept in check.

Finally, as much as I'd like to see the erstwhile high-fliers begging on the streets, I can't really fault the government for helping on things like Bear Stearns. There is a real "greater good for the greater number" principle at work here. It'd be irresponsible to let a thirst for vengeance tank the whole economy. As much as I'd like to see the Hamptons and Westport, CT, overrun by mobs with pitchforks and torches, that'd be a counterproductive indulgence that would end up being worse for everybody.

It should now be patently obvious why I felt disinclined to weigh in on the issues. Pity my backspace key is broken.

AemJeff
04-08-2008, 12:24 PM
How do we distinguish between borrowers that deserve a break and those who don't?

I donít think that defining that particular sieve is a big problem. If a lender didn't follow its own internal procedures (which conformed to contemporary regulation) and/or if the borrower was clearly not a speculator Ė i.e. they were purchasing a primary residence, those are the criteria I would propose. If a couple of unscrupulous borrowers still get made whole, thatís a small price to pay.

What made the environment that produced this debacle unique was the assumption that market values were going to rise, with no end in sight. I think that assumption distorted the judgment of some lenders.

Wishful thinking makes borrowers illiterate.

The lenders are the professionals Ė plenty of borrowers just donít have realistic expectations of their ability to shoulder a particular burden. The system, in the judgment of this liberal, ought to balance the scales in such a way that this is acknowledged.

However, having defined my caveats to your arguments, Iíll concede that the structural issues are better understood by people other than myself. Iím making whatís ultimately a moral argument.

AemJeff
04-08-2008, 12:35 PM
Finally, as much as I'd like to see the erstwhile high-fliers begging on the streets, I can't really fault the government for helping on things like Bear Stearns. There is a real "greater good for the greater number" principle at work here. It'd be irresponsible to let a thirst for vengeance tank the whole economy. As much as I'd like to see the Hamptons and Westport, CT, overrun by mobs with pitchforks and torches, that'd be a counterproductive indulgence that would end up being worse for everybody.

I think that the "greater good for the greater number" principle can be understood differently on various time scales. The short term consequence is just as you describe. In the longer term, putting the fear of God more firmly into the calculations of speculators can only be a good thing.

bjkeefe
04-08-2008, 01:10 PM
I think that the "greater good for the greater number" principle can be understood differently on various time scales. The short term consequence is just as you describe. In the longer term, putting the fear of God more firmly into the calculations of speculators can only be a good thing.

I agree that it's a good thing to put more fear of consequences into the hearts of people who have the potential to cause catastrophe, but isn't it possible to do that after the fact, just by changing the law? I grant that this way, you don't get to punish those responsibility for today's problems, and so you don't have the immediate examples at hand, but wouldn't a clearly stated new set of policies get you almost all of the deterrence you want? And without punishing the whole country in the meantime?

AemJeff
04-08-2008, 03:32 PM
I grant that this way, you don't get to punish those responsibility for today's problems, and so you don't have the immediate examples at hand, but wouldn't a clearly stated new set of policies get you almost all of the deterrence you want? And without punishing the whole country in the meantime?

Admittedly, I might be a little irrationally bloodthirsty in this regard. The problem I see is that there generally doesn't seem to be much moral hazard for people playing way out on the cutting edge.

bjkeefe
04-08-2008, 03:38 PM
AemJeff:

The problem I see is that there generally doesn't seem to be much moral hazard for people playing way out on the cutting edge.

Yes, I see that as a problem, too, and I do think some of the complex financial instruments that our system permits to be created boil down to little more than Ponzi schemes. On the other hand, there is the argument that making the cost of risk-taking too high stifles innovation. Naively, I'd like to see a set of rules that allow a CEO to try to shoot the moon, but not to be able to do so with a secure golden parachute always available. That is, I'd like to come up with a mechanism to ensure that those making the big bets keep their skin in the game.