The Folly of Experts (and the Wisdom of Crowds)

In a recent NY Times piece, noted imperial advisor Nicolas Kristof points out that the Emperor’s Advisers Have No Clothes:

The expert on experts is Philip Tetlock, a professor at the University of California, Berkeley. His 2005 book, “Expert Political Judgment,” is based on two decades of tracking some 82,000 predictions by 284 experts. The experts’ forecasts were tracked both on the subjects of their specialties and on subjects that they knew little about.

The result? The predictions of experts were, on average, only a tiny bit better than random guesses — the equivalent of a chimpanzee throwing darts at a board.

I salute Kristof for having the courage to declare that his profession (along with pretty much everyone else) has no clothes (or at least far fewer clothes than we think—perhaps a German speedo!) I have sometimes disagreed vehemently with Kristof over various issues, but I have to admire anyone who has the moral courage to turn the harsh light on his own profession, and even himself:

The marketplace of ideas for now doesn’t clear out bad pundits and bad ideas partly because there’s no accountability. We trumpet our successes and ignore failures — or else attempt to explain that the failure doesn’t count because the situation changed or that we were basically right but the timing was off.

For example, I boast about having warned in 2002 and 2003 that Iraq would be a violent mess after we invaded. But I tend to make excuses for my own incorrect forecast in early 2007 that the troop “surge” would fail.

As Kristof notes, the greatest problem is with extremely self-confident experts who are morally certain that they’re right:

Mr. Tetlock called experts such as these the “hedgehogs,” after a famous distinction by the late Sir Isaiah Berlin (my favorite philosopher) between hedgehogs and foxes. Hedgehogs tend to have a focused worldview, an ideological leaning, strong convictions; foxes are more cautious, more centrist, more likely to adjust their views, more pragmatic, more prone to self-doubt, more inclined to see complexity and nuance. And it turns out that while foxes don’t give great sound-bites, they are far more likely to get things right.

Perhaps the problem is that expertise grants enormous ability to describe details about the present state of things in a field or area. There’s no absolute logical requirement for that to translate into better prediction in that area, but we’re basically hard-wired to think that there is. Combine that with our hard-wired response to confidence and we’ll follow a knowledgeable hedgehog anywhere, even to Hell itself.

Contrast that with the ability of markets,in general, to outperform experts. The best example is the stock market, whose simple average generally outperforms 2/3 of managed mutual funds each year (an example from last year: http://www.winninginvesting.com/index_vs_managed_funds.htm and another: http://www.fool.com/investing/mutual-funds/2009/02/25/index-funds-are-hard-to-beat.aspx). Over time, the results are even more staggering, as very few mutual funds repeat winning performance from year to year. Experts simply cannot complete with the “wisdom” of the market as a whole.

An important thing to keep in mind, especially today as we’re urged to put more and more confidence in expert management of the financial sector by government regulators, expert allocation of money by government bureaucrats, and the most massive transfer of money from the private market-driven economy to government experts in recent history. It’s perhaps no coincidence that the government is relying upon the least-regulated part of the financial sector (which has been least affected by the recent woes) to bail out the most-regulated part:

Democrats like Barack Obama and Barney Frank, at least on the campaign trail or in sound bites, have portrayed the financial crisis as the product of deregulation. The solution, they say, is more regulation. In that vein Frank, one of the brainiest members of Congress, is proposing that the Federal Reserve become a regulator of systemic risk, with the power to regulate firms that because of their size or strategic position are of systemic importance.

My American Enterprise colleague Peter Wallison has argued powerfully that this is a bad idea. Neither the Federal Reserve or other regulators identified the systemic risk which caused this crisis. Neither did most financial institutions or investors. Systemic risk is hard to identify for the very reason that it is systemic.

If experts are as unreliable as Kristof argues, can expert risk assessment (which is what regulation is) be expected to outperform market-based risk assessment (which is what an unregulated market does)? Certainly not all the time, which is precisely the lesson that we should learn from the recent crisis originating in the heavily-regulated mortgage industry…and precisely the lesson our leaders seem determined not to learn.

(Hat tip to Angry New Mexican for the Kristof link and article!)

