Good Math, Bad Math

With the insanity that’s been going on in the financial world
lately, a bunch of people have asked me to post a followup to my
earlier posts on the whole mortgage disaster, to try to explain
what’s going on lately.

As I keep saying when people ask me things like this, I’m not an economist. I don’t know much about economics, and what little I do know, I tend to find terribly boring. And in this case, the discussion inevitably gets political, so I’m expecting lots of nasty email.

Anyway, with that said, I’ve been doing a lot of reading, to try to understand this mess. And I’ll try to explain what I’ve figured out.

The situation is both very complicated and very simple.

The simple version? People made lots and lots of stupid loans that couldn’t be repaid.

Of course, it’s not really that simple.

The mortgage mess is the starting point. If you recall href="http://scienceblogs.com/goodmath/2008/06/mortgage_basics_part_2_the_sys.php">my
posts on the mortgage mess, what happened was:

  1. People like buying safe investments.
  2. Historically, mortgages are very safe investments: people
    will go to incredible lengths not to lose their homes.
  3. Banks realized that they could make lots of money by
    taking groups of mortgages, and turning them into
    bonds that they could sell, earning a commission, and
    passing the risk to whoever bought the bonds.
  4. These bonds became incredibly popular. Lots and lots of
    people and organizations wanted to buy them.
  5. There aren’t enough good mortgages to put together the
    number of bonds that people wanted to buy.
  6. So banks started giving out mortgages to people who
    couldn’t repay them, using
    elaborate and dishonest schemes to pretend that they were
    actually not bad mortgages.
  7. The people who got mortgages that they couldn’t repay
    didn’t repay them.
  8. The banks act surprised: “My god, no one could have predicted that so many loans would default! Whine, whinge, moan, someone come help us!

What’s going on now is directly related to that mortgage mess. A good metaphor for it is that the current situation is like a huge city of skyscrapers built on a foundation of sand; the mortgages are the sand.

What we’ve been seeing over the last couple of weeks is the
same basic scam as the mortgage mess, but on an even larger scale.
Lending money is a profitable business. Bundling loans into
investment vehicles is an incredibly profitable business for
producing what appear to be high-yield, low-risk investments.

Naturally, when there’s a big opportunity to make lots of
money, there’s a ton of people looking to get in on it. Of course,
just like with the mortgages, there’s a limit. Realistically,
there’s only a certain amount of money that can be loaned at any
time to people who can pay it back. But there was so much money to
be made that as the high-quality loans ran out, they started
looking for other things that they could wrap up as investments. Of
course, since people who buy these kinds of investments are
typically looking for something really safe, that means that they
can’t just give money out any-which-way; they need to have some
plausible way of saying “This is really safe”.

And here’s where the stupidity really started kicking in.

How do you take a bunch of loans that might not be repaid, and turn them into something that’s safe? Well, what do you do if you had a lot of money tied up in a piece of property that you could lose in an accident? Like, say, a car or a house? You’d buy insurance!

That’s basically what the investment firms did. They gave out
shit loans that any sane person should have known couldn’t be
repaid, and then they bough insurance on them to guarantee that at
least the principal would be safe.

So who did they buy insurance from? Mostly each other.

So they were taking massive numbers of shitty loans that
they knew couldn’t ultimately be repaid, and repackaging them
as safe investments. They did that by a combination of building up
structures like tranching, and by buying insurance. So between the structure and the insurance, they could take these
loans to a rating agency, and get them to say “This is a really safe investment”.

But it was really all a scam. The insurance didn’t exist; the structure didn’t actually really reduce the risk. Ultimately, the same basic gaggle of businesses that were selling the loans as investments were providing insurance to each other!

So what’s happening now is the natural, expected outcome.
Look at this mess: What could possibly go wrong? Let’s work it through. Suppose firm A issues a bunch of crappy loans, and buys insurance for them from firm B, and firm B issues a bunch of crappy loans, and buys its insurance for them from firm A. Now, both A’s crappy loans and B’s crappy loans
start to fail at the same time – that is, both discover that substantial numbers of those loans aren’t going to be repaid. Then firm A comes to firm B with an insurance claim requiring B to repay A’s failed loans; likewise, B comes to A with a claim. Both A and B are in deep trouble.

It gets quite a bit stupider when you look at the details of some of these deals. I saw an article about two weeks ago
in the New York Times (no links, because articles over a week old go behind a pay wall) that was talking about one loan package issued by UBS. They had one bundle of about 20 billion dollars of loans that they resold as bonds. They bought “insurance” on it from a much smaller investment firm, whose total assets (that is, every bit of money that they had any plausible claim to be able to raise) was 200 million dollars. Think about what that means:
the guys insuring those 20 billion dollars of loans had absolutely
no way of covering them: the insurer couldn’t possibly ever pay off the loans they were insuring if they failed. But on the paper that got the loans their high-quality rating, it said that they were fully insured. So there’s no way in hell that if those loans failed, the insurers would be able to pay up, and the folks selling the insurance knew it, and the folks buying the insurance knew it. But they just assumed that somehow, this would all work out.

This is really the basic idea of what’s going on right now. Massive numbers of loans were given out that couldn’t be repaid; massive numbers of people and institutions bought investments on the assurance that they were absolutely safe, when in fact they weren’t worth the paper they were printed on.

Of course, simple stupidity is never enough. People need to pile stupidity on stupidity on stupidity. Lots of those loans
were what are called leveraged investments. That is, suppose I want to invest in fund X. But to buy a piece of X, I need $100,000. But I don’t have $100,000; I only have $20,000. So, I borrow $80,000. Then I use that to buy X. If X pays well, then
what I earn from $100,000 of X will be worth more than the interest on my $80,000 loan. So I come out ahead. And the bank gets an $80,000 loan that they can wrap into an investment package, and sell it to some other sucker.

But if my investment in X doesn’t pay off – in fact, my $100,000 worth of X ends up being worth only $60,000, then I can’t repay my loan. So the bank is out $20,000 plus interest. But it’s not really the bank; it’s the other investment that they sold my unpaid loan into. So now someone else, who invested in a something that was supposedly safe, finds that part of their investment has been lost. And if they also borrowed money to make their investment, then they’ll pass on the trouble.

Of course, it gets even stupider.

When you go to buy debt as an investment in the form of a bond,
you get a rating which supposedly tells you how
much of a risk you’re taking on with the investment. There are ratings like “AAA”, which basically mean that there’s no foreseeable way that you’d ever lose your principal on the investment.

Who gives the bonds their ratings? Businesses called bond-rating agencies. And what do they get paid for? Supposedly for accurately assessing the risk associated with the bond. But
who pays them? The business issuing the bond. If agency X doesn’t want to rate something “AAA”, but agency Y will, then the bond issuer can just take their business from X to Y. Since the ratings agency aren’t actually legally responsible in any meaningful way
if their ratings turn out to be a crock of shit, that means
that their primary interest as a business is to keep their customer happy – and their customer isn’t the investor; it’s the people selling the investments. So they’ve been giving ridiculous, indefensible ratings to things, claiming that they’re absolutely, 100% perfectly safe even though they’re garbage.

I said that politics comes into it. The way that politics comes
in is that this kind of stuff shouldn’t happen. You
shouldn’t be able to buy “insurance” that can’t ever pay up. You shouldn’t be able to represent something as safe if it isn’t. Why did all of this stuff happen?

In a word: deregulation.

One of the big trends in American politics is deregulation. Right-winger’s in the government have been constantly harping on the idea that the free market is the perfect solution to any and all problems. Anything that restricts the market – any rules
or regulations imposed on it – are inevitably a bad thing, which can never do anything but screw things up. And they’ve worked hard
at removing any and all rules that might muddle up their precious
market.

