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Sunday, Nov 8, 2009
You say:
"And strictly speaking, a derivative is not a doohickey. It is a financial instrument. Can we be grownups here, please?
A pool of mortgage loans grouped together into a security that can be traded on markets is a derivative. . . . Derivatives belong to what should be called -- but never is -- the unreal economy, a place where speculators make bets about what will happen in the real economy.
A securitized pool of mortgage loans may be a derivative, but more importantly it is a basket or portfolio security."
When you want to pick on other peoples' accuracy you need to be careful about your own. A mortgage backed security is not necessarily a derivative. A derivative is something that takes an issued security and turns it into a different tradeable instrument. The most basic derivatives are zero coupon bonds and strips -- to explain, a mortgage back security came in principle with an printed bond and dozens of cut off coupons on the bottom for the interest. This security could be converted into a derivative by striping off the coupons and selling them separately from the bond -- the zero-coupon-bond entitled the holder to collect the principle at a future date, the coupons just the interest.
Other derivatives are made by combining instruments together, or severing the rights for instruments in various ways.
You also say:
". . . the same games that Wall Street played with subprime are likely being played in every sector of the economy.
Every sector, huh? What is your evidence for that?"
Actually, there is a fair amount of evidence that similar games have been played in many sectors, e.g. private equity, hedg funds, etc. The issue is tranches (where you accurately indicate that the issue matters.) Debt is being split up into prime and sub-prime by splitting a "basket" of debt up, so that one group have a preference for payment (they get paid first) and the other get paid later. Assuming arguendo that say 20% only goes bad, the preference debt holders will always get paid, and the debt they hold deserves its AAA+ rating. The problem is, well, it all depends on how you slice the loaf, and how good or bad the loaf as a whole is. There is a lot of reason to believe that there are problems with a lot more debt than mortgage debt.
Second, baskets of assorted sub-prime debt have been assembled in many markets, which consist of packaging bonds from multiple transactions and then arguing that the combination diversifies risk enough to justify a better, even prime rating. The latter matters because many major sources of capital, especially pension funds, are often prohibited from investing any or more than a small proportion of their capital in sub-prime securities.
And it is that last point that has been the big driver and may mean that the sub-prime prime problem is widespread. There is a lot of capital out there looking for high returns, that can only be invested in what is technically prime instruments -- hence the huge incentive to make instruments look prime that are, well, perhaps not.
A final comment -- if you think the US has a lot of sub-prime mortgage problems, wait for the UK's dodgy mortgage problem to hatch -- UK lending practices have been suspect for at least 5 years.
the problem is not just with subprime mortgages, there was a real change in qualified borrowers lending practices also. The old rule of thumb was you qualified for double your gross income, but suddenly people were allowed to qualify for 4 or 5 times their income. A friend of mine moved to North Carolina and was shocked to see people she worked with all buying $300,000 houses. She was wondering how they did it, well when she went to the bank they qualified her for $250,000-300,000. My sister and brotherinlaw qualified for over $500,000(all of these examples are middle class individuals with secure jobs, so hardly subprime) The rationale given was with low interest rates, you could break the old twice rule of thumb (though it is interesting that those same low interest rates in the fifties and sixties did not justify such large multiples ), we have just seen the beginning of our problems, add to that, the outstanding debt on credit cards, the ride has just begun
First of all, investing and betting are not the same. Risk is a component of both, but whereas speculating implies a simple end goal--that the purchased security will rise in value--investing implies that regardless of the outcome, the investor will own something tangible. Also, with an investment the invested money will be used for some purpose by the recipient whether it be an acquisition, another investment, or a loan origination. That's why betting on a football game is not the same as investing in a football team.
The writer has done a lot research but misses on many of the important nuances of structured finance. First, in the way he describes a derivative, a mortgage loan would itself be a derivative. It's not. It's debt. Debt is used to finance an asset. A house is an asset. A pool of loans is an asset. A pool of mortgage backed securities is an asset. You can finance these assets by using debt. Also, a mortgage backed security is not referred to as a CDO.
Everybody is so quick to blame Wall Street for all of the country's financial ills. I would have to agree that greed is the main factor in this bubble. It's greed by all parties. Structured Finance itself is nothing so magical. It does not create value. It's just a way to finance assets. It's when people stop worrying about the risk...that someone will default or can't make a payment, that it runs amok. This goes for all credit markets.
They can serve as a form of insurance--I can hedge against currency changes by buying options, say. Someone can lock in a price of a commodity like oil. That's the other side of the same coin.
This was a great article, though. One area which isn't touched is how much of these gambling strategies are controlled by algorithms through computer programs. As a programmer, I can tell you that every programmer has a "D'oh" moment, where you smack yourself on the forehead and go "why would you do that?" to a user.
When you have programs controlling trillions of dollars, those D'oh moments can be pretty bad. Witness the LTCM fiasco.
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