 

The Angry CEO

Lately, it has been hard not to notice that a good number of financial institutions have either gone under, or been forced to merge with other institutions before they failed.

So what are we to do? I’ve decided, strictly as a public service, to offer up my services as the Angry Libertarian CEO. First let’s look at how much Reuters reports some of the other, professional and highly trained silver back CEOs took home:

Company	Reuters reported CEO Compensation (USD)
Merrill Lynch	17,307,600
Wells Fargo	12,568,900
National City	3,419,170
Washington Mutual	18,000,000

Do I have the primate skills that the silver back CEOs of the above have? The firm handshake, the steady gaze, the reassuring pat on the shoulder? The Ivy League MBA? The full head of slightly silver hair? The connections? Nope. Not a chance in Hell.

But what I do offer is a much, much lower draw. For only $1,000,000 I’ll drive your company into the ground like a bird that just hit the side of a skyscrapper.

Oh, one other thing I almost forgot — the compensation needs to be in cash up front. No stock options or checks please.

 

Cowardice thy name be NBC

Saturday Night Live or SNL for short, has been a mainstay of American comedic television for over 30 years. Best known for its inventive original skits superb cast of all star comedic acting talent, it is often remarked that the show quality ebbs and flows over time, an undisputed mainstay throughout its years has been the its political satire sketch comedy such as weekend update . Thus naturally come election years or major news stories they often hit proverbial comedic gold! The mixture of wonderful writing, quality actors, and dialogue typically so close to the real thing it is both frightening to contemplate how poignant the parody but also so funny the audience is left in stitches.

SNL has hit in the past—recall Dana Carvey’s impression of Bush I—but most recently notable have been the instant classic sketches featuringTina Fey portraying Republican Vice Presidential Nominee Sarah Palin in an impression that can only be called ‘uncanny’ in a Palin-Clinton Speech, a Palin-Couric Interview, and the Biden-Palin VP debate (complete with Queen Latifa playing Gwen Ifill). Thus far all three sketches have been major headline news on every network come the following Monday morning, drawing many viewers back to SNL again. Fueling this surge is the high accessibility of recent SNL skits on the internet placed there directly by NBC itself.

On Saturday October 4, 2008 SNL presented a skit titled “Washington Approves the Bailout” focusing on many of the ludicrous aspects of the current economic situation. The sketch instantly became a hit with links to the official NBC posting of the video appearing all over the web almost immediately. Then suddenly chaos ensued. Withing a matter of hours on a lazy Sunday mid-day as citizens awoke and checked their digital communications, countless numbers clicked on links sent by a friend, family member, or co-worked promising a hilarious video, only to be met with a cryptic message that the sketch was no longer available and apologizing for the inconvenience. Instantly as the so commonly do, conspiracy theories began to run wild. For two days one in the know would hear every theory from space aliens to the illuminati. Then finally on Tuesday afternoon the truth broke and a now far less funny, edited version was put back up on the internet by NBC. Unfortunately for the American public, the truth was far more sinister than Martians or Free Mason wannabes. The truth was that NBC lawyers had pulled the sketch. Though NBC officially did not mention this in their statement:

“Upon review, we caught certain elements in the sketch that didn’t meet our standards. We took it down and made some minor changes and it will be back online soon.”

Apparently the sketch’s portrayal of Herb and Marion Sandler was considered a liability since it pointed out their acts of corrupting US Government officials and their severe culpability in the current financial meltdown affecting the US. Additionally as a faux C-SPAN video SNL had a chyron on-screen text shown below the Sandler lookalikes that would normally serve to identify the subject on-screen stating: “Herbert & Marion Sandler: People who should be shot”. Supposedly this is to be part of the basis of the video edit, as it may be misconstrued as a death threat to some people and/or offensive.

Now this is not the first time that SNL has turned against one of its funniest components. Norm MacDonald was fired from his stellar and unparalleled stint as the anchor of the weekend update sketch for making too many side splitting hilarious OJ Simpson jokes. Do not worry if you are confused, you are not alone. Many fans and casual watchers alike have asked themselves why a comedian would be fired for raising a dieing show’s ratings by making hysterical jokes at the expense of a public figure who is himself, well…. a joke. The answer was unfortunately the same then as it is in now in the case of the Bailout Sketch: NBC Cronyism and Politically Correct Cowardice.

