"Toxic Assets", the Financial Crisis, and the Bankers

[palo5]

Originally Posted by deepsepia

. . .but they're the basis of these securities

The bottom line was that the credits that failed in the financial crisis were largely loans to people . . . mortgages and consumer loans.

That these loans were bundled doesn't change the issue-- the securitized bundles would have performed fine if the loans and mortgages had paid.

...

"Toxic assets" are the result of this malignant process, not the cause.

I think it's a little different

We all know the assets failed because the mortgages failed, but without securitization most of those mortgages would never have been given in the first place. So we have to look elsewhere

The trouble was that the loans did not stay with the originators as they would have done X years ago. In those days, and still today almost everywhere else in the world, you would never get a mortgage (or any loan, for that matter) unless the lender knew you had an excellent chance of paying it back. And to lessen the risk, you would have to make a good-sized downpayment, just in case

But with securitization, the loans did not stay with originators, but were cut up, spread around different CDOs, given a AAA rating, and sold to investors, with the result that the originators didn't lose anything when the mortgages didn't perform. Which changed the incentives completely

Who did it make happy? - the homebuyers, because they got a house they would otherwise never get; the mortgage brokers, because they got bonuses for the deals; the originators, because they got their bonuses too; the rating agencies, because they got big fees for total incompetence at best, and downright fraud at worst; and the fat cats on Wall St because they made gazillions selling the CDOs

Now ask yourself who was burned, and who came out of it with millions in their pockets and, it seems, no liability

The guys who got burned were the homebuyers, investors and taxpayers. Which leaves the rip-off artists...

It was all a big fraud, deeps, and the trouble really was securitization, ie, the toxic assets

[deepsepia]

Originally Posted by palo5

I think it's a little different

We all know the assets failed because the mortgages failed, but without securitization most of those mortgages would never have been given in the first place. So we have to look elsewhere


{snip}

It was all a big fraud, deeps, and the trouble really was securitization, ie, the toxic assets

Securitization was mostly a good thing. The problem with "retained loans" for lenders is that it results in dramatic over-concentration of risk. Banks that only make loans in a narrow "home market" are excessively vulnerable to that home market-- and they can blow up too.

An example of that would be the Irish real estate bubble, and the destruction of the Irish banking system. These were loans made by Irish banks, to develop and purchase Irish real estate assets, and these loans were kept on their books . . . and Ireland's financial disaster is the equal of anyone else's . . .

The "root cause" of the crisis, IMO, is the leverage in the system -- Bear Stearns and Lehman Brothers were leveraged 40 to 1 before they collapsed. That's simply too high . . . you borrow with %2.5 down, and sooner or later disaster will strike.

Add to that a combination of government guarantees (explicit and implicit) and the ability of institutions to threaten systemic collapse, and you have a disaster.

Put it another way: No institution capable of threatening the financial system should be allowed to lever up, 40-1. You want to roll the dice on some high risk/high reward strategy? Fine, do it in some "quarantined" vehicle which doesn't contaminate the rest of the system.

Your point about the AAA credit ascribed to the various slices of synthetic securities is well taken. This was a strange bit of "finance fiction", based on mathematical models applied to a relatively small historical data set. Was it a "fraud"? No, I don't think so . . . it was reckless and while there certainly were instances of fraud, I'd say that the problem is much a very poor design.

[palo5]

Originally Posted by deepsepia

Securitization was mostly a good thing

It was good for bankers and the rating agencies. Can't fault you there

Your point about the AAA credit ascribed to the various slices of synthetic securities is well taken. This was a strange bit of "finance fiction", based on mathematical models applied to a relatively small historical data set. Was it a "fraud"? No, I don't think so . . . it was reckless and while there certainly were instances of fraud, I'd say that the problem is much a very poor design.

From what I've read - which must be true, because they aren't that dumb - many analysts did not like giving AAA to many CDOs, but they were told by their managers to give it anyway. Let's hope we hear more about this

The AAA thing had an excellent joke about it in a place I can't remember:

"Banker goes to rating agent. Tells him he needs to sell a thousand piles of shit to bozos, but needs a triple-A to do it. He'll pay the rater extra

The rater thinks a bit. That money looks handy. So he gives the triple-A and tells investors 'Buy this brown-colored gold - it's as good as US Treasuries' "

[deepsepia]

Originally Posted by palo5

It was good for bankers and the rating agencies. Can't fault you there

Is a good thing for borrowers and savers too.

