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Default The economic crisis causes in a nutshell

April 17th, 2009, 15:13
Taken from MSNBC: http://www.msnbc.msn.com/id/27183355/

A good succint summary of the interconnected threads to wrap your head around the key players and events, good for both an economic novice, and good reference for a vet.

"The Fed
The collapse of the Internet bubble, followed by the terrorist attacks of 9/11, threw the economy into recession and inflicted damage to the financial system. In response, the Federal Reserve, led by longtime Chairman Alan Greenspan, slashed interest rates and flooded the system with money. The economy slowly recovered, but the Fed kept rates low, providing the mortgage lending industry with a ready source of cheap capital. In 2004, near the peak of the housing bubble, Greenspan encouraged Americans to take out adjustable-rate mortgages."

Home buyers
As the housing boom turned to a bubble, buyers succumbed to the mania. Many were novice investors trying to "flip" real estate for a profit. Others, watching the American Dream recede as prices skyrocketed, justified home purchases that were well beyond their means. For some of those buyers, homeownership was simply not a realistic goal, despite the cheerleading from Congress, the White House and the housing industry.

The real estate lobby
A powerful force on Capitol Hill, led by the National Association of Realtors and National Association of Home Builders, this group championed policies to push homeownership rates to unsustainable levels. Congress and the White House went along; to vote otherwise was to oppose the American Dream. Real estate agents, armed with research from their trade group, fed the myth that home prices would continue to rise and that even if they took a breather, they would never fall by much.

Mortgage brokers
Mortgage brokers earned big commissions even if a loan eventually went bad, because their employers almost always sold the loans quickly. So some brokers stretched the rules to the limits - and beyond - to generate new loan volume. Some committed outright fraud. Others steered borrowers with good credit to higher-fee subprime loans. Borrowers were sold on the idea of overborrowing based on low-cost "teaser rates" - with the false promise that they could always refinance before the rate reset to unaffordable terms. Many mortgage brokers adhered to the letter of the law by disclosing ruinous terms in reams of closing documents, but then made contradictory verbal assurances.

Congress
Members of Congress have always been cheerleaders for homeownership, which after all is the cornerstone of the American Dream. Yet some critics have argued for limits on the virtually sacrosanct deduction for mortgage interest, which provides an incentive to buy more expensive homes. Some analysts have pointed to the Gramm-Leach-Bliley Act of 1999, which knocked down the last remnants of a Depression-era separation between commercial banks and brokerages. But others say the current crisis would have been worse without that law, which has allowed commercial banks to help rescue failing brokerages. In a bipartisan failure, Congress failed to tighten regulation over mortgage giants Fannie Mae and Freddie Mac, which ultimately failed at enormous cost to taxpayers.

Investment bankers
The idea of selling mortgages to investors originated in the 1930 with the creation of the Federal National Mortgage Association, or Fannie Mae. But those loans were made under strict guidelines; investors who bought them were reasonably well protected from loss. As the lending bubble picked up steam, aggressive Wall Street investment bankers used financial alchemy to turn risky loans to borrowers with weak credit histories into Triple-A-rated, safe investments. This fool's gold took two major forms: mortgage-backed securities and credit default swaps. The collapse of these investments is a major cause of the financial crisis.

Fannie/Freddie
As unregulated lenders generated huge volume, Fannie and Freddie wanted in. Fannie and Freddie, both of which had large lobbying operations, went to their friends in Congress and got the green light to jump into the pool of risky loans too. In doing so, the companies put profits for shareholders ahead of their original congressional mandate to serve the interests of home buyers. An accounting scandal in 2004 led to the ouster of Fannie Mae chief executive Franklin Raines and increased calls for reform, but Congress would spend five years debating how to rein in the two companies before the government takeover in 2008.

Appraisers
These professionals are supposed to prevent lenders from lending too much money when buyers bid more than a house is worth. Because they were hired by mortgage brokers, some appraisers abetted the price bubble by valuing houses based the loan amount — sometimes without even seeing the house. Some mortgage brokers would send out multiple requests for a single appraisal, giving the job to the first appraiser who could "hit the number." Some honest appraisers were forced to seek other work.