Once upon a time, banks had to keep the bank money (i.e., deposits) separate from other things. In fact, they had to keep
the entire business of banking separate from the investment business. There were rules about what they could invest in. And so on.

All of this was torn down by the conservatives in our government. And as new financial products came onto the market, instead of making rules to make sure that people were being
fair and honest, they insisting on maintaining a strict hand-off
policy.

Free markets are great things. But the big catch is that like anything else run by human beings, they’re easy to abuse if you’re not honest. The purpose of regulation is to try to limit the kinds
of abuse people can get away with. If someone sells you an investment and tells you that your principal is absolutely safe,
then damn it, it should be safe. If it’s not, they should be required to tell you what the risks are.

But for now, they don’t. There’s no legal framework for creating or enforcing rules. No one can be punished for the damage they’ve done. No one loses the huge rewards that they pocketed by screwing people over – because there’s no rules, no legal mechanism, that says that they can’t. As I’m finishing this article, I just came across a news story. Lehman Brothers is one of
the big investment firms that was involved in this. They were forced into bankruptcy as a result. As they’re starting to liquidate and sell off their assets, we learn that one of the last things they did before filing for bankruptcy was setting aside
two and a half billion dollars for performance bonuses for the staff of the New York office. The very people who put the firms money into worthless investments, who ran a hundred year old company into the ground, made sure that before
they filed for bankruptcy, they squirreled away more of their investors money to pay themselves bonuses. And that’s legal – they can take that money out of the pool of liquidated assets to pay themselves, instead of leaving it to pay back the people who are owed.

This is getting really long, and there’s frankly still more to say. So I’ll leave this post off here, and follow up tomorrow.

Comments

  1. #1 EastwoodDC
    September 22, 2008

    I’m even less of an economist, but your description of the situation seems apt.

  2. #2 Steve Sandvik
    September 22, 2008

    It might be worth mentioning that Bill Clinton signed the Gramm-Leach-Bliley act into effect (which repealed Glass-Steagall, and thereby was the most visible example of the deregulation you’re referencing). That being said, in large part it was a recognition that banks (both commercial and investment) were so good at working around the edges of the regulations that they were mostly a fiction–unfortunately the repeal allowed commercial banks to exert their significantly greater scale in the investment banks’ sphere directly, which compounded the problem.

    Oh, and the primary stupidity was making loans that were perfectly sound as long as real estate continued to appreciate in the short term. (because then defaults are cheap for the banks, as the asset is worth close to the debt…or in some cases more than the debt)…once again, we demonstrate that if it looks like a bubble, it’s probably a bubble.

    And the Bush (43) administration proposed significant regulation of the mortgage market in 2003, but it never went anywhere. So although in the general case, it’s reasonable to point to Republicans as the primary advocates of deregulation, this isn’t necessarily the best case to make that argument. This had more to do with the fact that banks tend to be very well represented at the federal level because they’re able to buy good lobbying and thereby influence Senators and Representatives of *both* parties disproportionately to the interests of the public as a whole. By the numbers, Democrats were probably slightly more in the pay of Fannie Mae and Freddie Mac, for instance, which were significant contributors to the pool of bad loans.

  3. #3 Bill Mill
    September 22, 2008

    1) s/Right-winger’s/Right-wingers

    2) How can you overlook the government’s role in fostering unsafe mortgage lending practices by allowing Frannie to run wild?

    3) If you want to contend that Glass-Steagall is involved in this mess, please respond to this article: http://www.marginalrevolution.com/marginalrevolution/2008/09/glass-steagall.html

    4) This is about finance, not economics.

    5) You should talk about Gramm-Leach-Bliley when you talk about dereg; that had much more impact than Glass-Steagall IMHO. http://en.wikipedia.org/wiki/Gramm-leach-bliley

  4. #4 John Armstrong
    September 22, 2008

    no links, because articles over a week old go behind a pay wall

    That’s odd. I was sure they changed that a while back. I just loaded some old pages now and didn’t pay a cent. Are you sure you’re not just being lazy?

  5. #5 Baldeagle
    September 22, 2008

    I think it was summed up best, back in July…
    (NSFW-cursing) http://www.businesspundit.com/sub-prime/

  6. #6 John Fouhy
    September 22, 2008

    There was an NY Times blog post on this topic a few days ago: How Wall Street lied to its computers.

    Summary: Wall Street firms are legally required to assess the risk level of their investments. If the risk is high, they have to keep more money aside (as a kind of self-insurance). They didn’t want to do that; they’d rather use that money to make money. So:

    1. They gave their risk models extremely optimistic assumptions.
    2. They lied: they took complicated multilayer super-tranched crazy bonds and entered them into their models as simple bonds with a set interest rate (the complex bonds had been rated AAA, so it was practically the same thing anyway, right?).
  7. #7 OmegaMom
    September 22, 2008

    I think the thing that boggles me the most is that many of these people *believed* their own BS. They *believed* “real estate never goes down!”, so they *believed* that people getting the subprime mortgages would be able to turn around in a year or two and sell for a nifty increase and pay off the subprime mortgages. And now real estate has been going down for two years, and everyone’s shocked, *shocked!* to discover that, hey, all those wacky investment objects are, essentially, vaporware.

    Don’t forget to add in Greenspan’s practice of dropping the interest rates rapidly to ensure that the money that was vanishing due to the dot-com bubble could find another place to be invested, which drove the housing bubble…

    And there was a coalition of state attorneys general who tried to get the feds to do something, about three or four years ago, and they were told to go suck an egg, because, dontcha know, “real estate always goes up”.

  8. #8 Who Cares
    September 22, 2008

    These people can’t even be nailed for fraud? Geez.

  9. #9 lukas
    September 22, 2008

    These people can’t even be nailed for fraud? Geez.

    Why should they? What they are doing is legal, and investors knew from the start that this scenario was an option. It’s their fault for trusting rating agencies that are accountable to no one and investing in a bubble that was bound to pop rather sooner than later.

  10. #10 steve s
    September 22, 2008

    “All of this was torn down by the conservatives in our government.”

    Dude, don’t be a partisan hack. The GLBA was passed like 90-9 in the Senate, and 360 to 60 in the House, and signed into law by Bill Clinton.

  11. #11 Lord
    September 22, 2008

    It’s how our kleptocracy works. Before we have more revisionist history Glass-Stegall repeal didn’t really affect much because the investment banks were too profitable to be bothered to join commercial banks and commercial banks were never very successful at investment banking. Frannie amounted to less than 15% of the market in these, largely buying them from the same investment banks selling to everyone else. Bush vetoed Frannie legislation maintaining low regulatory policy. Greenspan ignored warnings of weak lending to let the market take care of things. The increase in leverage allowed them by the SEC in 2004 greatly magnified the problem. Finally, it’s only stupid for the suckers that get left holding the bag, like us. The smart ones cleaned up.

  12. #12 Albion Tourgee
    September 23, 2008

    The deregulation was under Clinton, with a Republican congress. So this was not a one-party system, but under Bush with the relaxation of regulation by the SEC, it’s gotten out of hand. Now they are proposing that Treas. Sec. Paulson, who actually still owns several hundred million dollars in Goldman Sachs stock, get a “clean” appropriation of $700 billion to do with as he sees fit, because, clearly, Sec. Paulson is a trustworthy man — except, he led one of the biggest Wall Street firms in setting up this whole disaster. Our Congress is about to make the largest single appropriation of money in human history, based on a plan that took about 2 days to develop and that was set out in a 3-page memo. This will be known one day as the Panic of 2008, and it’s likely to cause the USA real fiscal ruin.