Thus an entire American populace is left one step closer to an Orwellian Nightmare in which our right to speech and thought even as basic as humor is subject to regulation by the State at the whims of the ruling oligarchical elite. That is unless a line is drawn in the proverbial sand, saying “This far and no further”. For those looking to stand up and fight back by saying “NO!” to the tyranny of the minority, by saying “NO!” to those who would tell you how to think and how to laugh; stand up and wave the banner of Free Thought high in the sky. Spread the UNEDITED VERSION as far and wide as you can. Show it to your parents, siblings, spouse, grandparents, cousins, friends, co-workers, and to anyone you possibly can. The sketch is downright hilarious to anyone with a single drop of a sense of humor in their entire body, and (based on the talk of the town prior to the pulling and editing of the video) the quote “people who should be shot” is one of the most memorable gems of the bit. So much so in fact that to one who has seen the original, the edited version leaves one feeling quite dissatisfied. Make sure that the memories of original version Do Not Go Gentle into That Good Night! Together it is possible to prevent NBC from pulling a Lucas on this classic!

Ultimately it is a matter of “How dare NBC!?!”. How DARE they back off from calling a spade a spade? How dare they a non-news organization try to hold themselves to a journalistic standard when speaking about the rich and powerful whom have destroyed people’s lives (some figuratively others literally)? How dare they back down from vilifying scumbags who wrecked the entire world economy so that they could glean a few extra shiny nickels! To paraphrase from one SNL’s own skits, I invite them to grow a pair, and if they can’t, I will lend you mine. So in case anyone else is looking to make a bumper sticker or t-shirt:

...because NBC doesn't have the juevos!

 

Fit to Fail [with apologies to James Burke]

“The tree of capitalism must be refreshed from time to time with the
blood of investors and bankers.” — Angry Political Optimist

 

James Burke once wrote, in an essay entitled “Fit to Rule”, that the modern world was connected to root events having to do with Linnaeus. His penchant to catalog and organize nature led to Darwin’s Galapagos trip; and from that Karl Mark derived his economic theories giving rise to Communism. Nietzsche’s interpretation, itself misinterpreted, philosophically enabled Nazism and Hitler and the “manifest destiny” derivative in the hands of J. P. Morgan and Getty gave rise to capitalism. Finding root causes is always an interesting journey. So when one looks around today, especially with politicians eager to cast the blame on others, it’s good to try and establish what exactly the root cause of the current fiscal mess might, in fact, be.

The story begins in 1933 at the end of the Great Depression with the passing of the Glass-Steagall Act by Congress (F.D. Roosevelt administration) which prohibited banks from selling investments and created firewalls between investment banking, commercial banking and insurance. Soon after, in order to resolve the mismatch in maturities in loans, and because banks couldn’t loan enough to support the post WWII baby boom, the Federal National Mortgage Association or “Fannie Mae” was created as part of the New Deal in 1938 (FDR administration) to provide a secondary market for mortgages. This organization purchased loans from banks which then allowed them to continue to service and lend. And all was good — the greatest generation prospered.

For thirty years, FNMA had a near monopoly on the secondary market, then, in 1968, FNMA was privatized by L.B Johnson because of Vietnam War fiscal pressure. Now, as a private entity, FNMA could generate profits, yet FNMA still obtained special treatment under regulatory and tax laws. As a consequence of this, investors perceived minimal risk in the company. In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac, was created under the Emergency Home Finance Act. The FHLMC purchased mortgages on the secondary market, aggregated, tranched, and sold them as asset backed securities (ABS). Between them, FNMA and FHLMC was estimated to hold approximately 90% of all US mortgages accounting for 46% of the national debt.