Federal regulators
Lax regulation of Wall Street and the mortgage industry have been blamed in part for the crisis. In late September Christopher Cox, chairman of the Securities and Exchange Commission, a longtime proponent of deregulation, acknowledged that failures in a voluntary supervision program for Wall Street's big investment banks had contributed to the meltdown. Yet ironically, an obscure accounting rule called mark-to-market, created in the wake of the 2001 Enron scandal, may have worsened the financial meltdown. Because many mortgage-backed securities cannot be sold, they are being priced as if they are worthless. That is forcing banks and investment firms to write down huge paper losses.

Unregulated lenders
Following a series of regulatory changes, the growth of this industry in the 1990s helped finance that decade's historic rise in homeownership rates. But as the economy recovered from the 2001 recession, and home prices soared in value, lenders had to stretch borrowers further to make deals happen. These lenders thought they bore little risk, because they quickly sold off mortgages to Wall Street investment houses. But when home prices stalled and mortgage volume dried up, bad loans soon swamped these lenders. Many of them are no longer in business.

Bond rating agencies
For decades, investors have relied on three companies — Moody's, Standard and Poor's and Fitch — to analyze and evaluate bond risks. A strong rating keeps borrowing costs low. But Wall Street bond issuers pick up the tab for these ratings, which created a conflict of interest for the agencies. Compounding the problem, these firms also offered 'consulting' services - including disclosures of their rating methodologies - to the Wall Street firms trying maximum ratings. That made it easier to design complex securities that got high ratings. Massive ratings 'downgrades' came too late to save investors.

The White House
The rise in the foreclosure rate is at the heart of the current meltdown; until it begins to fall, the housing market - and the securities backed by mortgages on those houses - will have a hard time finding a bottom. The Bush administration has opposed aggressive measures to stem foreclosures. Instead, in the early months of the crisis, it assembled the Hope Now hotline to try to prod lenders to work with troubled borrowers. As msnbc.com reported, readers told of long hold times, inconsistent advice and little help. "

To sum it up, I feel our space program ended up like this. "It's one small step for man. One giant leap for man kind. Oops I fell on my butt after that leap and can't get up anymore."
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April 17th, 2009, 16:56
I've heard a lot of talk lately supporting this view that it wasn't just one thing that caused the crisis, i.e., just the subprimes, Fannie and Freddie/AIG or deregulation of the market, etc. I think it's very important to realize this is a complex situation, and any recovery solution is going to have to address all these components. It's also important that the eye-glazing complexity isn't allowed to disguise any false moves or financial tricks brought forward as part of a solution. That's where I get paranoid about things actually being able to be fixed.

Where there's smoke, there's mirrors.
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April 17th, 2009, 17:33
Originally Posted by buckaroobonzai View Post

Bond rating agencies
IMO the absolute core of the whole debacle was these people. If they hadn't been putting the AAA seal of approval on stuff that anyone remotely unbiased and competent would have rated at high B's / low A's at absolute best things just wouldn't have gotten out of hand.

Investment bankers wouldn't have been able to package up shit & sell it on. Mortgage brokers wouldn't have been incentised by volume and appraisers wouldn't have been encouraged to green light lending on anything
because their employers would have been gambling with their own money.

Fannie/Freddie wouldn't have jumped in because nobody else would have been lending stupid things. Unregulated lenders wouldn't have taken off because they'd have needed their own capital. The real estate lobby wouldn't have had much influence because the money wouldn't have been there if all the pension funds & other capital providers hadn't been fooled. Home buyers wouldn't have spent what they couldn't have borrowed.

The Fed could have lowered interest rates and it wouldn't have mattered if the banks were writing sensibly with appropriate risk premiums & affordability criteria even once rates rose, but they didn't because they just needed to write, take the fees & offload. The mark to market business from the federal regulators wouldn't be an issue if there wasn't all this securitised poo around.

