Wednesday, February 4, 2009

The Dismal Scientist - UPDATED 05/02/09 1.25pm

"And other: so far the people quoted by Danyl as syaing this CRA thing is all crap, are ALL working for the FED" chortle: like those NASA AGW experts that reinforce each other's insane ideas about how temperatures are going up...when they aren't.

Note that state regulations in some 29 states absolve borrowers of responsibility for the debt: they can walk away and leave the financier with the house but no right to chase the borrower for any shortfall. The borrower mails the keys to the bank with a note saying so long sucker: the so-called "jingle mail".

So when you get federal regulation pressurising you to lend to sub-prime borrowers and then other regulations preventing enforcement, it's no wonder the financiers tried to get the mess off their books via CDOs.

When it is clear that a bank cannot recover some or all of the money lent to a borrower, they “write-off” the non-recoverable amount

Here’s a simple example to try and illustrate what happened to financiers. In this example called Banco.

Shareholders give Banco $200. Depositors give Banco $800. This is a total of $1000. Banco owes these people $1000.

Banco lends the $1000 to homeowners. The homeowners owe Banco $1000. The world is in harmony.

After time passes, the property price bubble bursts.

After further time passes, the homeowners cannot (or choose not to) pay their mortgage, so walk away from their homes and the loans. Banco repossesses the homes and sells them. The sales raise only $750. Banco has $750, but owes $800 to depositors. Forget about the shareholders…
So assets of $750 minus liabilities of $800 equals negative $50. As there is no such thing as a negative asset (as in “that does not compute”) the bank is “insolvent”. If only people were trusting (and patient), Banco could borrow some more money and start doing high quality lending, making $50+ of profits and be in a position to pay back all their depositors. In the meantime, the depositors (and maybe even their children) have died of old age and hell has frozen over.

Now, Banco (and others in Banco’s industry) are not really letting on that they have a shortfall of $50. Everyone knows that they are likely to have lost money on the sale of the homes, but no knows if they got $850 or $750 or somewhere in between. Everyone gets nervous and stops giving money to Banco & mates. (No CDO’s in sight yet).

In fact, it is worse: Banco didn’t get $750 on the sale of the homes: they only sold half of the homes and raised $375. They can’t seem to give the other homes away. So what they do is value those unsold homes using g the data from the sale of the other home. They come up with a value of $375 for the remaining house. Cash + homes = $750.

Borrowers say “please to give us most of our money back. We’d be happy to have 750/800 x our deposit back now = 93.75% of our money.”
“Err, but we can’t pay you back 93.75% right now,” say Banco “as we have only 46.875% of your money…”
“Fine”, say depositors, “sell those $375 worth of house and pay us our 93.75%.”
But of course those houses aren’t really worth $375, because no one seemed to want to buy them.

“Why the fuck did you lend money to people who couldn’t pay it back?” ask the depositors.
“Because the gummint pressured us to (point 1), but also God appeared to us in a dream (point 2) and told us that property values will be going up for quite a while yet, so we’d be sweet-as if there were a default” reply Banco.
“Holy heck, you didn’t put that into your prospectus!” say the depositors “still, some of the defaulters must have other assets, or income you could get your hands on.”
“Err, actually, in these states here, here and here, they don’t let us do that (point 3).” comes the response from Banco.

Depositors say: “Tammy, dear, I’m just off down the Winnebago dealer to cancel our order. Also, we won’t go on that world cruise in the spring after we retire. In fact, we won’t be retiring just yet: close your wallet, dear (point 4)!”

Later “And the main news story tonight: sharply falling banking stocks drags Wall Street (and CAX, FTSE, DB, NZX, etal) down in frantic trading (point 5).”

“Gee, the stock market’s down! My retirement savings just shrunk: close your wallet, dear (point 6)!”

“And in financial markets news tonight, retailers issue dire profits warning. Retail stocks plummet, dragging Wall Street down.”

See, lots of points and links. CDO’s are merely one of the vehicles or pathways through which real individual savers/depositors gave their money to financiers who then gave a fair proportion to sub-prime borrowers.

Personally, I think the effect of regulations merely made the problem worse, but didn’t cause it. I don’t even think it all comes down to sub-prime borrowers: cheap money (loose monetary policy) let ALL borrowers compete to bid house prices up to unsustainable levels. We had different regulations in NZ and STILL we all bid up house prices.
And at some point, folk began to get nervous about how much debt their gummints were racking up on their behalf. Remember, there is only one way to pay back gummint debt: tax the workers. So they close their wallets in anticipation. (Well, the gummint could just print the money to repay the debt/fund public services, but that ain’t working out too well for North Korea/Zimbabwe is it?)

Oh, and about fraud? It happens all the time: it's just easier to spot when things turn to custard.
Most poor people are ethical, have jobs and don't steal things.
Most bankers are ethical, have jobs and don't steal things.