    BTW, while part of the problem was insurance of loans, actually, there are about $60 trillion in credit default swaps (i.e., insurance of debt instruments) while the total amount of debt instruments in the world totals something less than $15 trillion. This means, you didn’t have to actually own the debt to buy insurance against it failing. In other words, a big casino, with bystanders betting on the guy rolling the dice. Except, in this casino, you had to be really rich or really dishonest or both to play, and the taxpayers are going to bail out the guys who lost at the table. If you were thinking universal health care, or even, current levels of public funding, well, hmm, we’re about to have $700 billion less to pay for that!

  13. #13 derek
    September 23, 2008

    To the people saying “Bill Clinton proves it wasn’t conservatives!”: all you’re proving is that Bill Clinton was too conservative. If you’re more conservative than him, you bear a big part of the blame for this mess, so I don’t expect you to be able to see the implications of what you’re saying. That goes double if you’re so conservative that the Senate that you now want to blame for passing conservative laws was nevertheless too leftist for you all these years.

    Everybody who has played a part in driving the political landscape so far to the right that a *Clinton* of all people should be held up as the epitome of a wild-eyed lefty should think hard about that, but won’t.

  14. #14 Max
    September 23, 2008

    John A., you have a .edu account at NYT. Presumably things are different for regular people.

  15. #15 jon
    September 23, 2008

    John A. seemed to be somewhat needlessly insulting about it, but I recall the same thing.

    And I just opened NYTimes in another browser where I was logged out and managed to pull up a story from 1989 on the Keating scandal (I needed something I was sure was old enough, and given the context that came to mind first). It loaded just fine.

    Mark, it’s worth checking if that restriction is gone.

  16. #16 Scott
    September 23, 2008

    I am also not an economist, and I could very well have this wrong, but the picture isn’t entirely one of pure greed and bad decisions. My understanding is that the leveraged investments had a larger ripple effect. When the leveraged investments in mortgage bonds went south, the companies (or the insurance companies) involved had to cover their wager. How? By selling large chunks of their other investments. When large chunks of one investment hit the market, the price on that security suddenly drops. Companies that didn’t even hold the mortgage bonds suddenly find their (possibly leveraged) assets depreciating. Then they have to dump other securities to cover their losses, and the whole thing starts to spiral downhill. My understanding is that the mortgage bonds were only a small fraction of the total pie, but because they were concentrated in a few firms, it didn’t take much a push to get the dominoes falling.

  17. #17 Capitalist
    September 23, 2008

    You are just bitter and envious because liberals like you don’t have the balls to make that kind of money.

  18. #18 Dunc
    September 23, 2008

    Was it really stupidity? From a personal perspective, more-or-less everyone involved acted in an economically rational fashion – they all made out like bandits. Sure, their companies are screwed, but the vast majority of the people are up on the deal. If you can make a boatload of cash and force some other sucker to carry the can, I’m not sure I’d call that stupid

    I think we’ve crossed that event horizon where sufficiently advanced stupidity becomes indistinguishable from malevolence.

  19. #19 RBH
    September 23, 2008

    John Fouhy has it right when he wrote

    1. They gave their risk models extremely optimistic assumptions.
    2. They lied: they took complicated multilayer super-tranched crazy bonds and entered them into their models as simple bonds with a set interest rate (the complex bonds had been rated AAA, so it was practically the same thing anyway, right?).

    “Mark to model” translates as “make it up.”

    Capitalist wrote

    You are just bitter and envious because liberals like you don’t have the balls to make that kind of money.

    What an insightful contribution to the discussion. [/sarcasm]

    The verb “to make” connotes that something of value is produced. That’s a pretty debatable proposition in this area. And I write that as one who has traded financial derivatives professionally for nearly 20 years, currently for a large New York based hedge fund.

  20. #20 RBH
    September 23, 2008

    Dunc wrote

    Was it really stupidity? From a personal perspective, more-or-less everyone involved acted in an economically rational fashion – they all made out like bandits. Sure, their companies are screwed, but the vast majority of the people are up on the deal. If you can make a boatload of cash and force some other sucker to carry the can, I’m not sure I’d call that stupid…

    Sure it was rational on the part of the traders, but it was irrational on the part of their employers. Combine individual compensation (bonuses) based on short-term unrealized trading profits, where the trader takes on long-term risk (e.g., CDOs) for the firm, and you have a recipe for rationality on part of the trader incurring disastrous risk for the firm due to the firm’s irrational compensation scheme.

  21. #21 Mark C. Chu-Carroll
    September 23, 2008

    Re: #17

    I think that there’s a mixture of stupidity and malevolence.

    There’s a level on which a lot of the actions people took made sense: they were acting in a way which made themselves huge amounts of money.

    But at the same time, they *knew* that the bottom was going to fall out – but they still had astonishing quantities of their own money invested in this rubbish.

    They simultaneously did the dishonest work of putting together garbage and lying to make it look like good quality investments, and *bought* those same investments as if they were really good quality. That’s stupid.

  22. #22 Mark C. Chu-Carroll
    September 23, 2008

    Re: #16

    Yes, I’m a liberal, and I’m proud of that. But I’m not jealous of the slime who perpetrated this monstrosity.

    I realize that this might be hard for a greedy asshole to understand, but there are things in life other than money. Money is a means, not an end.

    One of my best friends in college went straight to work after getting his BA, for one of the big investment firms in NYC. He got *very* rich. He also became a miserable alcoholic. Last I heard from him (about five years ago), he was in the process of getting his second bitter divorce, was still drinking, and was frankly a thoroughly miserable SOB. But he’s got a huge beautiful condo with a view of central park, and more money than he knows what to do with.

    I went and got my PhD. I spent 11 years at IBM research, and now I’m at Google. I have a job that I love to do. I look forward to going to work in the morning. I own a beautiful house. I make enough money that I don’t need to worry about it; I can pay for my home, my entertainment, my kids education, and have enough left over to save a nice safety cushion.

    What do I really have to be jealous of? If I made more money, what would I change? I don’t want a bigger house. I don’t want a fancier car. There’s nothing *important* that I could do if I had tons more money. There are fun things I could do, but nothing important, and I’d need to give up fun things in my life to be able to afford them.

    I honestly don’t understand *why* people go to such great lengths to accumulate money that they’ll never be able to spend; why they’re willing to sacrifice so much just to be able to be able to say that they have more money.

  23. #23 Jim C
    September 23, 2008

    There is fault and greed at all levels. Are the greedy CEOs at fault? Yes the they are, but so are the greedy individuals who foolishly bought homes with loans they could not afford. At one time American used to take responsibility for their actions. Today we have leaders who argue that the definition of “is” is and who do see anything wrong with getting interest free mortgages on condos in the Caribbean. Is is any surprise that people over extend themselves to obtain cars and homes they could other wise never afford? After all society sees them as victims not as the cause.

  24. #24 jackd
    September 23, 2008

    I’ve been wondering how much of this was driven by the financial firms’ drive to match one another’s earnings. If Firm A makes gigabucks off a risky strategy, then their competitors on Wall Street are going to jump on the same strategy until someone starts losing money. In this case, it looks like they all started losing at once.

  25. #25 Omer Moussaffi
    September 23, 2008

    Good post. Just one little thig: there’s a pattern at work here, which goes back to the earliest days of banking.

    Basically, money is a value, not a commodity.
    But, money is symbolized by a certain commodity (property, metal coins, papers, computer bits, etc).
    You can then trade in that symbol, effectively making money into a commodity which can be bought with money.
    This is the basic vicious cycle of economics, and this is, of course, a par excellence paradox generator.
    This, in itself is a good thing. True, it makes economic theory self contradictory, and it makes many people into economics conspiracy-theorists (just search “money” on youtube and you’ll see what I mean). But it also makes economic growth possible.