Then Congress exempted FNMA and FHLMC from the FDIC Bank Holding Company Act capital/asset ratio reserve limit of 3%. Fannie and Freddie were free to leverage their assets. In 1999, the Graham-Leech-Bliley Act, supported by Robert Rubin (Clinton-Administration) repealed the 1933 Glass-Steagall Act and allowed banks to invest in securities, offer securities, and a cafeteria of financial services. This provided an immediate market for FNMA stock, especially as these shares were considered low risk investments and were returning high returns on investment. The 1995 interpretive letter approving low income mortgage securities as viable investments under the 1977 Community Reinvestment Act (12 CFR parts 25, 228, 345, and 563e) provided another market for FNMA. Commercial banks could now invest CRA dollars in FNMA legally. In 1992 Congress (H.W. Bush administration) mandated (GAO report number GAO-04-269T) that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers and specified that approval metrics such as the ratio test should henceforth include unemployment and welfare payments as sources of income. HUD (Clinton administration) established ‘quotas’ for FNMA and FHLMC to insure 50% of all their loans be to minorities by 2001. Since FNMA and FHLMC are secondary markets, they pressured originating banks to offer more minority loans.

(The story accelerates to Internet time.) FHA regulations are written with loopholes that allows 0% down-payment mortgages. Down payment assistance market develops to exploit the loophole. The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH) (G.W. Bush administration), requires the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. In 2005, FNMA revises its loan approval criteria to support post hurricane rebuilding.

The Rating Reform Act of 2006 passes into Law requiring the use of “Nationally Recognized Statistical Rating Organizations” or “NRSROs”. As a result, internal credit analysis at investment banks deteriorate. In 2007, FASB 157 is imposed on corporations requiring that assets be marked to market. Also in 2007, the Office of Federal Housing Enterprise Oversight (OFHEO) increased the FNMA conforming loan limit upwards to $729,750. This increase in allowed principle increased profit for FNMA. All these regulations and acts let FNMA and FHLMC offer securities at net interest margins that were extremely profitable. FHA mortgages with 0% down make it impossible for banks to compete. Banks have to match terms in order to compete. Financial houses have to develop new instruments in secondary markets to compete with FNMA and FHLMC.

At this point the dominoes are all aligned and ready to go. Backtrack in time slightly and pick up a second parallel thread. Two events occur: investors realize that a few lines of software, a pretty business plan, and a catchy name do not a market make; and two planes make unauthorized landings into downtown Manhattan. The 1-2 punch of the Internet bubble bursting and 9/11 sends the economy into a recession. The Federal Open Market Committee (“Fed”) ratchets interest rates lower and makes a horrible mistake, leaving them low for far too long. Liquidity is generated with nowhere to go since money markets and deposits are generating low returns. Well, there is always real estate.

Quants on Wall Street create new classes of securities to access this liquidity — Collateralized Mortgage Obligations (CMOs) and Structured Investment Vehicles (SIVs). Quants are not stupid and know that these are risky, so they create credit default swaps (CDSs) to cover and distribute the risk. Markets develop to trade these instruments. Purchases go global. Trillions of dollars are traded in these vehicles.

With easy money and low interest loans, more houses are constructed, exceeding the number of available buyers, even at 0% down. The value of real estate drops on market fundamentals (law of supply and demand). The underlying value of mortgages drop. Loans are valued at more than the house or real estate they are collateralized with. Because many houses were purchased on speculation, and the dollars invested are essentially zero, owners walk way leaving banks with securitized assets that are non-producing. The primary cascade starts.

As underlying values tank, derivatives such as CMOs and SIVs collapse and swap liabilities under CDS’s increase. FASB 157 requires assets to be marked to market and assets are devalued accordingly. As assets are devalued, new capital to make up the difference is required. However, the complex interconnection of derivatives and new investment vehicles do not provide mechanisms to evaluate risk. Few are willing to invest without an understanding of the risk involved. Bank and investment company outlooks become speculative and their stock prices reflect this. Rating agencies downgrade the companies. This triggers additional capital requirements written into the CDS contracts. The cascade increases. FASB 157 becomes virtually impossible to implement since there effectively is no market. Liquidity stops because 1) banks can’t value what they own; and 2) they don’t loan assets they have because they might need them for capital.