Aw, poo: I forgot to work Fannie (fzztt!) mae and Fat Fredrick Mac into the story, helping create "Moral hazard" in a way that no other english speaking economy replicates. Those 29 states I mentioned earlier: they're creating moral hazard as well. Borrowers are tempted to borrow just a little bit more, because if they over-reach, they can just shrug their shoulders and walk away. If your credit history is crap already, why would you worry about the "stigma" of default?


“my understanding is that the loans themselves weren’t the issue.”
Well, your understanding is poor then.
The loans, ALL loans, not just sub-prime, are secured over property that no one wants to buy. When everyone’s confidence in the property values and the banking industry is shaken to the core, the vehicle through which money flowed is not overly relevent.I have friends with 3 properties in the US that agents won’t even list becuase they have too many on their books already. Luckily, they can afford to wait it out.
Look at our own “sub prime”: the finance companies. The circumstances of the lending was somewhat different, but it still comes back to loans that are “secured” over property (hotels, apartments, 2nd-hand cars) that is not worth the balance of the loan, and there is no further assets (due often to limited liabilty of companies involved) beyond the property, some of which cannot be sold. No CDO’s here, yet it all seemed to kick off at the same time (or even before) the US problem became apparent.


Che says "ahhhh... i see. so the new Zealand government forced all those loan sharks to extend loans to people of dubious quality?"

Sorry, I thought I was quite clear: I don't believe CRA, Fannie/Freddie, non-recourse loans are the CAUSE of the crisis. The bursting of the property bubble is the cause.
95, 100 and 110% mortgages were all the rage in the UK when I lived there in the very early noughties. (I don't remember 125%, but I guess folk were reassured by Moron Brown's claim that he had eliminated the cycles of boom and bust that seem to plague fractional banking systems!) Yet the UK has no equivalent to CRA, Fan/Fred, non-recourse…

The regulation just didn't help. Like not wearing a seat belt doesn't cause accidents, but it does make it worse...

The bubbles formed through loose monetary policy PLUS loose fiscal policy* PLUS irrationality when it came to asset prices PLUS greed and fraud, pyramid schemes, herd mentality PLUS the regulations PLUS planning laws, building standards, etc.

*loose fiscal policy:
- Bush jnr (hey: spell-check "jerk") and his wars and his pork
- Moron Brown and his quangos
- Italy Greece Spain & Portugal on whatever they spend it on (pork?)
- Cullen and his train set, interest free loans, health sector money-shower, millions of extra public "servants", 20 free ECE, Kiwisaver handouts, etc



Barnsley Bill said...

briliant post, clearly explains the situation in a fashion that even I can understand.

Clunking Fist said...

That's cos you got a functioning brain. The same cannot be said for some of our leftie friends..

an ex-apprentice said...

Dear Mr Fist,

A lot of the debt issued in the last few years was in fact fully synthetic - that is, it was not backed by an actual mortgage or other actual debt instrument, but was created out of swaps and other derivatives that "acted like" the real thing. 
The problem with this sort of lunatic creation is that it relies entirely on the ability of the counterparty who wrote the swap to pay. If they can't pay then all you have is a worthless piece of paper since you can't even foreclose on the underlying property and seize the collateral. 
With no meaningful margin supervision most of these so-called "counterparties" cannot pay.  That means all those "synthetic" instruments are in fact worth nothing.

Clunking Fist said...

Thank you, Mr X!

When it comes to how our gummints are dealing with the recession, all I can say is We're all fucked. I'm fucked. You're fucked. The whole [world] is fucked. It's the biggest cock-up ever. We're all completely fucked.


Mark said...

Mmmm. Your comment that you missed out Fannie & Freddy from your story and the resulting moral hazard reminds me of the other assertion often made in this debate which I don't follow ...

Much is made of the moral hazard of bailing out the banks. Now, I follow that argument to some extent. However, I honestly don't see that the bailout is the real source of moral hazard. The real source, it seems to me, is the asymmetric nature of the risk/reward as it applies to individuals (not companies). It was individuals who made the decisions to invest heavily in CDOs, MBS etc. These individuals then reaped the (often vast) rewards as the market values of the instruments rose. When the market s*at itself, what did they suffer? Maybe they missed a year's bonus and had to find another job elsewhere.

If we (as a society acting through our gummint), are concerned that our banks can't be allowed to fail, then should we not regulate to at least force reward structures in these crucial businesses that minimise this major source of moral hazard?

Clunking Fist said...

It is a matter of opinion on whether banks should be allowed to fail or not.
Note that NZ did not have any specific guarantee until the recently enacted scheme.
But as to regulation of reward, that's the directors/shareholders job. What makes the current situation unfortunate is that, due to all the contributing factors, so many banks were affected in the same way at the same time. Had sanity prevailed (ie an economy based on production od goods & services rather than the production of bubbles), we would probably not be having this conversation.

Clunking Fist said...

Of course, bailing out a bank (rather than just, say, the retail depositors) keep those decision makers in their jobs...