Originally Posted by palo5

From what I've read - which must be true, because they aren't that dumb - many analysts did not like giving AAA to many CDOs, but they were told by their managers to give it anyway. Let's hope we hear more about this

No question but that that's true. The question is: "Why do ratings matter at all?" The US Government, for example, with trillions of dollars of debt outstanding-- S&P can see nothing that you or I can't see. And the credit markets price US Government debt and risk every day . . . so what's the point of a rating agency? Notice that after S&P downgraded the US, money has flooded into Treasuries, and the interest rates on US debt has actually declined . . . meaning that their evaluation of the credit risk of the US Government has had a perversely inverse impact.

The impact of the ratings agencies was to permit more leverage to be applied to these instruments. There's nothing wrong with someone who wants to buy a package of dodgy loans -- that's how poor folks can buy things. You just shouldn't be levering them 40 to 1

[palo5]

Originally Posted by deepsepia

Is a good thing for borrowers and savers too

How?

The question is: "Why do ratings matter at all?"

They are supposed to give investors a qualified opinion on the grade of an asset. And some institutions have minimum rating requirements before they invest at all

Notice that after S&P downgraded the US, money has flooded into Treasuries, and the interest rates on US debt has actually declined . . . meaning that their evaluation of the credit risk of the US Government has had a perversely inverse impact

... exactly, money floods out of stocks and into bonds, which is exactly what shouldn't happen, in theory

But that's no reason to trust the judgment of "the market". They're the ones who mostly cause bubbles and busts, after all

Wouldn't be bad if we had someone who did what the ratings agencies obviously don't, namely Due Diligence

[deepsepia]

Originally Posted by palo5

How?

Good for borrowers -- much greater availability of credit.

Good for savers-- able to build a much more diversified, higher yielding and resilient pool of interest earning assets.

In essence, a Mortgage Backed Security or Collateralized Loan Obligation (CLO) is like a savings and loan ("building society" for those in the UK) without current operations. That is, in 1960, if you bought shares in "Springfield Savings and Loan", you were buying "securitized mortgages" AND an operation which was continuing to create new mortgages. The CMO/CLO business takes the continuing operation of loan origination and distributes risk much more broadly.

The problem with "Springfield Savings and Loan" as a mortgage funding instrument is that the performance of the mortgages will co-vary, that is they're likely to all go bad at the same time. This happened in the US in the oil patch (Penn Square Bank) when oil busted, for example.

And it just happened in Ireland. Optimally, you don't want your financial system to be so interwoven with local factors that when some local problem hits the economy, it then destroys your financial system as well. So spreading risk is much better.

Originally Posted by palo5

They are supposed to give investors a qualified opinion on the grade of an asset. And some institutions have minimum rating requirements before they invest at all

But this is a perverse misalignment. The rated companies pay the ratings agencies for the service. The whole point of a market is transparency. I don't rely on someone's rating to decide whether Hewlett Packard is cheap or expensive . . . I look at their accounts. There's abundant evidence that ratings are of very little value, and objective financial measures far better. I don't care if something's "C" rated, if it pays.

Originally Posted by palo5

... exactly, money floods out of stocks and into bonds, which is exactly what shouldn't happen, in theory

Not really. Theory doesn't suggest that a bond should yield less when rated less highly.

Originally Posted by palo5

But that's no reason to trust the judgment of "the market". They're the ones who mostly cause bubbles and busts, after all

Oh, there's every reason to trust the market. Its pretending that the market price doesn't reflect reality that got us in this mess. With both Bear Stearns and Lehman, they had big chunks of real estate loans on their books, which they were calling "worth 95", when in fact they were trading at 65.

Today, that's the suspicion with Societe Generale and the other European banks. They have Greek loans on their books (we don't know how much) and they're claiming minimal impairments, when the way the loans are trading, we know they're fucked.

Which do you think is more truthful, the market price, or the banker's ascribed price?

