On Credit Default Swaps and The Mess We're In

[billroper]

By way of The Volokh Conspiracy, here's the best explanation I've seen of how Wall Street managed to convince itself that the rules about systematic risk had been repealed.

Comments

I love reading Felix Salmon:

[jrittenhouse.livejournal.com]

Along with the laws of gravity and the gods of the copybook headings. I liked this line particularly:

"In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop."

or

"But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up..."

or

'Why didn't rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO...Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked."

Sure thing. They loved all the easy money based on sure-fire models that had no constant basis in reality, and built a ridiculous bubble, and congratulated each other for finding an endless source of wealth immeasurable.

[madfilkentist]

Very interesting and enlightening reading, but blaming the mortgage collapse on investors who blindly followed a formula doesn't get to the root. The underlying questions are: Why did the risk in mortgages suddenly increase across the board, and why did investors across the board fail to anticipate it or at least make a greater allowance for changes in the model? And why did this happen in the mortgage market and not, say, in the auto insurance market?

As a comment by "Javert" on Volokh puts it: "Some second handers who didn't know what they were doing, blindly following others who didn't know what they were doing. But, while bad managers can wreck a company, only bad politicians can wreck an entire economy." This comment cites the Fed's lowering of interest rates to 1%, as well as "the twin government backstops of Fannie and Freddie, and the injection of the government's 'affordable housing' policy."

I keep thinking of ways that the government has been pushing people to put their money into dangerously large mortgages. Capital gains on a personal residence are largely tax-free, while most other capital gains aren't. Mortgage interest is tax-deductible while other interest isn't. There are various loan guarantees. Some of these factors have existed for a long time, while others increased in the past ten years. The result was a bubble produced largely by rational behavior (though not on the part of the policy-makers).

The investors' assumption that changes in risk were predictable surely plays a part, but it doesn't explain why there was so much hidden risk to begin with. Government policy explains that.

[billroper]

Thanks. Personally, I think you start the ball rolling downhill when you tell banks that they must issue loans in certain areas and to certain classes of borrowers -- regardless of quality! -- or be in violation of the Community Reinvestment Act and you actually put some teeth into the penalties. The banks, being no dummies, want to lay these loans off, so getting Fannie and Freddie to buy them works nicely.

As far as your first comment about the underlying questions:

Why did the risk in mortgages suddenly increase across the board? Actually, it didn't, but the risky mortgages that were buried in the so-called AAA tranches did become a lot riskier when:

1) The Fed raised interest rates to try to control inflation. This caused ARMs to start resetting at higher rates which the borrowers couldn't pay.
2) These same borrowers couldn't, in some cases, get out into a fixed rate loan they could afford, either because the fixed rate was still too much or because the small amount of equity they had in their homes was wiped out by a small downward movement in housing prices.

Why did investors across the board fail to anticipate it? Some did anticipate it. Those banks are in relatively good shape. They didn't make as much money during the last five to ten years as some of the banks that are currently in deep kimchee, but they're a lot better off now.

Why didn't this happen in the auto insurance market? Because the insurers there weren't forced to write bad policies. Really bad (or unlucky) drivers usually end up in their state's high-risk pool and pay terrible rates for minimal insurance.

In the mortgage insurance market, there was a lot of incentive to spin straw into gold. When you can convert risky assets into AAA assets by "insuring" them, well, there's money to be made! But the insurers badly underestimated the risks involved, because real estate prices only go up, right? :) Had the insurance been correctly priced, life would be very different right now.

[shrewreader.livejournal.com]

Black-Scholes 2.0. Assuming away irrational behavior on the part of investors does not make it so.

(You'd have thought we'd have learned that in '97-'98. Apparently not.)

[kevinnickerson.livejournal.com]

Interesting article. Thank you for the pointer.

Once upon a time I read the Tobias "The only investment guide you'll ever need" (IIRtTC). One thing I remember he mentioned in that was for how little of American history was it true that a house outpaced inflation and why were you counting on it now? This was 20 some years ago.

[patoadam]

Warren Buffett agrees:

"The stupefying losses in mortgage-related securities came in large part because of flawed,
history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas."