Michael’s bleg beg

He sounds like a very loyal MR reader to me:

Would you be willing to post a financial crisis topic bleg thread, where people can submit questions in comments and you occasionally pick from those questions?
I have so many questions as I try to get a handle on this stuff. I bet others do too, and that many questions are the same.

I make no promises but ask away…

And I haven’t forgotten your earlier requests, I hope to return to many of them once we are out of the woods.

Comments

Thank you very much for answering my request! That's the kind of responsiveness that keeps us all coming back to MR ;)
I'll submit a few possibilities:

People cite "leverage" as one culprit in the financial crisis. Why was leverage being over-used, if indeed it was?

In the long term, will we have to convert all OTC derivatives into exchange-traded so we can keep better track of the market's overall risk profile?

More generally, what are the options for ensuring the more accurate risk profiling of a derivative? Are these good options? Better than simply forbidding CDS's for example?

What was the "first cause" which led private lenders to lose their minds and make risky loans? Once there is a bubble going, "greed" is perhaps a pretty good explanation for how it continues, but how did it start? Was there a new generation of lenders who didn't understand the principles of mortgage lending?

There seems to be a bad incentive structure where people in finance can make short term profits and ultimately crash Wall Street and even if they lose their jobs they still have their last 10 years of big paychecks. Regulation aside, can we introduce market instruments/mechanisms that allow people to profit off of the short-term/long-term tradeoff, to put things back in balance?

First of all, thanks again for the best econ blog out there.

Second, I am most interested in the last issue raised by MK above: the incentives of the various participants in the creation of this mess. It is something of an unfair question since this is my own area of research, and I should be able to answer it as well as you, but, gosh, I am baffled.

I understand the incentives of a hedge fund manager on a 2/20 compensation scheme to take lots of tail risk and to hope for the best. The same applies to the unit of AIG that wrote all of these CDSs. But what about AIG's board? What about Hank Greenberg? Didn't he have every incentive to prevent this from happening? Or what about James Cayne at Bear Stearns? He had tons of equity in the firm and should have been very keen on wealth preservation. Why didn't he create adequate risk management systems?

Taking off my economist hat and putting on my self-interested voter hat, my one and only question is, why should I care what happens to these idiot banks?

I don't have a need to borrow several million dollars so the alleged credit shortage doesn't scare me. The company I work for is profitable and as far as I know doesn't finance anything with debt, and neither does our customer base (unless you count credit cards). I still get a dozen credit card apps in the mail each week, and banks -- even Wachovia -- are still on TV telling me how I should get a loan from them. Basically, aside from a few companies with famous names facing bankruptcy, I don't see what the problem is. So why should I be eager to go on the hook for a share of $700+ billion? Why can't we just let them fail?

If GM or United Airlines went bankrupt, their investors would take a bath, someone would buy their assets on the cheap, and life would go on. Are financial services bankruptcies different? If so, isn't THAT the problem we should be solving?

Let me second Noah's question above: why can't we just let them fail?

mk
A pretty good guess of first cause was the capital gains tax break from 1997, that should have (and did) cause a one time increase in home prices. However, it's timing led to that increase occuring as stocks producing large negative returns (just as housing was continuing to show increasing returns, and with low interest rates that followed we were off to the races.

I had a couple of questions/comments as well:

I was watching Barney Frank on Charlie Rose, and several times he talked about wanting that "no foreclosure" option built into the bill, so that certain homeowners (based on some criteria, I suppose) wouldn't lose their house. Is it possible that this could turn the "up" side of selling off these mortgage-backed assets into a downer? Or at least drastically affect the "it's not really going to cost $700 billion" argument?

This also brings to mind the notion that, like in Iraq, we need an exit strategy. I have heard cynical people assert that we went into the Middle East not really wanting to get out. I do wonder whether certain members of Congress want to build a nice outpost in the financial sector. Isn't that why Fannie and Freddie kept growing?

Very basic question of fact: What has been the recent default rate among mortgaagees and how does it look in comparative historical terms? and how big have been the banks' set-asides for defaults over the past three years and how do these set aside magnitudes look in comparative historical terms? In this regard, it'd be informative to separate the "sub-prime" from the "prime" mortgage data, insofar as that's possible; and also good to get down into the default rate or "degree of impairment" that is occurring for particular types of mortgage "strip" products, provided we are also being shown the magnitude of these strips in relation to the whole scene. In other words, I don't know the magnitude of the non-performing mortgages problem.

If any reader can point me to a site that is already presenting this information I'd be grateful for the link.

mk, I think he was being sarcastic when he said you must be a loyal reader. Tyler has done a lot of threads like these.

In the S&L crisis, we didn't have the internet which allows individuals to weigh in. To the extent that the current bailout proposal is the top news story, it seems to me that the media coverage, combined with the election coverage, gets millions more people involved. Two other factors are the financial media (cable TV) and the proliferation of individual brokerage accounts and investment.

I'd be interested to know what the effects are of media/internet today on Congress compared to the process of developing the FIRREA legislation in 1989 that created the RTC. It seems that now there are many more individuals, stoked by the media, who, in an election year, have an opinion strongly against the current bailout plan. I don't think that there is wisdom in this crowd, given that the underlying issues are poorly understood and now there is an angry mob forming.

It's a media/political question, not a purely economic one, but my hypothesis is that the changed nature of the individual's role is feeding volatility.

Arnold Kling has glancingly floated the idea of Treasury simply investing gobs o' money into bond funds.

An utterly superficial thought sez: seems sensible. But...

Does this make sense? Would it do the trick? What are the gotchas?

I have heard or read a number of people place partial blame for this situation on CEO pay packages. I think that to the extent that a CEO is incentivised to think of the short term over the long term, risky loans/actions were probably encouraged.

With that in mind, would increasing the time horizon of stock options for corporate leaders be a good idea? Imagine the majority of CEO's upside were to come from how the stock is doing in 10, 20 and/or 30 years. Are there any public companies that operate this way?

What would Milton do?

I was thinking the same thing as Noah. I actually work on Wall Street and see things first hand. Even the people I know at Bear and Lehman have quickly landed on their feet somewhere else.

I can understand the concern about the impact a crisis of confidence in the financial system can have on the broader economy. But I worry more about the fact that we are trying to maintain the current level of consumption despite the fact that it has been driven by unsustainably increasing debt ratios in both government and households - which Fed action is only going to exacerbate. That risk is being rerated and spreads are widening, to me, seems appropriate given that they had been abnormally low in the last few years.

The bottom line is can households and businesses who properly manage their finances get access to debt they need? I see no indication that it is a problem.

As far as your reserve question, it's probably not knowable. To borrow an example from an earlier thread, a common AAA rated security might be a 2007 issued bond that is 4th to be paid principle payments (contracted and prepayments), with 9% junior loans/credit protections (meaning they stop getting paid when defaults occur) bond is still paying the promised interest, and has a market price of say 10. What is the proper impairment for that note? From the previous charts, it's pretty obvious that the pool will have defaults much larger than 9% so there will be some losses, but it's quite hard to guess how high they will go, if they don't reach 30% you might still be paid, but since principle payments won't be made until 5-10 years from now, it will be a long time before there is much info that will allow more than SWAG on how much principle will reach you.

How is the Milton Institute going?

HC

nelsonal I'm much obliged for the links. Thanks for the favor.

Nelsonal's links show that mortgage defaults are occurring at an unusual rate only for mortgages originated in 2006 and 2007. Mortgages originated in 2005 and earlier are currently defaulting at a normal, ordinary rate. See e.g. page number 29 on the second of Nelsonal's links.

As for the reserve question, I confidently expect that the originating banks that kept their exposure to their 2006-2007 mortgages were wise enough to increase their reserves back at the time, knowing, as we all did, that house prices were going to top out real soon. But I'd like to see data that confirms this. Meanwhile, of course, the originating banks that opted to sell on their mortgages to the securities market are not exposed to the default problem.

It's clear that the securities market overpaid for the 2006-2007 vintage mortgages. It seems to me that that's the definition of this "crisis".

Let me second the last question in the first comment (already seconded by Commenterlein). The problem of perverse incentives seems relevant to all bubbles, not just the one that just popped.

In addition, I have a few questions of my own. Apologies if I do not use the correct terminology, or if I am asking something that other people asked with different words.

1. How come the risk of mortgage-backed securities was so grossly underestimated? are credit-rating agencies at fault?

2. What is the role of Chinese mercantilist policies? did the credit provided by China play much of a role in inflating the bubble?

3. Small investors are told (correctly) that they must diversify their investments. However, if financial institutions are entangled (that is, if these institutions are themselves diversified), then the protection offered by diversification to the private investor is much decreased. In addition, there is much less of an incentive for the professional traders to think about the investments they make. Am I right, and if so, can something be done to discourage entanglement?

4. Still related to financial entanglement: basically, when financial institutions choose to entangle, they are betting that the market as a whole will go up, i.e. there is no need to make selective investments. Under the circumstances, should interest rates and/or reserve requirements be raised when the level of entanglement goes up?

phineas
Correct 2006 and 2007 are the problem (to a lesser extent 2005 (because you don't see months 25 and beyond of those (where sub prime 2005 vintage goes zooming up, too). First, no those sorts of default rates were unprecidented, and the banks are only in 2008 taking the huge increases in reserves that that level of defaults will require. Second, mortgages refinance all the time, so older vintages are very small and younger vintages have most of the assets (2005-2007 likely account for 80% of the unpaid balance of all the mortgages in the chart, so they are big 80% of the loans not 25% of the loans.