    So, every dozen years or so, there comes a new financial genius, inventing a new financial machine (banking, bond issues, stock markets, trenching, shorts, sub prime bonds, etc.).
    On phase 1 he makes a gazzilion. The new machine generates enormous wealth. It is new, hence unfamiliar, and very attractive. It always facilitates some aspect of the circular nature of finance: money multiplying itself by buying other money.
    On phase 2, as more and more investors flock to the new irresistible device like flies to fire, it generates a bubble.
    On phase 3, the bubble bursts. And it must burst – because it is new and no one knows how to regulate it.
    When the bubble explodes, many investors are badly hurt. But some always some who retain their new acquired wealth (remember: economics is NOT A ZERO SUM GAME). This new financial device enabled some economic activity which was impossible without it (like financing a war), and some of that activity persists after the fall.

    Now comes the crucial phase 4: enter the regulatory authorities. The new financial miracle was too good to be busted. But, unregulated, it creates disasters. The solution is to regulate it, and embed it in the ever-expanding-list of “sound” financial institutions.

    Now it is the crucial phase 4 which is the real issue at stake. Phase 4, throughout most of history, was only reached only after dozens of boom-crash cycles of phases 1-3. Seems to me as if the current US administration is trying to avoid phase 4.

    So, bottom line:
    What you describe as stupidity is really an issue of lacking regulatory structures. The system of loan bonds isn’t necessarily evil. It is just new. If the current US government doesn’t regulate things, and just spends 700$ billion on cushioning the system, nothing has been achieved and the whole story will happen again in ten years or so. What needs be done is to build new regulatory
    infrastructure. That would save us from the next crisis.

    Until some new financial genius arrives…

  26. #26 toujoursdan
    September 23, 2008

    Just to make sure things are crystal clear, while Clinton did sign this into law, it was a veto proof bill. Whether he would have signed it anyway is hard to tell:

    http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

  27. #27 Scott M.
    September 23, 2008

    Mark,

    I haven’t taken the time to read the comments but I want to point out something I heard on NPR that is applicable at least related to the insurance part of these loans.

    AIG knew insurance at least as an independent events model. That is, they insure your house against fire and it works because a fire at your house doesn’t raise the risk of a fire at your neighbors house.

    Unfortunately they tried to apply this type of reasoning to the bundled mortagages and as you pointed out, they were all loaning to each other. So the independent events model no longer applies.

  28. #28 Uncle Al
    September 23, 2008

    Privatized profit and socialized debt, nationalization by bankruptcy, is camouflage. The boojum is far more sinister,

    http://blogs.wsj.com/economics/2008/09/20/treasurys-financial-bailout-proposal-to-congress/

    “Decisions by the Secretary [of the Treasury] pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”

    Awarding the Secretary of the Treasury unlimited power and financial carte blanche unchecked by the Oval Office, Congress, or the courts is insanity. The first $trillion disappeared will solve nothing. We face three loathsome but unavoidable choices:

    1) Do nothing. Just desserts. The guilty on all sides will be punished. The economy will recover after destruction of the nouveau riche.

    2) Dump a $trillion into private unpayable mortgages and reschedule payments for the rest of those bastards’ lives. If they cannot/will not pay they get ejected. Let the criminal aspects of the banking system die a deserved death.

    3) Dump a $trillion into bankers’ pockets while mortgaged homeowners die. That will do nothing. Dump $6+ trillion in total. All US savings, pensions, and investments will then inflate to ~10% of their current buying power while friends of Bush the Lesser own the whole planet.

    Choose wisely.

  29. #29 Sili
    September 23, 2008

    Labels are funny things. I cannot fathom how people who play fast and loose with thousands of millions of dollars, can in any way be considered conservative.

    Sad.

  30. #30 EastwoodDC
    September 23, 2008

    You are just b̶i̶t̶t̶e̶r̶ sad and e̶n̶v̶i̶o̶u̶s̶ ashamed because l̶i̶b̶e̶r̶a̶l̶s̶ ̶l̶i̶k̶e̶ ̶y̶o̶u̶ stupid evil people d̶o̶n̶’̶t̶ have the b̶a̶l̶l̶s̶ gaul to m̶a̶k̶e̶ steal that kind of money.

    Fixed!

  31. #31 ruidh
    September 23, 2008

    I want to add some probability comments on the insurance aspect.

    Insurance works when the risks are probabilistically independent events. Life insurance risks are, generally, independant events. You can reduce risk (measured by the variance in expected results) by pooling independent risks. Everyone pays the expected cost plus a margin and there’s enough to go around to pay the claims that do occure. But no life insurance company in the world could survive all of it’s policyholders dying at the same time.

    The problem with the insurance scheme was that the risks *weren’t* independent risks. Market risks are notoriously difficult to diversify because they are correlated. Get enough correlation and the statistics that insurance relies upon to work fail. Certain risks can not be reduced by pooling.

    So, it wasn’t a problem that the insurers could pay out on all of their capacity. Their problem was that their risks were too correlated. That is a very difficult situation to model. It depends on being able to predict the correlation in events where we don’t even have a good estimate of the true probability. I’m not at all surprised that the risk management models failed.

  32. #32 CyberLizard
    September 23, 2008

    Very nice summary. The devil is in the details, of course, and no summary can possibly contain all the nuances and grey areas, but it definitely helped me to understand all this trading of debt crap that’s been going on (no economist, me). I approached it from a more philosophical standpoint based on my own observations, but ended up at a similar conclusion.

    I understand the need to exchange currency for goods. I’m not anti-money, or anti-capitalism. But it seems to me that there is a fundamental problem that the free-marketeers are overlooking: humans are selfish, maybe even greedy. We’ve evolved that way. Survival of the fittest. May the best man win. It’s what kept us alive when survival was a tooth-and-nails experience. However we, as thinking, rational people, manage to balance this innate desire with some common sense and compassion.

    So, my point, after all this rambling, is that we need to provide safeguards against the known proclivities of people and part of that, I believe, is reasonable regulation of the financial markets. That way, even if those people who are so far removed from our reality that they fail to or cannot fathom why them making money at the risk or expense of others is wrong, they might still avoid doing it for a greedy and selfish reason: to avoid going to prison.

  33. #33 Paul Murray
    September 23, 2008

    The stupidity-underneath-all-the-other-stupidity is the notion that everyone, but *everyone*, should own a home, and that society and its economic structures should make that possible.

    Houses are an *expense*. They do not generate wealth. A society that spends 40 years carpeting the landscape with freestanding (not to mention energy-inefficient) houses dooms itself to poverty, no matter how the process of that doom plays out.

  34. #34 Matt McKnight
    September 23, 2008

    The problem was caused by poor regulation, not deregulation. The government encouraged loans over 80% LTV, see all the stories on Andrew Cuomo’s reign at HUD and the encouragement of FNMA and FHLMC to take on these risky loans. Greenspan keeping the prime rate so low for so long caused some of this too.

    A funny thing about these loans was that many were structured as 80/10/10 or 80/15/5 to avoid PMI. I don’t even understand how anyone could get a 100% loan- it seemed stupid at the time, it seems insane now. The bad part about over 80% LTV loans is that they are very sensitive to price drops. The collateral is worth less than the loan. The value of any derivatives based on that loan just became a lot less valuable- even if the payments are made on time.

    The housing bubble popping is the root cause of this. Greedy people buying overpriced houses until the biggest sucker was found. Greedy people refinancing their homes to take out lots of cash reduced their equity stake. As prices rose, people needed higher risk loans, higher LTV ratios to get what they thought they deserved. Small time investors bought everything hoping to flip. As prices drop, the value of those loans drops too.

    As far as the over-leveraged investment banks- bad move on their part. Reread “Black Swan” guys. Start over as commercial banks with a 12x maximum leverage or let them burn. Nothing is too big to fail now.