People don’t understand because political parties are off blaming each other. News commentators spew gloom and doom scenarios. Runs on money markets ensue. Money markets sell short term securities to cover withdrawals and the market for commercial paper, which is funded through the money markets, dries up. Liquidity in commercial loans drops. Companies cannot access their lines of credit by commercial paper (bonds, etc,) Companies have to restrict operations and downsize.

People without jobs cannot pay mortgages. Second stage of cascade begins. Consumers look at institutions and decide that their money isn’t safe. They withdraw funds — banks become insolvent and are seized by the FDIC. Other banks stocks fall as result. Confidence erodes further.

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So if we look at the root cause of all this, while Wall Street has it’s share of responsibility, you don’t discipline a dog for urinating on a fire hydrant — he’s just being a dog. Similarly, investment bankers do what they do — borrow and lend money and attempt to make markets. In this case, the road to hell is paved with good intentions and shares of Fannie Mae stock.

 

Primum non nocere

Once there was a group, established by a society, which was endowed with a high level of respect. Members of this group were fragmented in their beliefs and practiced their craft in accordance with their beliefs. Some, enamored with righteousness and a belief in the primacy of the Church, believed that society’s ills were the work of demons and established laws and rituals to expunge them. Men of high status were called evil and their works questioned. Others, no less righteous, insisted that there were fundamental humours that were required to remain in balance for good health, and periodically vented and tapped these to release them from the body. As may be expected all this venting and tapping had some unintended consequences — the patient died. At some point, around the 1850s, some members of this group stepped back and performed a little critical analysis noting that the patients untreated had as much change of survival as patients treated. This observation led to a complete philosophical paradigm shift. A phrase was taught to all who entered this profession: “Primum non nocere —First, do no harm.” Physicians use this expression to note that human acts with good intentions may have unwanted consequences.

In the last few weeks, various treatments to the illness of the financial markets have been tried. These included federal takeover of Fannie Mae and Freddy Mac (Why are there two of them anyway?), the fire-sale manipulation of Bear Sterns, the abandonment and bleeding of Lehman Brothers, what amounts to the acquisition of AIG, and most recently the promise of some new and radically untried set of procedures. These include the suspension of short sales, the acquisition of asset backed securities by the government, the FDIC like insurance of money market mutual funds, and the opening of FED credit lines to cover corporate paper and short term liquidity needs.

In order to implement many of these policies, the regulatory bodies — the SEC, the FED, the Treasury — need Congressional approval. As any first year economics student is taught, actions and expenditures by the government have attached multipliers and consequences on the macroeconomic landscape, not all of which can be accurately predicted. It would prudent then for Congress to do the minimum necessary to treat the problem. Doctors Bernanke, Paulson and Cox have a prescribed treatment plan — one that doesn’t involve additional economic incentive payments, additional mortgage subsidies, or riders to support venting of additional humours. Congress should realize that these prescriptions are for Main Street and not for just Wall Street.

Keeping the Act to enable these prescriptions to the minimum necessary will surely test the wills of both sides of the aisle. It will be difficult enough to fill in the details without loading up the bill with each party’s pet programs and election-year incentives. And as for the details, a couple of suggestions:

1. Let’s go easy on the shorts. Markets work best by including all information and short sales provide a valid channel of information. By all means, lets clamp down on the ‘naked’ shorts, but an accross-the-board ban on shorts is a bad thing.
2. If the Treasury is going to buy securitized mortages, CMOs and SIVs, the so-called “toxic paper”, then let’s value the asset on the basis of discounted cash flows and not mark-to-market. Especially when a viable market doesn’t exist. Not only will this eliminate a bad accounting practice, but it will rapidly establish a mechanism for global markets to understand the risk/value of assets already on their books. It will also eliminate the death spiral of under-capitalization, Agency rating downgrades and further capitalization reserve requirements which are weighing down Goldman Sachs and Mogan Stanley. It probably would have helped Merrill Lynch and Lehman Brothers also.
3. Providing FDIC-like insurance to Money Markets and Mutual Funds needs to be thought through. We don’t want to make the funds more attractive than deposits and cause a massive unintended shift of capital from the commercial banks. That would just shift the crises from Wall Street to Main Street. Perhaps insurance coverage could be adjusted to equalize over the return on investment on any given instrument — treating deposits and funds equally after weighting.

