[hrothgar]

pdmunro, on Dec 31 2007, 05:26 AM, said:

Below are some quotes from an article from WSJ.com as it appeared in our national paper, The Australian
http://www.theaustralian.news.com.au/story...from=public_rss   If anyone can put it into plain english, it would be appreciated.

How Wall Street wizards conjured up sub-prime's hurricane Norma
Carrick Mollenkamp and Serena Ng | December 29, 2007

In recent years, as home prices and mortgage lending boomed, bankers found ever-more-clever ways to repackage trillions of dollars in loans, selling them off in slivers to investors around the world. Financiers and regulators figured all the activity would disperse risk, and maybe even make markets safer and stronger.

Then along came Norma.

Norma CDO I Ltd, as its full name goes, is one of a new breed of mortgage investments created in the waning days of the US housing boom. Instead of spreading the risk of a global home finance boom, the instruments have magnified and concentrated the effects of the sub-prime mortgage bust. They are now behind tens of billions of dollars of writedowns at some of the world's largest banks, including the $US9.4 billion ($10.7 billion) announced last week by Morgan Stanley.
...
Only nine months after selling $US1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk. The concept behind Norma, known as a collateralised debt obligation, has been in use since the 1980s. A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.
....
In principle, credit default swaps help banks and other investors pass along risks they don't want to keep. But in the case of sub-prime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds. UBS Investment Research, a unit of Swiss bank UBS AG, estimates that CDOs sold credit protection on roughly three times the actual face value of sub-prime bonds rated triple-B.

The use of derivatives "multiplied the risk," says Greg Medcraft, an Australian who is chairman of the American Securitisation Forum, an industry association. "The sub-prime mortgage crisis is far greater in terms of potential losses than anyone expected because it's not just physical loans that are defaulting."

....

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, (What does this mean?) according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

Critics say the cross-selling reached such proportions that it artificially propped up the prices of CDOs. Rather than widely dispersing exposure to these mortgages, the practice circulated the same risk among a relatively small number of players.

I suspect that Josh Sher is in a much better position to discuss this than me, but I'm on the East Coast, he's on the West so I might as well see what I can explain while he catches some Zs...

A Collateralized Debt Obligation is a financial instrument that is used to repackage risk.

Lets assume that I have a large number of risky assets - hypothetically, this might be a pool of 1,000 mortgages. An individual mortgage is risky. There is a certain chance that the borrower will default on his loan. In turn, this means that the mortgage issuer loses all of the downstream payments that they expect to collect and are stuck with a property of some kind which they aren't really in a good position to use.

In many cases, a pool of mortgages is less risky than a single mortgage. If we are lucky enough to be able to assume that the chance of foreclosure on individual mortgages are independent events then statistical averaging will decrease our variance. However, if there is systemic risk - a major economic downturn or some such - this assumption of independence might be unwarranted. Its possible that we might see significant positive correlation between the foreclosure chances of different individual mortgages. (This is all banking / insurance 101)

Enter the CDO: CDOs are used to repackage risk by creating a rules set governing the distribution of mortgage payments. For example, I might decide that I am going to divide the mortgage payments into three distinct tranches that are distinguished by the order in which they get payed.

The Senior Tranche will receive preferred treatment. All mortgage payments will be used to fund the Senior tranche up until the point that they have received all the money that is due them. At this point in time, the fund stream is turned to fulfilling obligations to the Mezzanine tranche. Anything left over gets used to pay off the Equity tranche.

Hopefully its clear that investing in the Equity tranche is much riskier than investing in the Senior tranche. Accordingly, the Senior tranche does not provide as high a rate of return as the Equity tranche.

CDOs are neat stuff. If used properly the significantly increase the efficiency of the market.

With this said and done, CDOs aren't without risk. As I noted earlier, a pool of investments doesn't necessarily offer much protection if there is significant systemic risk built into the system. Creating a new CDO whose payoff is based on the income stream produced by other CDOs can be viewed as a mechanism to compensate for systemic risk. Lets assume that I created a three tier CDOs based on the payment streams generated by a set of Senior tranches from mortgage backed CDOs. I am simultaneously increasing the size of the underlying mortgage pool while also creating a new risk tiers.

