This paper by Baily, Litan, and Johnson is the best overview I’ve read so far of what went wrong in the housing and financial markets (HT: Arnold). It is a primer of sorts, so if you remain confused, you will find much enlightenment there.
But many questions remain. One is the question they raise:
The lack of due diligence on all fronts was partly due to the incentives in the securitization model itself. With the ability to immediately pass off the risk of an asset to someone else, institutions had little financial incentive to worry about the actual risk of the assets in question. But what about the MBS, CDO, and CDS holders who did ultimately hold the risk? The buyers of these instruments had every incentive to understand the risk of the underlying assets. What explains their failure to do so?
The authors give an answer, the standard one that is not so satisfying–people were careless, profits were huge, the assets were opaque. This all may be true, but I suspect there is more to the story. Consider this picture:
This is taken from a superb paper by Rossner and Mason on the CDO market. CDO’s are these assets that are bundles of bundles–repackaging of mortgage backed securities. The pictures shows the premium earned by BBB tranches above and beyond LIBOR, a short-term interest rate. What the picture shows is that starting in 2003, the premium plummeted. Then it stayed low throughout 2005 and 2006, a time when the quality of the subprime loans that underlie these assets is deteriorating. Rossner and Mason point out: For example, 38
percent of all subprime mortgage originations in 2006 were for 100 percent of the
value of the home. Adelson and Jacob (another very interesting paper) argue that as these spreads fell and stayed low, the traditional investors in this market who had demanded insurance or other forms of protection from credit risk, stepped to the sidelines and were replaced by investors who didn’t care. Very interesting. Something changed. What was it exactly? What caused it? I have some ideas, but they are very incomplete. I also have many more questions…
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Rossner and Mason's paper is piece of crap:
See eg. "Policy implications":
"The potential for prolonged economic difficulties that also interfere with home ownership in the United States raise significant public policy concerns. Already we are witnessing restructurings and layoffs at top financial institutions. More importantly, however, is the need to provide stable funding sources for economic growth. The biggest obstacle that we have identified is lack of transparency. The structural changes noted in Part I.A largely went unnoticed by MBS investors until only recently. We explain that those changes went unnoticed largely because of the existing complexity and valuation difficulties underlying today’s MBS markets.
High yields in MBS in the past several years led to a massive infusion of CDO “hot money” into the MBS sector in an environment similar to that of the thrift crisis of the late 1980s. Like the thrift crisis and its aftermath, therefore, recent events not only threaten these institutions, but also threaten the U.S. consumer and taxpayer as well.
Perhaps of greater concern is the reputational risk posed to the U.S. capital markets—markets that have historically been viewed as among the most transparent, efficient, and well regulated in the world. The economic value of mortgage securitization and the risk transfer value of CDO issuance support their further use. However, there should be significant resources allocated to building the regulatory framework surrounding their structuring, issuance, ratings, sales, and valuation. We believe that efforts to provide transparency to these new product areas can foster stability while maintaining liquidity to the underlying collateral sectors and supporting further meaningful financial innovation and capital deepening.
At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus’ in order to monitor the sector.
Significant increases in public access to performance reports, CDO and MBS product standardization, and CDO and MBS securities ownership registration can help decrease the existing over-reliance on ratings agency inputs to rate and ultimately value the securities and reducing the valuation errors inherent in “marked-to-model” (rather than marked-to-market) portfolios. SEC Regulation AB was a (late) start for ABS and MBS. Overall, however, the U.S. economy needs an efficient public CDO market that allows transparent open-market repricing of market risk and outside research into new securities and funding arrangements. U.S. homeowners and consumers deserve stable and efficient funding to support their pursuit of the American dream."
Blah, blah, blah, blah… What are policy implications? That "U.S. homeowners and consumers deserve stable and efficient funding to support their pursuit of the American dream." We knew that even without consulting Mason and Rossner.
The answer is bubble mentality. People take a short view of the past and extrapolate it fowards… even investment bankers.
The AAA rating of all the CDO's by Moody's and S&P didn't help a bit either. Their government aided duopoly is another piece of the puzzle.
