The Meaning of "Monty Python and the Meaning of Life"
Robert Waldmann
Barry Ritholtz argues that the problem with mortgages was underwriting standards and not securitization. He appeals to the very great authority of Monty Python. Click the link.
Ritholtz seems not to be familiar with this new idea in economic theory called “Nash equilibrium”. Over -rated yes. Totally irrelevant not so much. One can not assume that underwriting standards are exogenous. If there had been no MBS, no firm would have underwritten those mortgages. It was exactly because it was possible to blend them, and then sell them to people who didn’t spin the mortgage tapes before buying, that the mortgages existed in the first place.
Let me work with his analogy. First, while I have great respect for the Monty Python team, few people have been killed by canned Salmon. Even blended into mousse, it kills fairly quickly and can be tracked back to the canner. The way bacteria work is that if you mix some contaminated stuff with other stuff you have trouble for sure. It doesn’t work that things seem fine until people notice.
At a way lower cultural level than Ritholtz I appeal to road runner cartoons. Wile E. Coyote runs along in mid air until he notices. Then he falls. As noted by everyone, this is the way financial markets really work. The non Monty Python quality humor is based on the fact that gravity doesn’t really work that way. Neither do bacteria. Analogies between rotten mortgages and rotten Salmon fail for this reason.
Notably, the ingredients in the Salmon mousse are few enough that the dead diners immediately know what went wrong when death points at the mousse. That’s not the way MBS work let alone CDOs of MBSs or CDOS of tranches of CDOS.
A better analogy would be making hamburger. Bits from hundreds of steers end up in the same package at the supermarket. If one bit has E. coli on it, you can get sick. If they tried to sell you that bit, you wouldn’t buy it because it would stink. However, mixed in with hundreds of uncontaminated bits of beef, it doesn’t stink.
Is there a hamburger problem? Yes there is. One is much more likely to get food poisoning from hamburger than from unprocessed meat. Is the solution special regulation of hamburger? It sure is.
I’m just a half-trained bookkeeper, but to me the mortgages were a problem that could have been digested by the markets. The securitizations could not be digested by the markets, which caused the meltdown and the bailout.
Am I wrong?
Which half?
I am quite familiar with the Nash equilibrium — I’m not sure it is applicable here.
Why?
Securitization had existed for decades prior to the collapse with no serious consequences. It wasn’t until we had ultra-low rates came about, followed by the Lend-to-securitze model.
Once that was given the A-OK by Alan Greenspan (they were “Innovators”) — who as Fed Chief, had the resposibility to supervise these nnon-bank lenders, but didn’t — was the junk mortgage problem an issue for securitizers.
Garbage in, garbage out . . .
And needless to say, if the hamburger quality raters were paid by the slaughterhouses, and they took the position that they did not want to know what quality of meat was going into the hamburger, disaster would result.
Of course, one would imagine that the corrupted meat raters would be put out of business. And that the manufacturers and sellers of this poisonous meat would face criminal charges.
Here’s a timely analysis from Gretchen and Louise over at the NY Times, from today’s (2/6/2010) edition:
http://www.nytimes.com/2010/02/07/business/07goldman.html?hp
It helps to understand that some thing stinks in the entire affair, and that some bank got away with some very questionable business practices. How this doesn’t rise to the level of out right fraus puzzles me.
It came about because of the housing bubble and then became self fulfilling as there was more demand for mortgage backed securities which lead to there being new ways to supply them through non-banks. If there wasn’t this huge demand for them MBS would still be just a way for individual banks to mitigate idiosyncratic risk. But once they went from a banking instrument to a finance instrument is when they blew apart.
I’m with Barrry on this one.
There are some things during the “Internet bubble” that “everybody” knew. An IPO run by Goldman: try to get into it. An IPO run by Bear: not so much. If you could get Goldman to lead your IPO, you were good enough to be a Goldman IPO.
Similarly, up until Daniel “Son of Roger, Acts like Harry” Mudd, GSE-created MBSes were higher quality than (*sigh*) Bear or Lehman MBSes. For the same reason: if you couldn’t sell your Whole Loans to a GSE, one of the IBs would buy them and securitize them.
It wasn’t that people didn’t know something was wrong: Dean Baker sold his DC condo around the same time the GSE share of the MBS origination market fell below 80%. As with the Ritholtz “but for”: if Fannie doesn’t move into Muddville, the death of the market (Hallowe’en 2006) happens much sooner. The problem is that the Angus (GSEs) gets turned into cheap chuck just when the market is starting to get saturated.