  35. #35 Matt McKnight
    September 23, 2008

    And I forgot the 1997 tax law change that let people keep tons of money from the home sales. It appears to have a nice correlation with the bubble.

    http://cafehayek.typepad.com/hayek/2008/09/some-bubble.html

  36. #36 Kenneth Parker
    September 23, 2008

    Wonderful article! It seems that it takes a mathematician to explain politics!

    You’re now on at least one Political BLOG now.

    Best regards,

    Ken Parker in Seattle, Washington

  37. #37 Dunc
    September 24, 2008

    Sure it was rational on the part of the traders, but it was irrational on the part of their employers.

    Except that the employers (as individuals) also made out like bandits. None of the decision-making individuals at any level have come out of this badly – sure, they’re no longer as astronomically rich as they thought they were on paper, but they’re still a hell of a lot richer than you or me.

    Instititions have lost, and lost big. But that loss hasn’t really been felt by any of the individuals in decision-making positions in those institutions. Everyone seems to assume that the CEO of MegaInvestementCorp is more concerned with the long-term fortunes of MegaInvestementCorp than with his own personal fortune. He’s not. If he can make himself richer by burning his company to the ground, that’s exactly what he’ll do. The rich are not motivated like normal people – otherwise they wouldn’t be rich.

    Combine individual compensation (bonuses) based on short-term unrealized trading profits, where the trader takes on long-term risk (e.g., CDOs) for the firm, and you have a recipe for rationality on part of the trader incurring disastrous risk for the firm due to the firm’s irrational compensation scheme.

    Exactly. And how did the compensation scheme get that way? The senior decision-makers decided to enrich themselves.

    Are we all familiar with the following quotation?

    “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury.”

    It doesn’t just apply to government, or democracy.

  38. #38 Valhar2000
    September 24, 2008

    #36:

    You quote:

    “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury.”

    A very witty remark, and sensible too… but has this every actually happened? The USA is the oldest democratic nation around, pretty much, and it has not yet come to that (though it seems to be closing in, indeed).

  39. #39 Dunc
    September 24, 2008

    The USA is the oldest democratic nation around, pretty much

    Say what? It’s not even close to being the oldest democratic nation still around, by any definition of either “democracy” or “nation”. Anglo-Saxon England was (in many important senses) democratic a full thousand years before the USA was founded. Democracies have come and gone, for a variety of reasons, ever since the term was first used in Athens in 508 BCE. (And there were many prior civilisations that we would probably regard as more-or-less democratic earlier than that.)

    Where on Earth did you learn your history? No, don’t tell me, it’s obvious…

  40. #40 Inquisitive Raven
    September 24, 2008

    Dunc, perhaps more to the point. Iceland.

  41. #41 Brian
    September 24, 2008

    Thank you for this!

  42. #42 cereal
    September 24, 2008

    This whole mess is only “stupid” if you completely ignore the reasoning and perspective of the people who created it and benefitted from it (and who will also benefit from the idiotic bailout their henchmen in DC are now cooking up).

    See, as “capitalist” above points out, these people had the “balls” to make a crapload of money off this nonsense. And short-term, massive profit, especially when any downside is long off and almost certainly will be mainly borne by someone else, is a “reasonable” motive.

    The people at the i-banks and mortgage companies and so on who ginned all this up have socked away millions and millions and millions of dollars each. Why should they care what happens to storied old investment firms, rubes in small towns, anguished families losing their homes, saps working 9 to 5 jobs for pittances, and so on?

    They don’t. Not a bit. They got theirs, and what’s the worst that will happen to them now? Even if the US slides into a depression, they will do fine, either in the US or wherever else they want to go and lord it over the shivering masses. They will always be able to afford whatever they want, no matter how bad things get for everyone else, and there will always be somebody willing to make stuff for them, slave away on their estates, and so on.

    This is one of the basic reasons that capitalism DOES NOT make things better for everyone as free-market fanatics always claim – instead, it encourages short-term, highly destructive rapacious greed. Get yours fast, get out, and who cares who gets screwed later?

    That’s called “rational economic thinking, folks. It’s not “stupid,” It’s AMORAL.

  43. #43 Sven
    September 24, 2008

    Great post. I have to take issue with a core conclusion :

    #5 There aren’t enough good mortgages to put together the number of bonds that people wanted to buy

    The “bad mortgages” were a feature, not a bug. Subprimes were exceptionally profitable. And people could repay them…as long as housing prices kept going up.

    Wall Street was purposefully setting underqualified buyers up with “bad” mortgages so it could suck the equity out of the property. The buyer was merely a means to that end; their creditworthiness was irrelevant to the transaction.

  44. #44 James
    September 24, 2008

    The mortgage meltdown came about because of lending industry deregulation, led by Republicans with a lot of Democratic help. Before 1995, profitable and performing loans were the same. Deregulation of the industry led to fragmentation of the industry which then incentivized all of the people in the mortgage origination-to-sale chain to create profitable as opposed to performing loans (loans that people pay every month). In 1995 the Republicans in control of Congress changed the RESPA anti-kickback rules as they applied to mortgage brokers and allowed lenders to pay brokers what is called a yield spread premium or a par plus payment. In a nutshell, this is a payment made by the lender to the broker if the broker originates a loan that is a higher than par rate. For example if a broker has an “A” rated borrower based on his loan application, and now his FICA/Fair Isaac score, that qualifies for the lender’s 6% loan, the lender will pay the broker a premium if the broker can lock and close that “A” borrower into an 8% loan. That 8% loan has more value to the lender because an “A” borrower, who is less likely to default, is paying an interest rate that a “B” borrower would pay – who is more at risk of default. I and several other consumer lawyers around the country argued that this payment was a kickback for the referral of business made illegal under RESPA because the broker does no more work to close the loan at 6% than he does at 8%. The broker is being paid by the lender for the higher than par rate loan. The mortgage industry got Congress to eliminate this anti-kickback rule so that we had to prove the overall compensation was unreasonable – an impossible task because most states allowed lenders to charge up to 10% of the loan amount for his commission. Countrywide saw this as a means to eliminate offices, and the overhead and management issues of having a Countrywide office in every city. Countrywide created a nationwide network of brokers who they would pay yield spread payments for originating loans. Before 1999, Countrywide would get short term money to fund the loans, which had to be “qualifying loans” then turn around and sell them to fannie mae or freddie mac. The broker would qualify the borrower by giving him an adjustable loan with a 1 year discounted teaser rate and qualify the borrower at the lower monthly payment. So, for a simplified example, an “A” borrower goes to a mortgage broker and says “I need a $100,000.00 loan”. Since he is an “A” borrower he qualifies for 6%, but the broker would search for the lender who would pay him the highest yield spread, usually Countrywide and tell the borrower all he can get is a 8% loan. At closing Countrywide would draw $100,000.00 on its short term line of credit, and fund the loan paying the broker the yield spread. Countrywide would sell these qualifying loans in the secondary market. The loan was “teased” down to 4% for the 1st year, and the borrower qualified under that lower rate. He could not qualify under the higher rate, but the broker would tell him “Do not worry about the increase, just come back when the loan increases and I will refi you.”