I'm amazed the rating agencies haven't been pulled to pieces.
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April 18th, 2009, 11:15
Originally Posted by Benedict View Post
IMO the absolute core of the whole debacle was these people. If they hadn't been putting the AAA seal of approval on stuff that anyone remotely unbiased and competent would have rated at high B's / low A's at absolute best things just wouldn't have gotten out of hand.
Well yessss… but.. where was the due dilligence on the buy side? The rating agencies deserve some blame sure, but it wasn't exactly a secret they had conflicts of interest. Whoever was buying those products should have known what they were buying anyway.
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April 18th, 2009, 11:23
The whole point of rating agencies is that they do the due diligence and publish the results, to make the buyer's life is easier. That's what being a trusted third party is all about.

IOW, I'm sort of sympathetic to the idea of getting rid of the rating agencies altogether, so that every buyer would have to do their own homework, and the market would assess the risk as spreads. Because of the time and work involved, this would have the additional side effect of raising transaction costs and adding time delays, which would reduce volatility.

However, if trusted rating agencies exist and are used by everybody who's anybody, I think it's unreasonable to expect that most buyers decide not to trust them and dig deep into the data anyway.

In fact, because of the amount of work involved and the sheer efficiency gain you get from having a third party do the risk assessment, rating agencies are bound to emerge anyway, unless they're specifically forbidden through regulatory measures.

I agree that Buffett's maxim of "if you don't understand it, don't buy it" is extremely sound investment advice — but good luck having everybody follow it.
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April 18th, 2009, 23:03
Well again yes …but
There's a role for rating agencies but they're only making life easier and cheeper when they're doing a good job; add in the cost of the recent bailouts and they're not looking so cost effective. At the very minimum the buyers should have been doing proper due dilligence on the agencies themselves if they were relying on the ratings to make investment decisions.

To turn the arguement about would you be happy with your financial institution investing solely on the basis of agency ratings currently?
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April 19th, 2009, 08:45
No, I wouldn't. Not currently, and probably not ever. But then I'm a fairly risk-averse investor, what little investment I do. (I don't expect huge returns either, naturally.)

However I do think it's reasonable to assume that there are large numbers of investors around who *do* choose to trust the rating agencies, under "normal" market conditions anyway.
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April 19th, 2009, 12:29
Originally Posted by Prime Junta View Post
No, I wouldn't. Not currently, and probably not ever. But then I'm a fairly risk-averse investor, what little investment I do. (I don't expect huge returns either, naturally.)

However I do think it's reasonable to assume that there are large numbers of investors around who *do* choose to trust the rating agencies, under "normal" market conditions anyway.
I'd suggest the only difference is that we all currently know what any competant investment back -should have- known about the agencies five years ago.
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April 20th, 2009, 13:58
Originally Posted by Prime Junta View Post
However, if trusted rating agencies exist and are used by everybody who's anybody, I think it's unreasonable to expect that most buyers decide not to trust them and dig deep into the data anyway.
That - in part because most investors won't actually have the data or have any realistic method for obtaining it in a timely fashion even if they wanted to go to the (vast) expense of analysing it themselves.

And frustratingly, rating agencies are actually pretty good at the things that they've traditionally done. Sovereign / corporate default ratings are pretty solid, insurance company solvency ratings are good, their original core business has always been done well, and is based on many years of history and analysis.

Then all of these abstract financial instruments suddenly come along with no history and no standard or objective methodology and the rating agencies didn't exactly make it clear to investors that their ratings for those weren't nearly as credible as their other ratings that people had quite reasonably come to rely on.

There was some frightening statistic of only 4 companies in the whole world having a AAA rating but over 25,000 structured products being out there at one point with AAA ratings . . . craziness.
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April 20th, 2009, 14:04
What do you think, Benedict — is it even possible to reliably rate structured investment products? If so, how, since the abstruse statistical models they use now (which, apparently, are pretty much the same models used to construct the damn things in the first place), clearly don't work?

