Super Senior

YOU CAN'T HANDLE THE TRANCHE!!

I can't say I can get my head around all of this at once. But this does seem to drive the final nail in the coffin of the absurd wingnut claim that the crisis was caused by the Federal government forcing banks to make bad loans to people who had no business buying homes, since it was quite the opposite: there was such a voracious market for the bad loans that (non)banks were effectively having to create the financial equivalent of batches of bad loans out of thin air in order to satisfy that market, because there weren't enough actual people with bad credit who could be persuaded into buying houses and taking out mortgages.

The impact on the real economy was in driving down interest rates on riskier assets - the default protection / insurance made it theoretically safer to holder more and riskier debt. That in turn drove down spreads on riskier debt, making it cheaper to finance projects etc.

Actually worked reasonably well through perhaps 2004/2005.

But yes, for the commentator supra re the lunatic party political claims by the US right that the US Gov forced bad lending etc, that is pure bollocks - even more divorced from reality than the Leftists fulminations about fraud etc. in this particular crisis.

The very fact you are Trotskyite rather amuses, talk about Ponzi schemes.

In fact, securitisation schemes proved to be rather sustainable, as evidenced by decades of ongoing securitisations, if properly managed. Financial engineering was useful, for a long period.

OK, so my abstracted take on this is the following:

Start with standard mortgages. A mortgage is basically a stream of money.
We have a house. We ("society") claims the house is worth a million dollars.
- the owner sells the house and gets a million dollars from the bank
- the buyer promises to deliver to the bank a stream of money that, over 30 years, corresponds to a million dollars plus interest
- the bank is out a million dollars right now, but is promised a stream of money in the future to make up for that.

Oops, society changes its collective mind --- now we think the house is only worth half a million dollars.
- the ex-owner is sitting pretty, since he has his million dollars [but see later]
- the buyer concludes that it makes no sense to continue paying his expensive mortgage for a house that is worth much less, since he could rent or whatever far more cheaply, so
- the bank is out a million dollars, with the future stream of money run dry. (Presumably the bank now owns a house worth half a million dollars, which is both less than a million dollars, and an illiquid asset.)

So what we have seen is
- half a million dollars worth of value that was based on collective delusion has disappeared. This is interesting but nothing special; It's just example of the fact that prices are not anything "real", they are society wide agreements, and like any agreements, they can change when society changes its mind
- the bank has taken the bulk of this loss.
- what about our ex-owner? Sure he is up a million, but chances are he bought a new house, so he again took the position of "buyer", and either bailed on his mortgage or is underwater but gamely paying each month because that is what responsible citizens like him do.
- so ex-owner's million dollars presumably then, ultimately goes to developers, and from the it goes a little to the original land-owner, some to construction people, some to marble cutters in Italy, and so on
- net result of all this money sloshing around is something like
+ lots more houses
+ money on sell side widely dispersed across the US and the world
+ losses on the buy side dispersed widely among people who bought a house, and CONCENTRATED among banks (or anyone else who owns that mortgage and thus was promised that stream of money over the next 30 years)

OK, now we construct a synthetic mortgage. Presumably what we now have is
- no house, no buyer, no seller
- someone, call him Happy, promising to deliver a stream of money over the next 30 years that matches the characteristics of a mortgage (and that, with the same frequency as real mortgages, stops paying if real mortgages stop paying)
- someone, call him Sad, delivering a million dollars NOW, in return for this promise of a mortgage-like stream of income over the next thirty years

So now what happens when the mortgage default rate rises?
- Sad is out just as much money as when a real mortgage fails. He is out his million dollars now, and all he has to show for it is a piece of paper that, presumably, is worth the average price of foreclosed homes, so, to match what we said earlier, about half a million dollars. (However, this piece of paper is still, presumably, a more liquid, more hassle-free asset than owning a real foreclosed house, so is ahead in that small respect).
- Happy should be very happy. He has a million dollars in his pocket, and a responsibility to, at some point in the future when foreclosure prices are settled, pay Sad half a million.

I believe this is all essentially correct as a summary of what happened, and it allows one to understand how any organizations that owned a large number of mortgages and mortgage equivalents has lost a whole lot of cash.

But the obvious question is, who is Happy, and where is his cash? In the case of the real mortgage, I think I presented a plausible story for how this cash is basically spread over the entire world, with only a few smart individuals doing especially well. (For example Mark Kleiman selling his house and shifting to a rented apartment.) However Happy is a few concentrated entities, and they're not spending the money on buying a new bigger house.

At this point I hit something of a roadblock in my analysis. I can tell you that what I imagine has happened NOW is something like this
- Happy spends his cash by buying a whole lot of stocks (which, when he bought them, were expensive)
- NOW Happy's stock's are worth half what he paid for them, so he's not quite so happy. (If Happy started off with zero dollars, he now has one-quarter of a million dollars worth of stocks, so he's still doing fine. However if he started off with, say, half a million dollars worth of stock, and, with that shrunk by a half, and with his new quarter million dollars of stock bought from his synthetic mortgage money, he's no better off now than a year ago.)

What is missing in the above story is the specific linkage between why our banks getting screwed should result in the stock market tumbling, and thus Happy getting screwed.
One possible hypothesis for this calamity is
- all major players thought exactly like I do --- there is a limited link between foreclosures and stock markets, so we can run risk models for each separately, and heck, we're doing fine by moving the money we make on the immediate sales of synthetic mortgages into the stock market
- BUT there IS in fact a strong link between these two when things get stressed enough, specifically: when all the entities that owned mortgages are no longer receiving their streams of income, they need to raise cash some other way, and in desperation they start to sell their stocks, and sell them at fire-sale prices, which then pulls down the entire stock market, and wipes the smile off Happy's face.

OK, people, is that about it, or have I omitted something important?

JamesonWhen my cousin goes to gamble at the track, he's not doing anything to increase economic production either, but that doesn't mean that the activity is inherently bad. A side bet is a side bet.

But your brother, unless he is a very unusual better, on the whole loses money from his betting. So let me modify my original statement so say that if parties are regularly making huge profits from a financial activity, then there is likely something suspicious going on.