A book on the best-seller list is by an investor and author named Taleb called "
The Black Swan: The Impact of the Highly Improbable". In this book he uses the analogy of the black swan as a metaphor for risk; the Europeans had never seen a black swan nor even acknowledged the possibility that a black swan existed (e.g. they weren't including it in their mental models) yet the
black swan thrived in Australia and shocked the sensibilities of the Europeans who settled the continent. I will go through his books at a later time but while reading about the mortgage crisis and issues it hit me that the mis-perception of risk is the root cause.
The Old Model:Back in the early 90's I was an auditor in public accounting. As is my wont, I was in the wrong place at the wrong time. The savings and loan industry went gangbusters in the 1980's, leveraging up with properties and construction loans (even more volatile than sold real estate are loans to firms that are building "on spec"). By the time I got involved, it was working under contract for the
Resolution Trust Corporation, a government entity that was in charge of taking over the defaulting savings and loan institutions and shutting them down.
What had happened was that the banks, who were insured by the Federal government (the FDIC insures deposits to make sure that individuals aren't wiped out when the banks fail like they were in the depression), made loans (mostly) on property under the motto "Heads I win, tails the government loses". They made a lot of loans and if the loans went well, they collected the interest and prospered. But if the loans went bad, they shut down, and the government had to go in and pay off the depositors and try to figure out what to do with the collateral. In this case, it meant selling off the property at some fraction of the original mortgage, with the government taking the loss.
This work for the Resolution Trust Corporation (RTC) was a sad business. We'd wait outside the banks and then go in and seize the assets (shut down the bank) after working hours. The people in the banks weren't stupid; they saw us outside and patiently let us in. This was Kansas City (the great Midwest, after all) so they were polite; probably wouldn't have been so easy in NYC. After the assets were secure the RTC would go about their business of selling the assets. Of all the government entities, the RTC was actually a pretty successful one, and their mission was essentially to "go out of business" by fixing the problem rather than creating a permanent mouth-breathing bureaucracy.
The Next Model:After the savings and loan debacle, the rules were changed. The government regulated banks and saw to it that they didn't hold these loans to maturity through penalizing the banks by requiring them to hold more capital. Thus the banks wanted to get the loans and then sell them off to someone else who would hold the risks involved.
In parallel, Louis Ranieri (the guy famous in "Liar's Poker" about Salomon Brothers, a highly recommended book) basically invented the concept of "packaging" mortgages and then reselling them to third party investors
(Wikipedia has a good summary of what a mortgage backed security is at this link).
With this model, one group of people originated the mortgage, the banks processed and resold (most) of the mortgages, which were in turn put into securities and re-sold to investors who were seeking "yield", which is basically a return on their investment.
This model got more complex; someone had the interesting idea that you could "create" AAA rated securities (the highest quality) out of a bunch of individual mortgages, some of which will fail. How is this done? Even under the most adverse circumstances at least 60% of the total contracts in the pool are going to pay off; thus if you "slice" the risk then this pool receives a very valuable security with very low risk of default. The risk, however, is concentrated into the other "tranches". At the highest risk (who demand the greatest return) are those that receive the first defaults in the pool; if there are very few defaults they make an extreme return; but they can also be wiped out entirely when events go badly. The middle "tranches" are in between in terms of risk and return. There is a HUGE demand for AAA securities and a limited universe of potential products; thus these mortgage securities were in demand. The riskier products also had demand in terms of people or institutions seeking yield who were willing to bear more risk.
The individuals originating the mortgage were groups like "New Century Financial". New Century Financial melted down in 2007, tied to the subprime mortgage craze. Companies like New Century Financial developed new products to drive demand, items like interest-only mortgages, or mortgages with a fixed initial rate (low) which adjust to interest rates later, leading to a spike in mortgage payments. These products had different (bad, but unknown) risk characteristics when compared to the traditional 30 year fixed rate mortgage with a big down payment (say 20%).
Risk:Now the pieces are in place. Companies like New Century Financial were developing products for marginal borrowers and issuing mortgages like crazy; these individuals bought homes they couldn't afford and their mortgages were packaged up and sold to third party investors after the banks dumped them.
At one point I was purchasing a condo a few years ago. The condo was modest and I was going to put down a large down payment and borrow the rest. I had other financial resources and was not required to get a mortgage, but I didn't want to liquidate some items and draw down cash too far.
The mortgage broker, however, treated me like I was a piece of dirt. He constantly asked for more and more documentation, changing his requirements each time I talked to him. I tried to tell him that in fact they had NO risk since I was only financing 50% or so of the total cost of the property; the only way that the loan would have any risk is if the property DECLINED BY MORE THAN 50% IN VALUE. However, his (broken) internal risk model treated all borrowers the same; sure the sub-prime borrowers paid a higher rate (a couple of percentage points) but in fact they should have paid a hugely higher rate; my loan had ZERO risk while their 100% interest only loan in fact had immense risk of default.
So what happened? The model is collapsing. As the interest rates adjust and the cycle of ever upward home values ceased, a whole range of borrowers are now underwater. Since they have little or no equity in their homes, they are going to default at rates far higher than the historical norms.
The subprime lenders have been savaged by the market. New Century Financial went bankrupt along with many of the other players. The banks are mostly unscathed because they didn't hold the loans. The institutions that bought the mortgage backed securities are going to feel the pain next; they are already writing down the value of these assets on their books (the riskier tranches). Hedge funds hold a lot of these assets, too - Bear Stearns recently had 2 of their hedge funds in trouble until the company agreed to inject capital into them to keep them solvent (they could have walked away). Hedge funds compounded the risk and return by leveraging up on these instruments; thus changes in value had a larger impact on them - these Bear Stearns funds had delivered fantastic returns to investors prior to this meltdown, a characteristic of leverage (you do great on an upturn, but get killed on the downturn).
What's Next:No one can predict the future. Here is what seems likely to happen:
-
Existing sub prime borrowers are going to continue to default due to stagnant or falling home prices and low equity - they also can't refinance because those options are now gone
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New sub prime borrowers aren't going to be able to get into the market because loan policies have been tightened and interest rates would be exorbitant
- these defaults and cutting out 20% or so of the potential market of home buyers will further depress home prices, as the institutions who re-possessed the homes unload them back to the market (these institutions are MOTIVATED sellers)
- these defaults will ripple through the various institutions that have responsibility for the defaults and those that bought the end products (higher risk tranches). Where institutions used leverage to increase returns, they will fall first
- the ratings agencies will jump on these issues sooner and issue downgrades faster; this likely will increase the "spread" on riskier assets
In the end it is likely that a new set of policies will be put into place to limit marginal borrowers. This will restore much of the buy / rent imbalance that has occurred and bring values of homes back closer to their "imputed" rent value (the theory that your home's value is at least partially based on what you could rent it out for). The financial design of mortgage backed securities will stay and innovation will continue to increase; there likely will be some sort of widening of spreads to better reflect risk.
In summary, the contracts will better reflect the risk of the borrower, and many of the most marginal borrowers will be priced out of the market entirely.
That was the end of that. He fully understood that he was supposed to give 30-50%, not full contact like he was doing to me. He was pretty cool about it and apologized to me. The scary part was that his thigh kicks on me were all he had - and they hurt me, but not too much. My kick, on the other hand, was definitely hurting him as he had a huge welt forming.