But most importantly, moderation and minimal intervention.

After all, when the heart surgeon cracks you for that triple bypass, he doesn’t usually divert to perform a liposuction, or have his OR technicians perform a manicure on the patient, no matter how beneficial to the patient’s image. Anything that diverts attention from the heart attack is to be avoided. Perhaps the Congressional motto should be changed to “Primun non nocere”. Congress take note.

 

Caution to the Wind — Part 2: Credit Enhancement

So in the last segment we reviewed the securitization of our portofolio with the following results:

	Loans to Cashmere Coats	Loans to Used-Car Salesmen	Loans to Bums
Rate	2%	4%	6-8%
Risk	Low	Medium	High
Joe’s Rating	AAA	BBa	‘junk’

In any industry, there are clever little engineers that can make interesting things. The finance industry is no exception, except for a couple of salient facts. Most of these engineers are young (after all their products didn’t exist as much as 10 years ago), and most have never lived through a significant down market. So a certain set of eternally optimistic financial engineers looked at the mezzanine tranche (the Loans to Used Car Salesmen), and asked whether they could do something to strengthen the sales of this group.

One thing that they came up with was to apply a bit of insurance theory. Develop a product that could spread the risk even further than securitization. Take the pool of loans from the used-car salesmen and insure that pool against loan loss. That is to say, if any of those loans went south, the insurer (Guido) would cover the face value of the loan and the person who actually invested in (read bought) that tranche, would be guaranteed his principal back. Of course nothing is free so the person who was packaging the loans, me in this case, would pay a premium for that insurance just like I do on my house or car. However, in return for the insurance, the credit rating of the used-car-salesmen offer would improve as the risk would decrease. Joe would rate it higher — maybe A or AA. This means that since the risk was lower I would give only 2.5% or maybe 3% interest on the package to the investor.

The ABS package wouldn’t be AAA but it would be higher than BBa. And even though I had to pay Guido some cash for his protection, I ended up with a larger spread in rates. 6% – 2.5% is 3.5% for me verses the 6% – 4% or 2% I would normally get for unenhanced used-car-salesmen loans.

And Guido, even though he was betting my used car salesmen were a good risk and pricing my premiums as such, would spread his risk by protecting a large pool of such loans. Hey! It works for insurance with only minor glitches like Hurricane Hugo and Katerina.

So my new offerings look like this.

	Loans to Cashmere Coats	Loans to Used-Car Salesmen	Loans to Bums
Rate	2%	2.5%	6-8%
Risk	Low	Low-Med	High
Joe’s Rating	AAA	AA	‘junk’

 

Thus with this piece of financial ingenuity we have created a new market. The companies in this market include ACA, AMBAC, FSA, and MBIA.

ACA recently saw its stock plummet 57% due to downgrades on its holdings. MBIA’s trillion dollar portfolio is under stress from $2.4 billion in debt obligations related to subprime mortgages as well as AMBAC. FSA has taken a $215 billion dollar hit. Fitch, a rating agency (Joe’s friend), has downgraded obligations of several banks, including Barclays.

The problem here is that the risk was incorrectly estimated — i.e., the people offering the securitized holdings were optimistic to just plain wrong. Spreading your exposure over a pool of equally bad obligations does not increase the quality, so the insurers did, in fact, not reduce their exposure to defaults. This is similar to major insurance companies issuing policies over a wide geographic area, noting that tornados, hurricanes and fires are localized events, only to have an asteroid strike the earth.

 

Next installment: Adding more structure.

 

Subprime & Homeless: Part 2

Home ownership has been elevated to an American right. This belief, directed at mortgage companies and lenders, has fueled the Alt-A and sub-prime mortgage explosion. The results were predictable. The unpredictable part was that the securitization of debt, its aggregation into trading instruments, and the resultant distribution of risk penetrated so deeply into the world financial markets. Unfortunately, distribution of risk is not elimination of risk, as we are now seeing.

The US Census Bureau establishes current home ownership at 68.9%, up from the level sustained from 1980 to 1995. (current US Census data and sustained level.)