There a couple issues with this type of approach:

1. Wall Street charges fees to create CDOs. Each time you add a new CDO into the system, more of the returns get siphoned off into management fees. I'd argue that one of the main issues with daisy chaining CDOs isn't undue concentration of risk, but rather the management fee structures.

2. Let's assume that assume that I have set of 1 million mortgages. I use this to create 100 CDOs with three different tranches. I then create three new CDOs (each with three tranches). Think carefully about the following asset: I am going to create an asset which defined as an Equity level tranche of a set of 100 equity level tranche each based on a pool 10,000 mortgages. This is an extremely risky asset. (As much risk as possible has been shoved into this one tranche). In order for the system to work, you need to find someone who is willing to buy the "Toxic Waste"

[kenberg]

Thanks, Bro. It helps, but I'm still working on it. While I am trying to digest this very sophisticated analysis would you care to comment on my very unsophisticated thought that at least part of the cause is this very complexity coupled with a diffusion of responsibility? We (we=those reading this) all know enough not to send money to some guy in Nigeria so that he can get his gold out of the country and split it with us. But people do fall for it. Here you say it is necessary to get someone to invest in the Toxic Waste portion of the debt. Who would? Well, there's a sucker born every minute and the population has increased considerable since Barnum made that observation. So there was this long chain. Loan officer approves loan. Everybody is happy. Bank sells off loan to folks who will create CDOs. Everybody happy. Investors buy CDOs. Why not? Sounds good. etc.

A question: Would it have helped to have required more comprehensive information available to investors? One of the more scary things in the article above is that some folks who are in the business were, or say they were, surprised by the speed and severity of what happened.

I moved two years ago. After I bought my new house I had to sell the other, and I insisted with the realtor that we find a price where it would move fairly quickly (it did). I could live without getting the top price but I was sure a crash in housing prices was coming and I did not want to own two houses in a falling market.

[hrothgar]

kenberg, on Dec 31 2007, 05:37 PM, said:

Thanks, Bro. It helps, but I'm still working on it. While I am trying to digest this very sophisticated analysis would you care to comment on my very unsophisticated thought that at least part of the cause is this very complexity coupled with a diffusion of responsibility? We (we=those reading this) all know enough not to send money to some guy in Nigeria so that he can get his gold out of the country and split it with us. But people do fall for it. Here you say it is necessary to get someone to invest in the Toxic Waste portion of the debt. Who would? Well, there's a sucker born every minute and the population has increased considerable since Barnum made that observation. So there was this long chain. Loan officer approves loan. Everybody is happy. Bank sells off loan to folks who will create CDOs. Everybody happy. Investors buy CDOs. Why not? Sounds good. etc.

A question: Would it have helped to have required more comprehensive information available to investors? One of the more scary things in the article above is that some folks who are in the business were, or say they were, surprised by the speed and severity of what happened.

I moved two years ago. After I bought my new house I had to sell the other, and I insisted with the realtor that we find a price where it would move fairly quickly (it did). I could live without getting the top price but I was sure a crash in housing prices was coming and I did not want to own two houses in a falling market.

There's a number of ways that one can sell "Toxic Waste".

The simple way is to price it attractively. There is always a chance that the toxic waste will yield some positive returns... Indeed, if you are living in a housing bubble where no one ends up foreclosing, toxic waste can be a very attractive investment vehicle.

Moreover, you can collateralize losses. Sometimes companies want losses for tax purposes...

My impression is that root of the crisis is not with the concept of CDOs per se, but rather with

1. The credit rating agencies - Moody's investment Services and the like - which did not do a very good job evaluating credit worthiness of the Mezzanine tranches of the CDOs.

2. High degrees of correlation in mortage returns

3. A number of the players seem to have been using derivatives as speculative vehicles rather than hedges.

[mike777]

Richard's 3 point summary is excellent.

One could break it down in more detail but I would rather combine all three points into one. Call it the superportfolio. A large unstable structure of partially overlapping arbitrage posititions.

An event, less than cataclysmic, causes the superportfolio to begin to unravel. In other words spreads widen or call it implied volitility increases in an increasingly illiquid market forcing further sales.