    Allowing interstate banking, then Gramm-Leach-Bliley bill that eliminated the wall between investment banks, deposit banks, and insurance companies, with a boost from the parity statute created a non-qualifying pool of money to lend and so allowed Countrywide to take this pool of loans, all mixed in of “A” “B” “C” and “D” grade borrowers and go to someone like Merrill Lynch and say “I have 1,000 loans average $100,000.00 each with an average 10% yield over 30 years with a present value of $125,000.00. I will sell you the loans for $115,000.00.” Countrywide would then pay back its credit line and just made $15,000.00 per loan less its yield spread less its costs of money for 1,000 loans, or lets say $10,000.00 per loan which is $10 million. Meanwhile Countrywide kept the servicing rights for these loans which also generated another income stream for Countrywide. Merrill Lynch who before deregulation was prohibited from entering the mortgage business but now was an unregulated lender has an income stream from Countrywide as the servicing agent, then securitizes and sells the pool of loans to Bank of America (who after buying Countrywide and Merrill Lynch has a vertical monopoly in the mortgage business from Countrywide’s network of brokers, to BOA’s ability to short term fund the broker’s loans, to Countrywide’s mortgage servicing business to Merrill Lynch who would securitize the pool, to BOA who acts as Trustee for the securitized loans), as a non-regulated security ie they in essence sold shares of stock in the pool of mortgages. The rating of these pools of loans was essentially privatized, which meant that a company like Moody’s was given the rating task – a job that they never had before. Moody’s had no idea how to rate a pool of loans which had a mix of “A” through “D” loans, all with greater degrees of risk of default because these borrowers were now paying slightly higher interest rates than they would be expected to pay, and probably not pay whent the rates changed. What happened in essence was that Moody’s saw that say 10% of the pool of loans were “A” borrowers and so rated the pool as AAA which was its highest degree of safety. So the pool of in essence junk loans was sold as AAA rated securities to entities like Bank of America, as Trustee for “ABC” asset backed securities. (As I understand it they later divided these pools into tranches or 3 different degrees of safety and sold them accordingly) As you can see no one had an incentive to make sure the loan originator closed a performing loan – a loan that the borrower would pay back. The Broker and Countrywide as originator, and Merrill Lynch and Bank of American only had an incentive to close profitable loans – loans they could sell. They could care less if the loans were performing loans. Everything was “sellable” as long as the pool was sold before too many of the loans started to default. There were no underwriting rules because these “lender’s” were unregulated so you started to see non-income qualifying loans i.e. stated income. Many people gave the correct income info to the broker, who then submitted an application to the lender with false income information. These loans were justified because of the values of the properties. The brokers would get friendly appraisers to give a high-ball appraisal then submit the loan package. The appraiser would either give the higher appraisal or he would lose that broker’s business. This was the first wave of foreclosures that are going through the courts. These sub-prime loans defaulted because they were based on false income and false appraisals, 1 year discounted teaser rates, and all the borrowers were paying higher interest than they should have paid.

    The next wave we will see is when deregulation compounded the problem by allowing the 4 option mortgage. This mortgage allows a borrower to elect to pay on 1 of 4 options each month: 1) ½ of the interest that was due on the loan with the remaining ½ put on the back end of the loan. At the end of a fixed period, usually 3 or 5 years the borrower would have to amortize the full mortgage principal plus back end interest at whatever the rate was; 2) interest only; 3) amortize over 30 years; 4) amortize over 15 years. The Countrywide broker now could qualify a borrower if his income allowed him to pay ½ of the interest. This opened up a whole new category of borrower who could not otherwise qualify for a 30 year amortized loan. The broker would sell this 4 option mortgage to the consumer by telling him “just come back in 3 years or 5 years when the loan adjusts and we will refinance you because the house will go up in value” The broker used the same appraiser to over-appraise the value. Here is an example of how that loan works. A $100,000 10% mortgage would require $10,000 per year interest or about $850.00 per month. The broker would qualify the borrower at $425.00 per month which is ½ of the interest. After 3 years, the $100,000 principal is now $115,300.00 and costs about $1,000.00 per month to fully amortize over 30 years. The borrower’s payment more than doubles. These are the loans that we are starting to see come through the foreclosure division in my county now and we will see this wave for a few years.

    You have to remember, too, these are amateur borrowers who have maybe 1 or 2 mortgages in their lifetime, relying on professional lenders who are closing 1 or 2 mortgages a week. The borrower usually relies on the lending professional to give good advice because the borrower thinks the broker is working for the borrower when he is not.

    The Broker is working to maximize his yield spread payment. The incentive for the broker is to close as many loans as he can to maximize his profit. He has no stake in making sure the loan performs as long as he gets paid. If he worked for a bank that kept the loan and he closed too many loans that defaulted he would be fired. Countrywide had an incentive to pay brokers large yield spread premiums and turn around and sell the loans as fast as possible. They did not care if the loan performed, so they closed an eye to the bad underwriting that went on and in fact encouraged its employees to qualify everyone – who cares at Countrywide as long as the loan is sold before it defaults. Merrill Lynch does not care if the loan performs as long as the pool is AAA rated and can be sold. This is why we are where we are. The problem has a simple cure. Regulate the mortgage brokers prohibit yield spread payments, un-fragmentize the industry and enforce proper underwriting guidelines with oversight that has a bite.

  45. #45 Rick B
    September 24, 2008

    Mark

    Great summary. I’ve been blogging about a lot of it for over a year, but I had not realized how the default insurance worked as part of the scam.

    As a Texan who voted against the Austro-Libertarian Phil Gramm in every election he ever ran in and whose brother-in-law worked for Enron, I have seen the disaster of unregulated financial institutions up close. (Also, Texas deregulated the utility companies, so we have gone from some of the lowest and most reliable electricity and gas rates in the nation to the generally the highest priced and most unreliable in about five years.) This disaster was brought to us by the Reagan Revolution and the conservative movement, with key players being Grover Norquist, Alan Greenspan, Phil Gramm, Bush 43 and a cast of thousands.

    I still can’t accept that Bear Stearnes and Lehman Brothers were leveraged at 33 to 1 in order to invest in garbage like this.

  46. #46 salient
    September 24, 2008

    “All of this was torn down by the conservatives in our government.”

    Dude, don’t be a partisan hack. The GLBA was passed like 90-9 in the Senate, and 360 to 60 in the House, and signed into law by Bill Clinton.

    Just to clarify, by any reasonable world standard, Bill Clinton was fairly conservative, and most American politicians are incredibly conservative by any metric that’s universal enough to span beyond the range of American discourse.

  47. #47 ohmytyisis
    September 24, 2008

    SVEN: @#42

    “Wall Street was purposefully setting underqualified buyers up with “bad” mortgages so it could suck the equity out of the property. The buyer was merely a means to that end; their creditworthiness was irrelevant to the transaction.”

    BEAUTIFULLY SAID!!

  48. #48 James
    September 24, 2008

    #42 and #45 The equity in the home was of no moment, especially in the last few years. Not that brokers did not squeeze every last drop out because they did, but that was just extra. No one past the originator even examined the loan to value ratio, and I have seen plenty of 100% and some 120% loan to value ratios. Once the loan was funded and put in a pool no one could examine every underwriting package in a portfolio of 10,000 loans. At best they would survey 1 or 2 % of the loans in the portfolios and try to extrapolate. And, as I said earlier, Countywide could care less about the risk or the loan to value ratio as long as Countrywide could sell the pool.

  49. #49 Anonymous
    September 24, 2008

    I refinanced my house about three years ago. The mortgage broker pushed me real hard to sign on to an ARM. When I asked her what the mortgage rate was, she said “That’s the old way of looking at mortgages.” I ended up going with a 15 year, 5.25% loan. At first the broker wouldn’t let do me that – “I don’t feel I can ethically let you go that route, given that the ARM is clearly the better option for you,” she said.

    The problem is, most people trust their broker in the same way they trust their dentist, or their car mechanic. These loans were oversold, and pushed on people who didn’t know any better. Sure, some borrowers took advantage. But I lay this mess at the feet of the banking industry.

  50. #50 someone
    September 24, 2008

    Sure, democrats bear some responsibility but, co-me-on, my republican friends, what party supports free market all the way? Who thinks government is the problem? Who labels “socialism” any attempt to regulate the market?

    I’d respect Republicans more if they would stick to their word and have the balls to say “Shit, we screwed up. So sorry Wall Street, but you’re on your own.”