Originally Posted by palo5

Wouldn't be bad if we had someone who did what the ratings agencies obviously don't, namely Due Diligence

DD is the obligation of a fiduciary, which they are not. The impact of the ratings has been to insulate fiduciaries from the need to do their own DD.

[palo5]

Originally Posted by deepsepia

Not really. Theory doesn't suggest that a bond should yield less when rated less highly

What in your view does it suggest, compared with what's happening?

Which do you think is more truthful, the market price, or the banker's ascribed price?

It depends where I live, Comrade

[deepsepia]

Originally Posted by palo5

What in your view does it suggest, compared with what's happening?

A deflationary/liquidationist panic. The Western economies piled debt into every nook and cranny to finance consumption. We said "grandad will have a pension, I'll have a TV, and he'll have a new school". The trouble is, we didn't have the money to do this.

So bankers, obligingly, figured out how to lend us money against all that equity we'd built up in things like homes. At the same time, the central banks decided that housing asset prices were a kind of wealth, and were happy to let them do it.

So effectively we ramped up consumption, fueled by loans against stuff that's not worth nearly as much as we claimed/hoped.

So what do you get? Consumption collapses, impairing the value of any but the best credits. At the end of the day, no matter what S&P may think, the United States can print dollars, and US Treasuries are the only deep and liquid pool to absorb the wealth of surplus nations (look at what's happened to "poor" Switzerland as folks have crowded into the Swiss Franc)

Our model doesn't really have a place for countries with prolonged consumption shortfalls . . . look at Japan. They keep piling on debt, consumption has gone nowhere for twenty years. Theory suggests that this shouldn't have happened this way . . . and yet it has. The paradox is: you assume that as prices fall, that stimulates more demand . . . but what if it doesn't? What if, as prices fall, folks who own (probably leveraged) assets, get more scared, consume less, and are moved to sell rather than buy assets?

Originally Posted by palo5

It depends where I live, Comrade

Was very nostalgic when Comrade Putin resurrected that old familiar term, "parasite".

The curious thing -- the Soviet Union used to be a very reliable credit. Paid their bills on time . . .

. . . but old Soviets knew that the market price was very different than the official price, and they knew which one was "true".

[deepsepia]

useful reading . . . good book, not my link, prop to OP

"Why are there so many banking crises?" This book would be the "markets will solve the problem, if you have an appropriate regulatory regime" position -- its not a proven argument (the left counter would be "the weight of money will undermine any regulatory regime you might come up with, eventually")

Jean-Charles Rochet, "Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation"
Pri nceton Univ ersity Press | 2008 | ISBN: 0691131465 | 336 pages | PDF | 1,3 MB

Almost every country in the world has sophisticated systems to prevent banking crises. Yet such crises--and the massive financial and social damage they can cause--remain common throughout the world. Does deposit insurance encourage depositors and bankers to take excessive risks? Are banking regulations poorly designed? Or are banking regulators incompetent? Jean-Charles Rochet, one of the world's leading authorities on banking regulation, argues that the answer in each case is "no." In Why Are There So Many Banking Crises?, he makes the case that, although many banking crises are precipitated by financial deregulation and globalization, political interference often causes--and almost always exacerbates--banking crises. If, for example, political authorities are allowed to pressure banking regulators into bailing out banks that should be allowed to fail, then regulation will lack credibility and market discipline won't work. Only by insuring the independence of banking regulators, Rochet says, can market forces work and banking crises be prevented and minimized. In this important collection of essays, Rochet examines the causes of banking crises around the world in recent decades, focusing on the lender of last resort; prudential regulation and the management of risk; and solvency regulations. His proposals for reforms that could limit the frequency and severity of banking crises should interest a wide range of academic economists and those working for central and private banks and financial services authorities.

http://www.filesonic.com/file/1734994334/Rochet_-_Why_are_there_So_Many_Banking_Crises;_The_Politics_and_Policy_of_Bank_Regulation_(2007).pdf

[palo5]

Originally Posted by deepsepia

. . . but old Soviets knew that the market price was very different than the official price, and they knew which one was "true".

For some commodities there was only one seller, so to speak of a "market" is incorrect

Was very nostalgic when Comrade Putin resurrected that old familiar term, "parasite"

What was incorrect with the term?