[Winstonm]

Concerning the credit rating agencies, there were a number of problems - one of these being conflict of interest where the agencies themselves who rated these CDOs also helped create them - for an enhanced fee.

The second problem was the computer models they used. From an article from Mish Shedlock:

Quote

What follows are excerpts from Absence of Fear, an excellent article written by Robert L. Rodriguez at First Pacific Advisors.


We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions.

FPA: “What are the key drivers of your rating model?”
Fitch: They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years.

FPA: “What if HPA was flat for an extended period of time?”
Fitch: They responded that their model would start to break down.

FPA: “What if HPA were to decline 1% to 2% for an extended period of time?”
Fitch: They responded that their models would break down completely.

FPA: “With 2% depreciation, how far up the rating’s scale would it harm?”
Fitch: They responded that it might go as high as the AA or AAA tranches.

Might as well call this Ponzi Ratings, as the model was based on an neverending upward price movement of housing.

As this shows, the main driver behind the problem not only of foreclosures but also of the financial losses is the reduction of value of the underlying collateral. When the leverage is high, it takes very little adverse movement of prices to cause large losses to occur.

[Winstonm]

mike777, on Dec 31 2007, 01:44 PM, said:

Richard's 3 point summary is excellent.

One could break it down in more detail but I would rather combine all three points into one. Call it the superportfolio. A large unstable structure of partially overlapping arbitrage posititions.

An event, less than catclysmic, causes the superportfolio to begin to unravel. In other words spreads widen or call it implied volitility increases in an increasingly illiquid market forcing further sales.

Well said, Mike, and I might only add that opacity (clearly?) added to the increase in spreads and risk aversion that began the unwind of the portfolio.

[Winstonm]

Ken,

To add another point, it is my opinion that deregulation was the main culprit behind this fiasco. A gentlement named Robert Kuttner testified before the House Financial Services Committee describing this phenomenon. Although it is only one man's opinion, I believe he articulates the problem well, and I happen to concur with his views.

Here is a link: http://www.prospect.org/cs/articles?articl...n_1929_and_2007

[mike777]

Winstonm, on Dec 31 2007, 02:10 PM, said:

Ken,

To add another point, it is my opinion that deregulation was the main culprit behind this fiasco.  A gentlement named Robert Kuttner testified before the House Financial Services Committee describing this phenomenon.  Although it is only one man's opinion, I believe he articulates the problem well, and I happen to concur with his views.

Here is a link: http://www.prospect.org/cs/articles?articl...n_1929_and_2007

I did not find this article as helpful as you.


The whole question of just what is a bubble and if such a thing exists and the underlying causes is a huge unknown question. Let's start with a simple question.
What is a bubble, do they even exist, and why should we care? I do not know.

As for his other comments:
TOO much leverage, what does this mean?
TOO little regulation, what does this mean?


I only guess at this but it seems he would define 100% of the institutions as too leveraged and too unregulated.

[Al_U_Card]

Au contraire. Well presented, clear and concise. As a layman with a modicum of personal finance savvy, these items that directly influence my well-being lead to confusion and mistrust.

We don't have to take a step backwards....we just have to avoid stepping off the .

.

.

.

.

cliff.

[Winstonm]

Mike,

Sorry you did not find the article of value, but for me, this quote...

Quote

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy.

...fairly well sums up the securitization markets and how they worked. When the prices of housing doubles in a few years, it is fair to wonder if "bubble" is a correct term, but asset appreciation certainly occured - and now it appears that the appreciation was exorbitant, as home prices are falling. There is no doubt that bankers became intermediaries who simply sold packaged loans for a fee - hence the comparison between now and 1929.

I also thought he made it clear with this...

Quote

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way.

....the type of deregulation of which he was speaking.

And I don't think he said excessive leverage, but pretty well spelled out his meaning with this...

Quote

Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money.

....again, simply comparing the leveraged risk to the attitudes that prevailed in 1929.

But I thought his best point was that you can't have it both ways - non-regulation during the boom times and government and Federal Reserve bailouts during the busts. You either have free markets and live with the consequences or you have regulations - no cake and eat it, too.

[mike777]

Winstonm, on Jan 1 2008, 01:26 AM, said:

Mike,

Sorry you did not find the article of value, but for me, this quote...