That the root of all this is a lawyer at Wells Fargo who lobbied long and hard so that his firm could “do the things Fannie and Freddie do”–and which firm and others then proceeded to do things Fannie and Freddie never had before–is generally ignored. And that may or may not be correct.
But what is clear is that the contamination of the GSEs in an attempt to regain “market share” from a dubious business model is not a case of Nash Equilibrium so much as it is market segmentation that became blurred and distorted for short-term reasons, many of which were sold to supposedly long-term investors (e.g., pension funds).
The first traces of the salmon mousse were clear to Dean Baker. The infection followed Mudd into Fannie. And much of the collateral damage has been done to those who–as with the movie, and the part of the analogy with which Barry should have finished–did not have the salmon mousse in the first place, but are suffering the fallout of the systemic destruction and refusal on the part of the industry and the Administration to deal with the full extent of the problem.
Robert,
It’s more a case of hoping that all the borrowers would behave in a way that they would hold their securities until maturity and make all their payments on time. That would be great. But in life, stuff happens. Tranches were never intended to do anything with the composition of the securities in a pool but rather to prioritize who has to eat bad outcomes first, based on their preference trading off risk against higher returns. For instance, a planned amoritization class tries to deal with borrowers repaying their mortgages off early. Insurance companies with long term obligation don’t like this. However, another class of investor may be willing accept this sort of risk for higher return. So now the insurance company gets what they want and the speculative investors get the deal they wanted. This all resulted in more loanable funds being made available. That’s a good thing.
and matching them with lenders willing to accept the risk of those paying off early, and allocating
Planned Amortization Class
This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments.
Planned Amortization Class (PAC) bonds have a principal payment rate determined by two different prepayment rates, which together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher PSA will have declined enough that it will yield a lower prepayment. The PAC tranche will receive whichever rate is lower, so it will change prepayment at one PSA for the first part of its life, then switch to the other rate. The ability to stay on this schedule is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments to prevent extension of average life. However, the PAC is only protected from extension to the amount that prepayments are made on the underlying MBSs. When the principal of that bond is exhausted, the CMO is referred to as a “busted PAC”, or “busted collar”.
Target Amortization Class (TAC) bonds are similar to PAC bonds, but they do not provide protection against extension of average life. The schedule of principal payments is created by using just a single PSA.
Robert,
It’s more a case of hoping that all the borrowers would behave in a way that they would hold their securities until maturity and make all their payments on time. That would be great. But in life, stuff happens. Tranches were never intended to do anything with the composition of the securities in a pool but rather to prioritize who has to eat bad outcomes first, based on their preference trading off risk against higher returns. For instance, a planned amoritization class tries to deal with borrowers repaying their mortgages off early. Insurance companies with long term obligation don’t like this. However, another class of investor may be willing accept this sort of risk for higher return. So now the insurance company gets what they want and the speculative investors get the deal they wanted. This all resulted in more loanable funds being made available. That’s a good thing.
Barry:
I don’t know the Nash story other than the one in which Russell Crowe pertrayed. I agree MBS have been around for a coon’s age; but, I don’t believe one could sell junk as triple AAA rated until much later in the game.
CDOs came about at Drexel Lambert/Milken. CDS were an off shoot of Morgan. Ultra low rates for junk would have still been junk unless they could find away to hide the risk. CDS insured CDO did the trick and then we could have ultra-low rates as it didn’t matter what was in the CDO as they could be tranched and rated AAA.
And yes Greenspin did the old wink-wink as he believed the market would regulate itself. Well it didn’t . . . It was garbage packaged as cavier and sold as cavier.
OT: Why isn’t Robert or someone discussing the pending credit crisis spreading around Europe?
How do these developing stories go unreported on AB?
Loanable funds???
Funds are not “made available” for loaning. You’ve made this mistake a zillion times in your posts and its not a trivial matter. Loans are demand driven not supply of funds driven.
A person making a million dollars a year and seeking to borrow $2,500,000 on a $7,500,000 home and willing to pay 7.5% will NEVER be told “Sorry sir we cant lend you the money, we dont have any”
You really have no coherent view of our financial system do you?