I don't believe structured finance is going anywhere; from what little I understand of it, it seems to be like fire or gunpowder — highly useful stuff if you know what to do with it and take the proper precautions, but not something you'd want to let out of control.
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April 20th, 2009, 14:34
Originally Posted by Prime Junta View Post
What do you think, Benedict — is it even possible to reliably rate structured investment products? If so, how, since the abstruse statistical models they use now (which, apparently, are pretty much the same models used to construct the damn things in the first place), clearly don't work?

I don't believe structured finance is going anywhere; from what little I understand of it, it seems to be like fire or gunpowder — highly useful stuff if you know what to do with it and take the proper precautions, but not something you'd want to let out of control.
IM(actuarial)O it is completely possible to have a damned good crack at rating structured investment products, and the failure of the models is more due to poor model design than anything else. The key weaknesses as i understand them were:
  • Models used were sometimes (shamefully) fairly deterministic which is clearly unsuitable. The expected trend in house prices is upwards, and if it's upwards there's no losses, but when it goes it all completely goes. Can't remember the source but the FT had an (unsubstantiated) quote from someone at S&P saying their models didn't even test what would happen if prices went down. Scary!
  • The correlations between risks were, I believe, often set at a constant level and hence weighted towards normal market conditions. Normally, one person defaulting is down to their circumstances so their correlation with other people in the pool is low. In the extreme scenarios where things actually go wrong, the dependencies shoot up dramatically as people are defaulting because of market conditions. There are mathematical methods of allowing for varying dependencies within distributions (copulas), which weren't always used.
  • When copulas were used, the one generally used was the Gaussian copula which is based on the normal distribution which is symmetrical about the mean, and a copula based on a more skewed distribution (e.g. pareto) would have been way more appropriate.
  • The behavioural assumptions were clearly flawed - again don't have the link but a common assumption was that people would lose their credit cards and their cars before they risked not paying their mortgages, while in fact (quite predictably) in those states in the US where people can just hand back their keys and walk away then the first thing people will do is give up the property that's so far in the red they'll never get it back and rent while keeping their car and their cards.
  • Allowances weren't adequately made for affordability shocks such as the negative amortisation mortgages, which quite clearly were an unmitigated disaster bound to happen (and again would have made a massive difference to the correlation between risks, it wouldn't just be ninjas who'd struggle to pay with a hike like that).

I really don't think that it's something which can't be modelled. Sure, like all models, it won't be completely accurate but what is in investment? Look at equity price volatility, it's all over the place and the fact that there's no "real" value for them doesn't stop them being perfectly viable investments.

I think it's something that can be modelled but something where everyone doing the modelling had clearly flawed incentives to encourage overly optimistic underlying assumptions.

Unfortunately, I can't see that changing any time soon. I'd like to move to a system where investors commission the ratings for something they're looking to buy rather than leaving the rating funded by those looking to sell, or for there to be more consultancies who could perform reviews. I also think that there should be regulatory changes to require both the issuer of the product and the investment banks organising the issue to retain an interest in every product created.

Until then I wouldn't touch anything based on someone else's models, but I'd say there's a lot of money to be made by bold investors willing to build their own in house models and pick up some distressed products right now.
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April 20th, 2009, 17:06
Can't remember the source but the FT had an (unsubstantiated) quote from someone at S&P saying their models didn't even test what would happen if prices went down. Scary!
and also

Thanks for a very comprehensible exposition, Benedict. I only hope some of the people involved in dealing with this mess are as clear-sighted.

Where there's smoke, there's mirrors.
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April 20th, 2009, 17:16
I have a feeling that most of 'em are. The real problem is, as Benedict said, perverse incentives — when sellers are paying for the ratings, and different rating agencies compete with each other, there's a strong incentive to skew the results, either consciously or unconsciously, by commission or omission. What was the old quote that pointed out that it's very easy to convince someone that a proposition is true if his livelihood depends on it?
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April 20th, 2009, 17:22
The only one that comes to mind is
"All lies and jests!
But a man hears what he wants to hear and disregards the rest." (Probably not the one you meant, though.)
I'd really like to think the situation is at least mildly under control, but it seems so see-saw like, with the government on one end and the usual suspects on the other, and I can't tell but I have a bad feeling they're all wearing the same school uniform.
Which may not be a bad thing in that who else knows what's gone down, but there's another old saying about setting the fox to guard the henhouse that also leaps to mind.