Quote

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy.

...fairly well sums up the securitization markets and how they worked. When the prices of housing doubles in a few years, it is fair to wonder if "bubble" is a correct term, but asset appreciation certainly occured - and now it appears that the appreciation was exorbitant, as home prices are falling. There is no doubt that bankers became intermediaries who simply sold packaged loans for a fee - hence the comparison between now and 1929.

I also thought he made it clear with this...

Quote

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way.

....the type of deregulation of which he was speaking.

And I don't think he said excessive leverage, but pretty well spelled out his meaning with this...

Quote

Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money.

....again, simply comparing the leveraged risk to the attitudes that prevailed in 1929.

But I thought his best point was that you can't have it both ways - non-regulation during the boom times and government and Federal Reserve bailouts during the busts. You either have free markets and live with the consequences or you have regulations - no cake and eat it, too.

No no no. I go back to my post and the questions I asked.

[mike777]

1) What is an asset bubble...do they even exist and why should we care? He keeps talking about asset bubbles, whatever they are, but does not say what they are, dutch tulips, maybe no, and why we should care compared to all the other worries.

I am not saying people do not claim there are asset bubbles and that they are bad/evil...but saying so means nothing.
2) What is too much leverage?
3) what is too little regulation?

If you give me vague answers to these questions you get vague results.

[mike777]

I am not sure but WinstonM are you trying to get the police to arrest people and throw them in prison who:
1) buy overpriced stuff they should not?
2) lend money to risky people they should not?

Or what are you saying?

[pdmunro]

I came across an article titled Investment Landfill: How professionals dump their toxic waste on you.
It explains the subprime crisis in plain English.
http://goldnews.bullionvault.com/files/Inv...nt_Landfill.pdf
http://goldnews.bull...er/paul_tustain (Click 30 Jun '07 — Investment landfill)

Here is my attempt to summarize the article.

The task:

Combine a number of risky mortgages into one collateralized debt obligation (CDO).
Now find a way to sell it.

The solution:

1) Point out that house prices are rising and so mortgagees are making their monthly payments. Use the money obtained to lend more easy money, then bundle those mortgages into a CDO, and onsell. Keep repeating. With easy money available, house prices will keep rising, people won't default on their payments (they will want to keep an asset that is going up in value), and investors will keep buying CDO's. This is the strategy that investment banks and their hedge funds have marketed to the retail banks.

2) Tired of trying to sell the riskier investments? Then keep the CDO and its cash stream but take out an insurance policy. This insurance policy is called a credit default swap (CDS). The underwriter of the CDS gets a big return at the cost of having to pay up if the mortgagee defaults on his loan.

Interestingly when a number of CDS's are combined, they are called "synthetic CDO's" which better reflects their origin.

3) Parallel to the growth of the subprime market has been the growth of a derivatives market where bets are laid as to when the whole process is going to fall over.

Governments have shored up the subprime market. After the dot-com "boom and bust", legislation was introduced which forced funds to buy investment-grade bonds. And with house prices rising, the CDO's and CDS's were made to look like suitable investment-grade bonds. So retirement funds have invested in them.

[hrothgar]

pdmunro, on Jan 1 2008, 03:39 PM, said:

I came across an article titled Investment Landfill: How professionals dump their toxic waste on you.
It explains the subprime crisis in plain English.
http://goldnews.bullionvault.com/files/Inv...nt_Landfill.pdf
http://goldnews.bull...er/paul_tustain (Click 30 Jun '07 — Investment landfill)

Not sure if I'd take my economics advice from individuals who have a strong vested interest in selling bullion.

They tend to spin things in a completely ridiculous manner.

[kenberg]

There have been a number of interesting thoughts here. I'm going on vacation Thursday so I won't be following it to closely for a while.

My wife and I have one of these cross-cultural marriages. She grew up in SF not far from Haight-Asbury and I grew up in Minnesota. I was shocked to discover that while she had seen live, and early, performances by Janis Joplin and the Jefferson Airplane she has never driven a car on a frozen lake. We are off to northern Minnesota to correct this gap in her upbringing.

Anyway, I'll try to look in on new posts. I think they have heard of the Internet up there.