Clearly if standards had not collapsed prices would not have run up as much. The collapse of standards was due to the fact that those making the mortgages no longer had skin in the game, both the mortgage companies and the brokers. Long term mortgage brokers should be paid like old time life insurance salesmen, so much at closing and so much 1 and 2 years out if the mortage is still performing or paid off. Mortgage companies need to keep a percent of the stuff they push out to keep them honest.Further put a 3 year push back rule in place where as an originator you must keep reserves to handle mortgages that default before 3 years, and must take them back. (It may drive a lot of mortgage companies out of the business but so be it)
What we managed was to create a system where those who made the decisions took no risk. (Other than very long term risks of the whole system blowing up).
In summary both ideas are right, in that securitization allowed the lower standards because those making the decisions did not have the skin in the game. The lower standards led to the higher default rate.
Movie Guy:
Not to be mean; but, maybe Robert, or someone, has a life too?
I didn’t even EAT the mousse!
Greg,
Loans are demand driven not supply of funds driven.
You don’t get it. The packaging made making loans more attractive to those with loanble funds. An insurance company with long term obligations would not want to have to deal with reinvestment risk. But now you create a new security by creating a priority scheme on who gets paid back first. So you could create a security where the insurance company’s investment would be protected in such a way the maybe 60 or 70 percent of the entire pool would have to be paid back before the insurance company’s funds would be paid back early. This makes the insurance company more likely to invest in these funds. This increases supply. So your main point is wrong.
You are referring to PURCHASES of securities and talking about LOANS. You are the one who is confused. An insurance company buying CDOs is not LENDING anything. The presence of large amounts of insurance company or Chinese govt money certainly provided DEMAND for investment products, low interest rates from Greenspan made Treasuries a worse deal and bogus AAA ratings made these real estate loans seem as safe as T Bills, but this was not funds for LOANING. You make it sound like THIS was the money that was loaned to homeowners and it most definitely was NOT.
Just because in the static it looks the same as if the money was loaned from those sources the operational fact is NOT trivial. If you misunderstand (or deliberately misrepresent) the dynamics of the situation you will never figure out how to fix it.
In your “fable” the answer would be, “Just stop those mean ole Chinese and Insurance companies from saving money, that way they cant find poor people to give it away to”
In the real world the answer is “Make sure loans are made which are commensurate with income, when they are securitized use INDEPENDENT raters of risk not ones that are paid by the packagers and dont permit folks who have no real skin in the game to simply place bets on the defaults of these instruments”
This wasnt a “Too much money to loan problem” It was a “not enough integrity to be trusted with such vast amounts of wealth problem”
Is there a hamburger problem? Yes there is. One is much more likely to get food poisoning from hamburger than from unprocessed meat.
The main reason is that bacteria spreads from contaminated to uncontaminated meat. Bad mortgages do not infect other mortgages. So the analogy is false.
The real reason for pooling mortgages is diversification, which reduces risk.
Greg,
An insurance company buying CDOs is not LENDING anything.
This is a stupid statement on your part. Of course the insurance company is loaning their funds through a financial intermediary. And because now the CDO has reduced repayment risk the insurance company becomes willing to hold mortgage backed securities which they were not before. Ergo the supply of loanable funds in the mortgage backed security market is increased.
I wonder what’s wrong with you. Were you living in a bio-dome and never got all those phones calls from brokers trying to sell mortgages in the years before this recession? Those phone calls prove my point that the bubble and subsequent crash were from an oversupply of loanable funds. The system created too much supply, so all the bozos fixated on derivatives and complexity don’t know what they’re talking about, and any solutions coming from them will be bad ones.
Run,
Talking about having a life a no no for posting on a forum
Sammy,
Maybe, the diversification did not reduce the risk.
The bundles were not properly rated and when the “market” realized the AAA were not even C—
The scam unravelled as they say.
An MBS covered by a CDO makes the CDO go down with it.
sammy,
I suspect bad mortgages do infect other mortgages. If you bought a home you could afford and everyone on your block forecloses, a) your home loses value and b) your neighborhood becomes a less desirable for you to live in.
Last year the ex-GF and I bought two houses, one to live and one to rent out. We made an offer on a third home (to rent out) a few days ago. In each case, one of the things to which we paid a lot of attention was whether the neighborhood looked stable. We passed on a number of houses that were one of three or four for sale on the same block. Good tenants like stable neighborhoods too.
run,
Talking about having a life is a no no for posting on a forum