What is your question? Is the question what changed for those demanding credit enhancement and higher spreads? The answer to that is obvious. Or is your question why would the spreads fall in the face of deteriorating credits being underwritten? That could only be a response to the recognition that there was little true difference between the bottom end of investment grade and the credit quality of the banks lending money to one another (LIBOR). In other words, there was increasing recognition that the paper banks held as capital was only marginally better than the paper being sold via the CDOs. It was the one of the first signals of pending trouble for banks. Who was recognizing it? The institutional buyers that moved to the sidelines, the banks themselves.
When present demand for the uncertain promise of future income rises more rapidly than future income available for sale presently, only one thing can happen. People accept more risk.
I have a dollar now. You have a dollar now. We both want to purchase the promise of $1.50 a decade from now, but the total income in ten years, available for purchase now, is only $1.50, not the $3.00 we want, not even the $2.00 we have now.
So what happens? We both gamble on earning all of the $1.50. On the average, we each end up with half of what we want and a bit less than we have now, but that's only the average. Maybe, I get what I want, and you get nothing, or vice versa.
That's how free market capitalism really works, the only way it could possibly work, and that's how it should work and how I want it to work, but that's not how most people, even most nominal "libertarians", want their "retirement saving" to work. These people want an "honest return on their money", and if they don't get it, they start looking around for someone to accuse of "fraud" and demanding that authorities make them whole.
I don't know what it was exactly or even that it was anything exactly, but I suppose the demographic transition has a lot to do with it.
1) Labor force growth is plummeting in much of the developed world, including the U.S. and China, and is already negative in significant parts of the world, like Japan and Germany. The U.S. and Chinese labor forces peak in the next decade while labor forces in Japan and Germany shrink.
2) Simultaneously, the population of would be retirees is exploding, and demand for entitlement to future output, without earning wages, is exploding with it.
Under the circumstances, how could risk aversion in the pursuit of future income not fall?
Craig: If your explanation were correct (that the reason for the declining CDO-LIBOR spread was that banks recognized that other banks were a poor risk) for the mid-2000's, we should have seen then what we've seen only this year: a persistently high TED spread.
Jeff,
You are probably right but what I'm suggesting is that I think banks began to recognize that their own portfolios were under stress, looking behind the rating of the paper (the fact that other banks might be in trouble was secondary). As that trepidation grew, they stopped buying the longer term obligations tied to mortgages (seeing it for what it was) whether the securities had credit enhancement or not. I'm thinking that the spread represented by CDO-LIBOR (a five year number) will necessarily manifest itself before it shows up in the short term TED spread.
If I were a bank portfolio manager those would be my thoughts. Just a little more support for this, the board of FNMA fired Raines after finding out that a $9 billion restatement was in order at the end of December 2004 which coincides with the begin of the steep drop in the CDO-LIBOR spread. It may have been a precursor of the liquidity preference.
Jeff,
You are probably right but what I'm suggesting is that I think banks began to recognize that their own portfolios were under stress, looking behind the rating of the paper (the fact that other banks might be in trouble was secondary). As that trepidation grew, they stopped buying the longer term obligations tied to mortgages (seeing it for what it was) whether the securities had credit enhancement or not. I'm thinking that the spread represented by CDO-LIBOR (a five year number) will necessarily manifest itself before it shows up in the short term TED spread.
If I were a bank portfolio manager those would be my thoughts. Just a little more support for this, the board of FNMA fired Raines after finding out that a $9 billion restatement was in order at the end of December 2004 which coincides with the begin of the steep drop in the CDO-LIBOR spread. It may have been a precursor of the liquidity preference.
All good references on the cause of the crisis. Not much IMO points to government meddling as the prime cause but in fact the lack of oversight and again the allowance of complex financial instruments simply designed to defraud investors. These products were ultimately the catalyst fueling the sub-prime lending spree that no primary responsible lenders would have ever risked with out the pyramid system set up to pass risk along like a hot potato.
Great article on NOW with two insiders from credit rating agencies. Maybe the something that changed was how BBB worthy products were repacked into CDO's and rated as AAA.