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Looking at these data, we note that up to Bill Clinton’s effort to provide housing to all in the late 90’s, the percentage of ownership was 64.5%. After Clinton, Bush, the Federal Housing Authority, Fanny Mae and Freddie Mac got into the picture, the US Census numbers (2006) showed 68.9% ownership, a whopping increase of 4.4%. Let’s pull some quick facts from the census. Round off the population to 300,000,000. Of these people, there are approximately 105,000,000 housholds (or potential homeowners). Figure the median value of a home, again approximating the census data, as $120,000. Do the math and you can see that 4.4% increase in home ownership resulted in about 4.62 million new homes or about $554.4 billion in new loans.

Now while this is more pocket change than I’ll ever carry around, it doesn’t quite add up. The 2007 estimate of the US GDP was $13,790 billion. The newly originated loans constituted only 4% GDP. This is approximately the same cost as the annual defense budget as a percent GDP — hardly something that could tank the world financial market.

Yet we see the numbers in the papers all the time. Banks have liquidity problems. Credit default swap derivatives exposure is estimated at $26 trillion.

• 2/28/2008 Fannie Mae posts $3.56 billion loss
• 1/25/2008 Societe General posts $7.2 billion loss
• 2/27/2008 Bond Insurer MBIA default loss estimate $13.7 billion
• 2/25/2008 Bond insurer AMBAC looking to raise $3 billion in capital
• 2/18/2008 National Rock bank London nationalized to secure $107 billion
• 2/22/2008 Credit default swaps loss is $2 trillion

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The answer to this is clear. The current mess has very little to do with homeownership per se and everything to do with investing. If we only had an increase in 4.4% ownership, then the additional debt must have been acquired by people purchasing real estate for investment purposes and homes to flip, also for investment purchases. Add to that the clever derivatives instruments, where a lot of financial engineers and derivatives traders boasted of their multi-million dollar salaries, and you can see that the core of the “irrational exuberence” is based on making very risky bets on an upside market.

When the bubble bursts, and the risk becomes apparent, and bites you in the ass, the taxpayers of the United States are once again called upon to bail out Wall street and stupid, greedy investors. So now we are engaged in assuading the market through rate cuts to resolve liquidity problems, forcing the dollar lower and inflating the cost of essentials like food and energy. All because of the dictum:

 

What affects Wall Street eventually affects Main Street

 

Thanks to the Angry Virginian for comments and suggestions as to breaking this rant into digestible chunks.

 

Caution to the Wind — Part 1: Securitization

In our 12 Angry Men email discussions, one Angry Man asked why one of us didn’t rant about the “subprime mortgage meltdown”. After some consideration, and at the risk of offending those in finance with considerable more precision than I can provide, I delve into the topic. One of the reasons for the reluctance to address the topic is its complex nature. To truely understand what occurred, you have to understand securitization and structured investment vehicles. But as one who participated in a company who securitized credit card receivables, as I researched, I discovered several underlying commonalities. In fact, there is a lot of commonality with the way Congress and our government manages the Federal budget. When one sees so many threads aligned together, there is a suspicion of a whole cloth of consensual conspiracy, a tapestry of belief that underlies the way we view risk.

Before 1970, banks maintained portfolios of loans, serviced those loans, and generally covered the amount loaned by use of deposits, or by debt incurred by the bank itself. Regulatory agencies required that banks maintained a certain level of liquidity reserves, i.e. they couldn’t loan more than say 80% of the amount they had on deposit . When loans matured and the principle was paid, it could be relent to another. This serial process set limits on the amount of growth in the country as growth requires a pool of capital to finance that growth. The more capital available, the more growth. This was particularly true in the home building and mortgage industry. Mortgages were particularly bad because the cash assets were tied up in fixed terms of 20 or more years. Demand was high for new homes.

The solution was to package loans up as a “managed asset” and sell them, transferring the long term debt, future cash flows and risk to third party investors. Two benefits arose from this: accounting rules treated the movement of debt to a third party as a sale, and thus the debt could be moved off the bank’s balance sheet (and reduce the liquidity reserve required by regulators); and the bank received immediate cash, albeit discounted, from the sale which allowed it to originate more loans. Investors who purchased the asset received the interest cash flow and eventually the principle back. Moreover, such asset backed securities (ABS) could be traded between investors like any other security. Trading is important in that it allows information relevant to the asset, such as credit quality, to be reflected into the price of the asset. Assets which aren’t traded have no mechanism to establish their value (price).