The mortgage option value makes it a very, very wonkish promblem.

Stullman
The value wasn't in holding 5-7% paper. Sub Primes generally accrued interest at 7-10% (they were taking on credit risk) but the first two years were usually teaser rates tied to short term indicies so they were 2-5% then (savvy shoppers refied or sold as the teaser rate ended, until 2006 when that stopped being a possibility). Then three factors combined. The first factor was originators collected a fee (say 1% of the loan value for originating and securitizing it). The securities functioned like a layer cake with the top layer earning a huge interest rate, say 20% for holding all the credit risk for the first several percent of the mortgages. Those were either held by the banks or sold to hedge funds and were great business when houses were moving up in value (all the prepayments after 2 year teasers meant that they got 2 years of very high interest and all their money back). The next layer down were junk bonds that paid 0.5-1% more than most junk bonds these were structured to begin at about the long run historic default rate so usually about (5-10% of the capital structure). The rest were all rated AAA products which could still pay out well above Treasuries and real AAA credits. This allowed them to be highly levered (the risk based captial rules under Basel II meant that you could borrow most of the value of a AAA security and meet your capital requirements, since the spread was very wide, this was a profit engine (borrow 9.5 billion at short term LIBOR (2.5%), buy 10 billion of AAA mortgage securities at 6.5% and the return on your invested capital or equity will be enormous (even after you buy a credit default swap for 0.25% from AIG if you're a nervous European bank). This looks great since your mortgage department is using just 10% of your capital base of 5 billion.

The better credits were held by the GSEs (to earn a spread and meet their community development goals required by Congress, worse credits were held by British pension funds (who needed to recapitalize but were restricted to very high grade paper), banks, and investment funds. This paper traded on the likelihood of prepayments, (with one group getting the first prepayments and on down the line). When 2005 and 2006's default rates began to rise (in early 2007) it became pretty obvious that that the last pay group wasn't going to get their investment back (and the credit insurance measured used to generate marks for these (ABX-AAA) dropped like a rock marking the bonds from 100 to 5 in a few months). This and the rating downgrades meant that banks suddenly had to cut leverage (in our above example the bank might need an extra 3-10 billion in capital against those assets). For our 5 billion dollar bank this would be trying in good times and impossible today especially after the preferred markets dried up (with the GSE conservatorship) on a bank with a stock price in the single digits isn't going to happen, and that's the crisis in a nutshell.

A depression is usually highly deflationary, so rather than 25% inflation it's -10 or -20% inflation. The Fed pulls the economy with inflation similar to a car towing another with a strap, and in the same manner the Fed can't push a rope nor is it easy to break the self reinforcing deflationary cycle (my money will be worth more tomorrow so why spend today?).

nelsonal, thank you, I appreciate the education.

The mortgage securities owners incurred their losses in a very short time frame as the market crashed in anticipation of the extrapolated future losses. (As nelsonal said, it's a reliable extrapolation.) Meanwhile the originating banks who kept their mortgages will be incurring their losses over a longer timeframe, over the upcoming years, which gives them some breathing room to shore up their reserves. Increasing their reserves reduces the amount they'll have available to lend alright, but today they don't need to lend as much, for the simple reason that houses are less expensive today. The one approximately offsets the other. This offsetting will continue if house prices fall further.

As for the mortgage securities industry, it collapsed in the wake of a very modest and very foreseeable fall in house prices. A good prescription now is a severe pruning back of that industry, not a bailout for it.

For the long term what about increasing reserve requirements to different types of M and fiancial institutions other than banks?

You don't think goverment induced "minority lending" played a big role. Does that mean that you don't think that government
pressure was largely responsible for the bad loans?

Do you think monetary policy was a major cause of the bad loans?

Was there a cause for the bad loans? What was it?

If we could correctly identify who owned what would there be a problem? If not would there still be bailout?

Sub prime loans don't appear to have been the least worse usage of the money. So why wasn't the money invested in the least worse option on such a large scale?

1) If the recent MBS' are still producing most of their expected cash flow (given their higher default rates) why aren't others willing to buy them at an appropriately risk-adjusted price?

I can understand that some derivative tranches are completely worthless, but the new RTC shouldn't be buying-to-bury. Worthless is worthless. The ones to buy are the ones on sale (i.e., priced below their risk-adjusted dcf.)

2) If we line up the actors who "got it wrong" we have to include home-buying speculators, mortgage originators, repackagers, bankers, reinsurers, rating agencies, regulators, and politicians. I.e., the conventional wisdom, across the board, was wrong. Have any large fortunes been made by hedgies and others who bet the other way?

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