One Utah

Via Washington Monthly, I see a great article from Steven Pearlstein.  Pearlstein’s title gives you an idea of the content of his article:  It’s Not 1929, but it’s the Biggest Mess Since. 

Some background might be in order.  The 90s, when I was in business school, was the golden age of creative financial modelling - also known as chicanery.  Derivatives and other mathematically complicated financial models offered the appearance of low risk with the rewards of high risk.  The idea amounted to “We’re so smart, we have such great financial models that we’re all going to get insanely wealthy.”  And a lot of people did.  However, these financial products have with them an interesting down side - when they stop making money, they crash and crash hard.  Remember BCCI going broke?  It was derivatives.  (A quick working definition of derivatives - you were buying the right to buy something, you weren’t buying the actual thing itself.)

How does this connect to mortgages?  As Pearlstein explains:

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new — they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches — those with the lowest credit ratings — were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

This is where the chicanery came in.  Using very complicated financial models - the kind very bright people dream up - with equally complicated assumptions, the banks dressed up a bunch of somewhere in the middle mortgages as AAA mortgages.

The complicated web of relationships between banks, mortgage companies, insurance companies and credit agencies guaranteed that the inevitable crash - when it came - would resonate across the entire financial world. 

Pearlstein concludes:

If all this sounds like a financial house of cards, that’s because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That’s not just my opinion. It’s why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets . . .

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it’s a good bet that it’s way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

By the end of 2004, George W. Bush was the first president to preside over an economy that posted a net job loss since Herbert Hoover.  It looks like this will be the first time since the Great Depression that housing in the US will actually lose value.  Great record huh?

But it’s not just the fault of the Republican incompetents who refuse to believe in regulating industries.  A lot of otherwise very smart people convinced themselves they could outsmart the system.  They played with fire.  They convinced themselves that housing prices would always rise.  That bad mortgages could be transformed into good ones because the value of the house would go up.  That even if some went bad, their complicated deals would insulate them and others from the problems.  They convinced themselves things were better than they really were - precisely because the system rewarded them with massive incomes.  And they told themselves - and convince a lot of people including policy makers - that things were going so well that the government didn’t need to worry about regulating the industry.

There were a lot more bad mortgages than the very smart people told themselves were there.  Which translates into a lot more things that have gone wrong than the very smart people expected.  It’s not chain reaction - it’s much more subtle and potentially more devastating - interconnectedness.  You have a web of financial systems and companies tied together, using similar models and assumptions all trapped with similar assets and no one able untangle the mess.  Each negative event is reinforced, amplified and spread into the system.

Scary enough in and of itself, this is a key portion of the US economy.  At what point does it push the entire economy into recession?  What is the tipping point of an already weakening US economy?  Have we passed it?

This entry was posted Thursday, December 6th, 2007 at 5:43 pm and is filed under Economic Exploitation, Economy, Republicans. You can leave a response, or trackback from your own site.