Where there's smoke, there's mirrors.
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April 20th, 2009, 17:42
I think part of the issue is that ratings of this kind just aren't really the right way of looking at things like this. They're pretty good for gilts or company bonds, the company either goes under or it doesn't. Okay the actual amount received in a default event is a bit more uncertain but people (investors anyway) kind of understand the insolvency process and who'll end up with what, and there's plenty of history to go on. And the day to day market value is a bit more volatile but they always stay pretty liquid up until it all goes to hell.

Generally it's all really transparent as well. You can look at a country's budget, at reports & accounts, investment ratios etc and even within the same rating agency bandings take a pretty clear view with independent analysis. And one can make much better estimates of cyclical effects (ratings are, unfortunately all too rarely realised, measures of relative default risk over the cycle rather than absolute default risk at a point in time) using that information.

So they make a quick snapshot headline figure for something that can be analysed properly by internal departments elsewhere, good for general rule of thumb investment criteria but only part of the package.

Structured investment products just don't work as a single rating though, they can produce any range of partial defaults whose effects can take years to play out very opaquely rather than hitting insolvency proceedings for a (comparatively) quick resolution. The extent of that volatility is very different too, the same risk of a default event can have very different chances of total vs partial losses. And they're far from liquid as we've seen so the day to day values become a real issue.

And on top of all that they're hugely complex even if one somehow gets the underlying data and utterly inscrutable if, as is the norm, one doesn't, so the rating is the only thing one has to go on.

Investors shouldn't want a headline number because headline numbers are such a small part of the story for such a skewed loss distribution (99% of the time nothing and 1% of the time absolutely anything could happen).

They need to understand the volatility so that they can manage their aggregations and willingness to lose, so rating agencies should be giving ranges of results & scenarios - e.g. (with x, y & z generic assumptions for correlation etc & this model used) if house prices were to fall by 5% and interest rates went to 3% we would expect a 50% loss kind of thing.

Even if the rating agencies did things properly and came up with A / A- ratings for the AAA stuff (more the right kind of level IMO) investors still wouldn't understand the shape of the loss distributions properly, but they can all have a view on how likely a particular fall in house prices / movement in base rates / general macroeconomic situation is.

Mind you, even if they did that you'd need investors to understand that CDO A is subject to almost exactly the same pressures as CDO B so they shouldn't have both of them . . . .
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April 21st, 2009, 09:00
Interesting article in the LA Times about criminal probes into 20 cases of fraud associated with the bailout already:

http://www.latimes.com/news/nationwo…tory?track=rss

The report said little about who is under investigation and how the fraudulent schemes work, but investigators are already on alert for a long list of potential scams. Such schemes could include obtaining bailout money under false pretenses, bilking the government with phony mortgage modifications, and cheating on taxes with fraudulent filings.

"You don't need an entirely corrupt institution to pull one of these schemes off," Barofsky said. "You only need a few corrupt managers whose compensation may be tied to the performance of these assets in order to effectively pull off a collusion or a kickback scheme."

The risk of fraud is only increasing as the bailout becomes "more complex and larger in scope," he said.

Where there's smoke, there's mirrors.
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April 23rd, 2009, 15:18
Brilliant, short, succinct piece on the causes of the crisis on Mark Thoma's blog, with probably the least attention-grabbing title in the history of blogging: Using Anti-Trust Law to Break Up Banks that are Too Big to Fail.

Excerpt:

I have said that there is no single villain in this crisis, no one person, not one change in the law, etc., that caused this. It was a combination of things. But as I think about it more and more, I'm not so sure. The reason? According to the story I've been telling about why the crisis happened, there were incentive failures at just about every step in the process. Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on.There is not a single step in the process that wasn't compromised by an incentive or market failure of some type.
/me goes off to think about the implications a bit more
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