"But what about the MBS, CDO, and CDS holders who did ultimately hold the risk? The buyers of these instruments had every incentive to understand the risk of the underlying assets. What explains their failure to do so?"
Watch the NOW episode I linked to above and at 18:03 mark you'll see the answer to the above question. An internal memo from a Standard and Poor's employee dated in 2006…"rating agencies continue to create [an] even bigger monster – the CDO [collateralized debt obligation] market. Let's hope we are all wealthy and retired by the time this house of cards falters."
In other words as I've said all along these guys, Wall Street in general, conspired to create a pyramid scheme using mortgage equity to steal wealth from peoples homes, their banks accounts and from peoples retirement accounts. That's what happens when you let modern markets self govern.
They, the guys on top likely got out before the house of cards collapsed and are doing fine now. The rest of us get to help pay $150,000,000,000 to bail out AIG. That, as Joseph Stiglitz mentions in his piece on NOW is more then the World Bank lends out n 10 years and is significantly more then the approximately $5 billion dollars requested to cover the rest of this countries uninsured children that George W Bush vetoed claiming we couldn't afford it.
Again, "Let's hope we are all wealthy and retired by the time this house of cards falters." That's your free market for you. Incredible….Sad….
Forbidding the riskier securities doesn't increase the future income that would be retirees may purchase presently, and we certainly do not want states simply creating these securities by selling more and more entitlement to tax revenue, because this "solution" to the problem will starve the next generation of both investment and the fruits of their labor.
When muirgeo calls for greater regulation, he essentially calls for the prohibition of a large volume of the nominal "securities" actually purchased in the last decade, but he doesn't tell us what the purchasers would have purchased instead had these risky securities not been offered.
The collapse of a CDO pyramid erected over the last decade is not simply the fault of "the government". It's not the fault of "the government" for regulating too little, and it's not the fault of "the government" for regulating too much either. It's the inevitable consequence of an unprecedented lot of would be retirees seeking to purchase future income streams that free capital markets don't actually create in the future.
So we have a choice to make. Do we want the future income streams, drawn from confiscatory rents imposed on the next generation, or do we want the free capital markets? I have three children, and I want them to have every benefit in life that I've had, even if I must drink some koolaid before exhausting my limited means in my worthless old age, so this choice for me is a no brainer.
And if free capital markets don't create these income streams without imposing confiscatory rents on the next generation, you can bet that less free markets won't do it either.
Martin,
I'm not sure what your point was. Mine was that I want fair and well regulated markets. People making huge sums of money that is derived basically from fraudulently stealing other peoples money and chases out good money with bad is no way to run an economy.
How many of us or of those managing our portfolios would if they could go back in time leave these toxic opaque assets in their retirement portfolios if we knew then what we know now.
Are you trying to make an argument that fraudulent rating agencies are just part of the "competitive market" forces?
Sigh. How many times must I repeat this point before someone other than Sam gets it?
Riskier promissory notes are an inevitable consequence of a competition for promised future income when demand for future income exceeds the supply. Your willingness to defer a dollar of current consumption for the promise of a dollar and a half of future consumption ten years hence does not imply the existence of a dollar and a half of real income ten years hence available for your purchase today.
So what happens when you have a dollar you want to "save for retirement", but these fair and regulated markets don't provide you any promise of a dollar ten years hence, because the balance of supply and demand has driven yields into negative territory? What do you do then? Demand that statesmen create you a new Treasury note, promising to tax your children more heavily to deliver you a "return on investment"?
The yield of the ten year Treasury is now well below the CPI-U. What do you think that means? People are buying notes promising less future entitlement to consume than they're surrendering presently, assuming that current inflation persists. In other words, the real yield of the ten year Treasury is already negative, but demand for notes seems to be rising regardless. Why is that?
Despite the incredibly narrow ideological categories presumed in this forum, I don't have a problem with people making huge sums of money, though I do favor a progressive consumption tax limiting people's entitlement personally to consume rather than reinvest huge sums of money.
For the most part, the sale of MBSs and other "securities" of dubious value was not "fraudulent", because the sellers believed what they were saying when they sold the "securities". People have a remarkable capacity to believe whatever serves their immediate interests.