    Worse still: you will show outrage for the bailout, will get just enough repubs to vote for it, and later, to top it off, will blame the democrats for agreeing to it…

  51. #51 Sven
    September 25, 2008

    The equity in the home was of no moment, especially in the last few years. Not that brokers did not squeeze every last drop out because they did, but that was just extra.

    I worded that poorly. The equity that subprime borrowers would have built was absorbed by usurious interest rates.

    Before the mid-1990s, mortgage-backed securities consisted mostly of loans to borrowers with good credit and cash to make ample down payments. Then investment banks found they could do the same with riskier loans to borrowers with modest incomes and flawed credits. Pooling the loans created a cushion against defaults by diversifying the risk [or so they thought – ed.]. The high interest rates on the loans made for bonds with high yields that investors savored.

    Mmmm. Savory yields. Blarrrccchh.

  52. #52 Sven
    September 25, 2008

    Again with the link

  53. #53 Anonymous
    September 25, 2008

    Incidentally – don’t assume that they did not know what they were doing – after all – they’re Ivy League – Harvard etc. – they must have known exactly what they were doing – otherwise what is an Ivy League degree – a Harvard MBA – worth ?

  54. #54 Gabrellen Pfarr
    September 25, 2008

    I hope you will be patient enough to hear me out even though it reflects a Biblical point of view. First of all, the truth of the Bible reveals that we are all born into a corrupt nature and those who condemn the stupid and greedy must remember that. Those who escaped these particular actions did so because somewhere along the line they acquired some wisdom and self control which was from God (since God is the source of all wisdom and good and it filters down to man) so they should not exalt themselves! Second of all, I’m sure you’re aware that the ‘science’ of economics is not a science in the sense that it is based on things or principles created by God which are universal and constant as to be obervable, repeatable and reliable. I’m sure you also are aware that Adam Smith’s Wealth of the Nations was beset with contradictions from the beginning, the largest error being the irreconcilable juxtaposition of the labor theory of value and the cost-of-production theory…Adam Smith was aware of the contradiction but wouldn’t make up his mind which to adopt. The ‘science of economics’ comes down to values IMPUTED by acting men resulting in the ACT OF IMPUTATION being the foundation of the SUBJECTIVE THEORY OF VALUE. So what we really have now is man using ‘science’ to justify his stupidity and greed! I like this illustration. Let’s consider an expample we’ll call the BIBLE-PORNOGRAPHY PARADOX. The Bible is the very word of God and infinitely precious to mankind. Yet, in a perverse culture, it is wuite likely that a capitalist could carn far more income by selling pornographic literature than by selling Bibles. The market only informs us about comparative prices of specifics. Furthermore, the culture may be made up of rebellious people who are determined to work out of their own damnations without fear or trembling. They impute value to pornographic books, and little or no value to Bibles. The market will reflect this phinomenon in an objective manner. It will reflect it in the profit-and-loss statement of the publishers. Those who meet market demand will prosper while those who do not meet it will falter or go bankrupt. The profits and losses will be a result of the subjective valuations of acting men, who make decisions in terms of their values. Christian literature must be subsidized while pornography produces income. The humanistic, reltivistic econimist looks at these facts and can conclude that in a specific market, pornography is more valuable at the margin than Gibles are. He says that he is making no ETHICAL value judgment when he says this; he is only reporting the objective results of multiple subjective valuations on the market. But since he allows no concept of objective value to enter his economic analysis–not consciously, at least–he is unable to take a stand agains the market except by means of stating his PERSONAL OPINION that Gigles are better than pornographic magazines. However, the market supposedly must be left alone to have its wy, since one man’s opinion must not be allowed to thwart the operations of the market process. His relativism leads to an objiective result; the spread of pornography through the price competition, therby lowering the consts of achieving damnation and cultural disintegration. This backs up another Biblical truth…God is not mocked! Something to think about.

  55. #55 EB
    September 25, 2008

    I think the well known proverb “Only invest if you understand the investment” applies. We had regulation but Congress is bought off. What the f’ck does the banking and finance committees do (or the FED)? The moral is…even regulators can be corrupted so only invest in what you understand starting with educating oneself on how to read an interpret the Balance Sheet, Income Statement, and Cash Flow Statement (See Einhorn’s analysis of Lehman many moons ago). If you don’t even understand these things you really shouldn’t buy anything but US Treasury Bonds or an index fund of these.

  56. #56 Mark C. Chu-Carroll
    September 25, 2008

    Re: EJB (#53):

    I don’t think that that’s sufficient.

    As an investor, if I went to invest in something like mortgage bonds, I can’t get much information about the underlying mortgages. What I can get are the information providing to the ratings agencies, and the ratings reports.

    But the ratings agencies were in on the scam.

    So for an individual investor, even a very careful one, if you wanted to buy a bond – which traditionally a safer investment than stocks – you’d get the prospectus for the bond, which provides a description, analysis, and ratings. From all of the information available to you, it looks safe. But the people selling it to you were lying. They were giving you false information in the analysis and ratings.

    And we didn’t have regulation. Banks are regulated. Many of these investment firms weren’t. Between the conservative efforts to deregulate, and the fact that the regulations that were left pre-dated the invention of many of the investment vehicles that were involved in this mess, the vast majority of this mess was effectively free of regulation.

  57. #57 trrll
    September 25, 2008

    One of the big trends in American politics is deregulation. Right-winger’s in the government have been constantly harping on the idea that the free market is the perfect solution to any and all problems.

    The free market does work–at steady state. Unfortunately, it gets there kind of slowly on a human time scale, and often with big oscillations. What we are seeing now, that is the free market working–the free market has realized that a bunch of investments were overvalued, and it is now correcting (probably overcorrecting). Eventually, things will settle down and everything will be appropriately priced. Of course, that is small consolation if you were wiped out in the meantime due to the economic disruption of one of those oscillatory swings.

  58. #58 Jesse
    September 25, 2008

    Sir, you are very knowledgeable.

  59. #59 Martin James
    September 26, 2008

    A simple solution, but hard one for the shareholders

    http://www.nytimes.com/2008/09/23/business/worldbusiness/23krona.html?em=&pagewanted=print

    That brings to mind another point: Shareholder Power. Today company values shareholders more that the employees, so is the government going that way too. The shareholders for a government are its party fund contributors I guess, and employees are the taxpayers (a silly metaphor). Also this explains the stupid debate on the executive pay of these banks. Even when the banks are falling the board and top executives are making money on their retention and severence bonus. Hmm……

    Why cant we have an economy based on game theory???

  60. #60 Alison
    September 26, 2008

    My question is this: Between the very expensive war and now this “very sudden” (?) very expensive problem, CAN we recover as a nation? Are we following the footsteps of other nations such as England, Russia, and Rome?

  61. #61 Mark C. Chu-Carroll
    September 26, 2008

    Re #56:

    No, I’m not very knowledgable about this stuff.

    I don’t have any training in this, or any background, or any deep knowledge. I’m just good at research. I didn’t do anything that anyone else couldn’t have done: I went on a reading binge, finding every article about this situation that I could, and then putting together the information that I found.

    In this case, I’m not knowledgable; I’m just a good collator.

  62. #62 B. Simon
    September 28, 2008

    This all stems from the “Horay for me and Screw You” attitude that some people have, which is the attitude you take to make LOTS of money, and not feel guilty. I’m all for making money, but not at the expense of destroying other peoples lives or the United States of America.