[Winstonm]

mike777, on Jan 1 2008, 04:00 AM, said:

I am not sure but WinstonM are you trying to get the police to arrest people and throw them in prison who:
1) buy overpriced stuff they should not?
2) lend money to  risky people they should not?

Or what are you saying?

Your obfuscation is typically better than this, so I will answer in kind.

If you let unsupervised kids play with matches, don't be surprised when the house burns down - and when it happens, don't expect the government to buy you a new house.

[Winstonm]

Quote

What is a bubble, do they even exist, and why should we care? I do not know.

Maybe this from the San Francisco Federal Reserve will help:

Quote

In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a nonfundamental bubble component that may reflect price speculation or irrational investor euphoria or depression. The expansion of an asset price bubble may lead to a debilitating misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy.

I underline "irrational investor euphoria" as to me this is the base cause of excess in asset overvaluation, and not even the brightest among us is exempt from its affect.

Quote

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months."
- Irving Fisher, Ph.D. in economics, Oct. 17, 1929

[jtfanclub]

mike777, on Jan 1 2008, 03:46 AM, said:

1) What is an asset bubble...do they even exist and why should we care? He keeps talking about asset bubbles, whatever they are, but does not say what they are, dutch tulips, maybe no, and why we should care compared to all the other worries.

Asset bubbles.

Let's suppose that you decide to buy an asset you've heard good things about. Lots of other people think that the asset sounds good too, and bid against you. The price goes up. As more people get interested, the price goes higher, not because of anything about the asset, but because more people are bidding on it. Pretty soon, people are speculating not on the asset, but on the excitement about the asset...as long as people stay excited about it, the price will continue to increase. Eventually, people will lose interest and the asset's value will drop to its actual value. The difference between the actual value and the price increase caused by people bidding up the asset is the bubble.

Usually, bubble give a false impression not just of the asset, but of the economy in general. You by an asset for a dollar. I buy it for two dollars. You buy it back from me for three dollars. I buy it back from you for four dollars, and so forth.On paper, it looks like we've made enormous profits, and one of holds a very valuable asset. In reality, nothing's really changed. But it sure looks good on paper.

Take the value of land in Tokyo, which at one point if I recall correctly was greater than the value of land in all of the United States. A few square feet might be worth millions of dollars. But the only people who bought and sold these were a few Japanese banks, who inflated the price when buying and selling to each other to make the prices seem gigantic. In fact, nobody outside of these banks were willing to buy this land for thousands of dollars per square foot, let alone millions. But because the banks didn't try to sell it to the public, the "market value" wasn't corrected.

Why did they do this? Well, it made the banks look very strong, with lots of assets, and plenty of collateral to cover bad loans. It also meant they could borrow fantastic amounts of money, enough to simply buy the World Trade Center and numerous other landmarks.

Unfortunately, as usual with loans, some went bad. And when some banks couldn't repay, their assets were seized, and they were forced to sell this amazingly valuable land. Which nobody wanted to buy at these insane prices. So the "market value" of the land plunged, which meant that all of the other banks suddenly didn't have any collateral to cover their loans, which meant either that they went under or they stopped giving out more loans. Net result- the Japanese economy crashed, and took over 15 years to recover.

Should the "I'll pay $1 billion dollars for your worthless land if you'll pay $1 billion for my worthless land" bankers be punished? Did they even break the law? I don't know.

In our case, real estate agents and banks were deliberately inflating real estate prices, by assessing houses much higher than they were actually worth and giving out loans to people who couldn't possibly pay them back. I don't think the result is going to be Stock Market 1929, in part because the global stock market had crashed about 1925 so nobody could buy up the discount stocks back then, while now the Saudis and Chinese (and others) will happily gobble up the cheap stuff once the markets stabilize a little. This looks to me more like Japan 1990. Serious financial 'malaise' but not a depression for the next decade or so.

[Winstonm]

Quote

2) What is too much leverage?

Leverage to the degree that it requires government bailouts if losses are incured. This is usually not caused by the degree of leverage, per se, but by the model used to establish the positions.


3) what is too little regulation?

Regulation that facillitates opacity instead of full disclosure, which would also include current GAAP that, for example, allows banks to count negative amortization of option-pay ARMs as earnings.