Without selling even more entitlement to future tax revenue, a "solution" I strongly oppose, your "regulators" can't do anything about this problem. If we can't gamble on riskier assets, we'll only bid up the price of less risky assets until the yield of these assets is negative. We've already done it.
The smart money now is on not retiring. It's on enjoying life more now and expecting to work longer, because free capital markets aren't providing the promises of future income that would be retirees want to purchase. I do not want to "solve" this problem by substituting entitlement to tax revenue and other confiscatory rents for the properly risky assets that freer capital markets supply, because I love my children, not because I'm so wealthy myself. I'm not remotely wealthy myself.
The three credit rating agencies form a legally protected oligopoly, and AAA ratings from them are required for a vast array of investments. What am I missing if I posit that even highly incentivized institutional investors might have been unduly impressed by AAA ratings–not to mention retail investors, domestic and foreign?
Without the legal protection of this oligopoly (in 1970) is it possible that other agencies using more conservative risk models might have emerged to instill caution in investors?
More conservative risk models don't produce anything for you to consume in retirement. You need real productive resources for that, and human action is the most valuable resource, according to both Mises and Simon, and human action is what human beings do, and children are what human beings are before they start doing it, and raising a child to this point requires twenty years of very costly investment, and we started slashing this investment around 1965.
Martin,
What figures/programs are you looking at when you say we "started slashing this investment in 1965"? I am being curious,not contentious.
The "competition for future income" idea is something that I don't think I have seen before but seems obvious after you explained it. Thanks!
I refer to the birth rate, also the fertility rate.. 1965 marks the end of the "baby boom". Some demographers use an earlier year, but I use 1965, because it was the year of Griswold v. Connecticut, the Supreme Court decision legalizing contraception across the U.S. 1945 was the year of Japan's surrender, so '45 to '65 makes for an easily remembered 20 year "boom".
But there never was any baby boom. There was a baby bust in the 30 and 40s attributable to the depression and the war. Then there was a return to a more normal birth rate in the fifties. Then there was a more or less permanent bust in the sixties.
What demographers call "the demographic transition" involves both a declining birth rate and a declining mortality rate. We often hear of "infant mortality", but mortality declines at every age, so fewer children die in their first year (infant mortality) and in their first decade of life, their second decade, their third decade and so on. The cumulative effect of this declining mortality at every age is a much greater life expectancy.
So we basically cut our investment in future lives, and thus future labor, to purchase ourselves longer lives.
You might also be interested in labor force growth. The U.S. labor force basically stops growing around 2020, with obvious consequences for economic growth. This situation seems dire, but the U.S. is one of the few developed economies where labor force doesn't shrink in coming decades. Our labor force only peaks. Many European labor forces will shrink. Japan's labor force is already shrinking. China's labor force will peak around 2015 and then start to shrink.
I can show you credible figures for all these claims. It's no secret. I have no idea why economists, politicians and media pundits don't discuss it more, except that they're all "baby boomers" themselves now. The relationship to economic statistics seem so obvious.
I recently read a report of a 0.4% drop (annual rate) in Japan's GDP in the third quarter, announcing a "recession". The report discussed housing bubbles and the like but never mentioned the fact that Japan's working aged population is expected to decline by 0.7% this year and will decline every year from now own as far as the eye can see. So is Japan's "recession" permanent?
… from now on.
As population peaks, "recession" should no longer describe shrinking GDP. It shouldn't even describing shrinking per capita GDP. It should describe shrinking productivity of the labor force; otherwise, we'll find ourselves in a permanent state of "recession", sort of like the endless "war on terror". GDP will definitely shrink in some nations, and per capita GDP could shrink even as productivity continues rising, if the population grows faster than the labor force while the "baby boom" retires.
Peak Rent
Peak Rent refers to the increasing demand for rents imposed on a relatively shrinking labor force by a relatively growing population of retirees, but it's not simply about Social Security, not by a long shot. Demographers sometimes speak of a more stable "dependency ratio", with growth in the population of dependent elderly offset by shrinkage in the population of children, but this more stable ratio doesn't comfort me. Children don't vote, don't own property and don't impose rents.