  63. #63 Murray Rothbard
    September 29, 2008

    Seriously, it’s so easy to look at the symptoms and think that those are the causes. The root of the problem goes much deeper than what you mentioned and more government and regulations won’t solve it. Time to read up on Austrian economics.

    campaignforliberty.com

  64. #64 BetterLateThanNever
    September 29, 2008

    Someone has already seen this coming five years ago and his name is Ron Paul.
    http://www.lewrockwell.com/paul/paul128.html

  65. #65 CGomez
    October 9, 2008

    As the blogger said, it inevitably becomes political. However, besides just blaming conservatives, you also need to blame liberals for insisting that the tools of government are used to make these loans. In other words, there was an insistence on the parts of key Senators and Reps that Fannie Mae should keep buying up these subprime loans because it was such a good thing that people were buying homes they couldn’t afford.

    The record on it is crystal clear.

    The major problem, politically speaking, is that as usual both sides are pointing the finger at each other when there is plenty of failure and blame to go around. The supposedly competing interests of liberals and conservatives actually instead cooperated to form a massive unsustainable bubble. Each side was getting what they thought they wanted and their constituents were happy.

    Mainly, all it really proves is gridlock in the federal system in the US is a pretty protective mechanism. They can’t screw up what they can’t make law.

  66. #66 Paul Crowley
    October 10, 2008

    Even if the US slides into a depression, they will do fine, either in the US or wherever else they want to go and lord it over the shivering masses.

    No, that’s not it. I’m sure these people would much rather not see a depression – all those impoverished people breaking in and stealing their plasma TVs for a start. But there are enough of them that any one individual plays only a small part in creating the depression, and if they decide they don’t want to do that, they’ll be replaced by someone who does. So if they see that what they’re doing will cause a depression, they’re motivated to be even more rapacious, so that they have enough cash to sit the depression out.

  67. #67 Jonathan Vos Post
    October 11, 2008

    Condensation/excerption/modification/personalization of Wikipedia article (which has references) “List of recessions in the United States”:

    Panic of 1797 (1797-1800)
    Side-effect of deflation of the Bank of England from French Revolutionary Wars; disrupted commercial and real estate markets in the United States and Caribbean.

    Depression of 1807 (1807-1814) Jefferson’s Embargo Act of 1807 crushed shipping-related industries, empowered Federalists who fought the embargo and established smuggling in New England (a century later making the Kenndy family rich).

    Panic of 1819 (1819-1824) largest financial crisis in UA history to that point, featuring widespread foreclosures, bank failures, unemployment, and slumping agriculture plus manufacturing. End of the economic expansion after the War of 1812.

    Panic of 1837 (1837-1843) caused by bank failures and lack of confidence in the paper currency. Speculation markets were greatly affected when American banks stopped payment in specie (gold and silver coinage). Led to USA’s experimentation with the Plutonium Standard (Manhattan Project to GWOT) and Petroleum Standard.

    Panic of 1857 (1857-1860) Ohio Life Insurance and Trust Company crashed; popping European speculative bubble in United States railroads and caused a loss of confidence in American banks. Over 5,000 businesses failed within the first year of the Panic, and unemployment was accompanied by protest meetings in urban areas.

    Panic of 1873 (1873-1879) Europe’s troubles preciptated failure of the Jay Cooke & Company, largest bank in the United States, thus popping the post-Civil War speculative bubble. The Coinage Act of 1873 also contributed by immediately depressing the price of silver, which hurt North American mining interests. Cf. The Wizard of Oz as a tract about bimetallism (“Oz” = 1.00 ounces of element 79).

    Long Depression (1873-1896) Collapse of Vienna Stock Exchange instigated depression that spread, albet global industrial production greatly increased (in USA industrial output increased fourfold.)

    Panic of 1893 (1893-1896) United States Reading Railroad (cf. Monopoly game) and withdrawal of European investment lead to a stock market plus banking collapse also partly caused by run on gold supply.

    Panic of 1907 (1907-1908) Run on Knickerbocker Trust Company deposits on 22 October 1907 lead to severe monetary contraction.

    Post-World War I recession (1918-1921) Hyperinflation in Europe caused brief, yet very sharp recession, triggered by end of wartime production, as well as influx of labor from returning troops and subsequent high unemployment.

    Great Depression (1929-1939) Stock markets crashed worldwide (including the one where my father’s father had founded the Pasternak firm and owned a seat on the New York Stock Exchange), lead to banking collapse in USA, causing global downturn, including a second, more minor recession in the United States, the Recession of 1937.

    Recession of 1953 (1953-1954). World War II (which ended as the First Atomic War) led to World War II (Korea + Vietnam + Cold War). After a post-Korean War inflationary period, more funds were transferred into national security (Truman’s “National Security State”). Federal Reserve changed monetary policy to be more restrictive in 1952, over-reacting to fears of further inflation.

    Recession of 1957 (1957-1958) Monetary policy was tightened during the two years preceding 1957, followed by an easing of policy at the end of 1957. The budget balance resulted in a change in budget surplus of 0.8% of GDP in 1957 to a budget deficit of 0.6% of GDP in 1958, and then to 2.6% of GDP in 1959. Sputnik triggered river5s of federal funds flowing into Science qand Math education, greatly benefitting me personally, and leading to the USA winning the First Moon Race (and losing the 2nd Moon Race to China and India).

    1973 oil crisis (1973-1975) Quadrupling of oil prices by OPEC (the State Department did not believe what I demonstrated in a Political Military Exercise where I esxplicitly predicted OPEC) coupled with high government spending due to the Vietnam War (3rd phqase of WW III) leads to Jimmy Carter stagflation in USA (beta test for the George Bush stagflation and Baghdad Tragedies).

    Early 1980s recession (1980-1982) Iranian Revolution eliminated the Shah’s regime set up by the CIA, thus sharply increasing price of oil globally in 1979, a minor part of which was the 1979 U.S. energy crisis. Ayatollah and theocratic thugs exported oil at inconsistent intervals and lower volume, forcing prices up. Tight monetary policy in the United States to control inflation instead caused another recession. The changes were made in a misguided response to inflation left over from the previous decade due to the 1973 oil crisis and the 1979 energy crisis. Gulf War I = World War IV.

    Early 1990s recession (1990-1991) year Industrial production and manufacturing-trade sales decreased in early 1991. Bad time for me to fight at Rockwell International to prevent a 2nd shuttle disaster, exacerbated by plagiarists Turner and Jones whom I had to sue (along with Rockwell) in what became the longest running case in the largest judicial district in the world. Forced me to take huge pay cut and become a professor (and later another paycut to teach Math and sciences in high school).

    Early 2000s recession (2001-2003) Dot-com bust, plus September 11th attacks triggering World War V (GWOT), plus accounting scandals resulting from Reagan-Bush deregulation contributed to this relatively mild contraction in North American economy.

    Late 2000s George W. Bush recession (2008-Current) economic crisis was forecast by several important indicators of economic downturn worldwide, including high oil prices (which led to both high food prices due to a dependence of food production on oil production) and global inflation; substantial credit crisis leading to the bankruptcy of several large and well established investment banks; increased unemployment; and a global recession developed. Marks the end of the Reagan cycle of US politics, which had unravelled the previous New Deal, and de facto ended the American Empire.

  68. #68 ankhank
    October 15, 2009

    http://www.nytimes.com/2009/10/14/opinion/14trillin.html?em

    —- excerpt follows —-

    “Don’t get me wrong: the guys from the lower third of the class who went to Wall Street had a lot of nice qualities. Most of them were pleasant enough. They made a good impression. And now we realize that by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”

    “So what happened?”

    “I told you what happened. Smart guys started going to Wall Street.” …

    “But you still haven’t told me how that brought on the financial crisis.”

    “Did you ever hear the word ‘derivatives’?” he said. “Do you think our guys could have invented, say, credit default swaps? Give me a break! They couldn’t have done the math.”

    “Why do I get the feeling that there’s one more step in this scenario?” I said.

    “Because there is,” he said. “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that. All of that easy money had eaten away at their sense of enoughness.”

    “So having smart guys there almost caused Wall Street to collapse.”

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