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Now if I go out onto the street and lend the first 100 people I meet $1000 each, with their promise to pay it back in one year with some interest, (say 6%), I have receivables of $100,000. Further, I make them sign a piece of paper that says that they will pay me back. Now I go to another person, who happens to have some money he wants to invest. Hey, I’ll trade you this package of notes for $100,000 and you can keep the interest. Does he take the offer — I suspect not. What would I have to do to entice him into taking the offer?

First I would need a plan as to how I would collect the principle and interest, i.e. how I would service the loan. The investor doesn’t want to be bothered with running a collection operation. So either I have to do it or I have to hire someone to do it for me — both at a cost. Hmm. I could create a spread in interest rates. Charge each person a higher rate than I offered to pay the investor and use the difference to pay for the servicing. Hey, I could even wet my beak a little. I charge 6% and offer the investor 4% and use the 2% to pay for servicing.

But then I remember that the forth and fifth person I loaned the money to were bums. Hmm. How likely is it that they will just drink up the money and never pay me back? But that first guy has a cashmere coat and a nice haircut — he would probably pay me back. But the 10th guy was a used car salesman. Maybe I had better look at these loans and arrange them in order of who is likely to pay me back. In fact, it sure would have been better to look a little closer a them before I handed them the money. So I divide up the loans in to three piles. All the bums in pile three, all the used car salesmen in pile two, and all the cashmere coats in pile one.

So now my plan is to take all of the loans to guys in cashmere coats and package them up as an asset based security. Since the risk is very low that these guys will default and not pay me back, I am essentially giving away a sure thing. For sure things I offer a 2% rate.

The used car salesmen loans, I also package up. These guys are more risky so I offer the package for 4%. And since many of these investors don’t know me personally, I need to convince them that I haven’t slipped a bum or two into the used car salesmen group. So I go to Joe the Bookie. Now Joe really doesn’t know much more than I do, although he has one advantage — everybody knows Joe. Joe make a cursory glance through my package and doesn’t recognize any bums, sees a few car salesmen he knows, and decides that my package is worth a couple of B’s (It’s not really A list material, but it’s not that BBa-d either.) So when I offer this to my customers, I tell them “Joe says it’s not too BBad.”

The remaining bums are kind of a problem. I know I can’t package them up and offer them. (I mean, I could try, just to get rid of them, but I’d have to offer 6-8% and Joe would say to toss them in the junk.) No, these I’ll have to keep and make an aggressive attempt to collect my money. Hopefully, the 2% I get to keep for servicing will cover any loss. And who knows, some of the bums are trying to reform.

So I manage to sell of a couple of groups of my packages and get back some of my money. Plus the 2% is generating some cash flow. I decide to take the money from the sale and lend it out again, but this time I’m going to be really really careful about lending it to bums. I’ve just learned how to securitize my debt — cool beans. Since my assets are loans, these are asset-backed securities (ABS). If they were loans collateralized by homes, or mortgages, they would be mortgage backed securities (MBS).

	Loans to Cashmere Coats	Loans to Used-Car Salesmen	Loans to Bums
Rate	2%	4%	6-8%
Risk	Low	Medium	High
Joe’s Rating	AAA	BBa	‘junk’

[News flash!!! — Today the government announced that ‘bums’ are henceforth to be known as ‘homeless people’ and that since it is in everyones’ interest to own a home, the government is going to make it easier to loan money to the homeless people. Fanny and Freddie are no longer going to require that the homeless people put down 20% on an empty refrigerator box to live in.]

As I look around, I see that all of my friends are loaning money right and left, competing with Fanny and Fred. I better get on this bandwagon if I want to stay in business. I guess I’ll accept a few more used car salesmen this time, and maybe a few more bums —err homeless people than I initially planned.

Next installment: How to give used car salesmen cashmere coats.