Wednesday, August 29, 2007
Tuesday, August 28, 2007
Credit Snafu - Part 4
Alas, these broken mortgages... where did they go? Firstly, the mortgage brokers that initiated the mortgages promptly sold them to large banks. These banks, of course, had no desire to burden their own balance sheets with risky mortgage paper, so they had to sell them also, but who wants to buy a subprime loan with a high risk of default? There are those with a risk appetite but not enough to consume all of the loans
A solution was devised. The banks can create what are called Collateralized Debt Obligations, or CDOs. How do these work? First, you get together a whole lot of subprime loans. Then, you sell shares of these loans to other people. But, here is the trick, not all shares are created equal. Some are "senior" shares, and others are "junior" shares. What is the difference? When one of the many subprime loans defaults , it is assigned to the most junior shares, and when a mortgage payment comes in, it is first assigned to the senior shares. These share levels are called "tranches", and let's suppose there were five evenly sized tranches for the purposes of an example. If 40% of the subprime mortgages in the CDO defaulted, only the two most junior tranches would feel any pain. The three most senior ones would continue to get paid, and would not have any loss of assets. For this reason, the senior tranche could get a AAA credit rating, while the most junior tranche became known as the equity tranche, or in Wall Street lingo, "toxic waste".
To close, let's look at the reasons why this was done. Because a AAA credit rating has less risk, it can sell for a higher price (as was discussed in Part 1 post on risk and reward). Since a subprime loan is risky, it can be bought for a lower price. The difference between these prices can be profit.
Of course, that leaves you holding some "toxic waste". What to do? Buy insurance! This is called a credit swap. A bank can create a AAA quality CDO tranche, sell it for profit, and then pay someone else to absorb the losses if the toxic waste experienced defaults (like when you pay someone else to cover your losses in the case of a house fire).
And, since we all know that house prices go up 15% a year forever, that insurance can be bought very cheaply (wink, wink).
A solution was devised. The banks can create what are called Collateralized Debt Obligations, or CDOs. How do these work? First, you get together a whole lot of subprime loans. Then, you sell shares of these loans to other people. But, here is the trick, not all shares are created equal. Some are "senior" shares, and others are "junior" shares. What is the difference? When one of the many subprime loans defaults , it is assigned to the most junior shares, and when a mortgage payment comes in, it is first assigned to the senior shares. These share levels are called "tranches", and let's suppose there were five evenly sized tranches for the purposes of an example. If 40% of the subprime mortgages in the CDO defaulted, only the two most junior tranches would feel any pain. The three most senior ones would continue to get paid, and would not have any loss of assets. For this reason, the senior tranche could get a AAA credit rating, while the most junior tranche became known as the equity tranche, or in Wall Street lingo, "toxic waste".
To close, let's look at the reasons why this was done. Because a AAA credit rating has less risk, it can sell for a higher price (as was discussed in Part 1 post on risk and reward). Since a subprime loan is risky, it can be bought for a lower price. The difference between these prices can be profit.
Of course, that leaves you holding some "toxic waste". What to do? Buy insurance! This is called a credit swap. A bank can create a AAA quality CDO tranche, sell it for profit, and then pay someone else to absorb the losses if the toxic waste experienced defaults (like when you pay someone else to cover your losses in the case of a house fire).
And, since we all know that house prices go up 15% a year forever, that insurance can be bought very cheaply (wink, wink).
Thursday, August 23, 2007
Credit Mess - Part 3
Of course, all of the problems that are being experienced in the lofty world of high finance come from very concrete root problems. So, this time, I wanted to discuss the very foundation of the recent troubles.
After 2001, the Federal Reserve lowered interest rates to 1%. This is ridiculously low, since inflation runs around 2.5%. Now, a lower interest rate could mean a lower house payment, but many people buy houses by asking the question, "How much house can I afford?" And they answer the question in terms of a monthly payment, which means that with a lower interest rate the same monthly payment can by more. So, people spent more, and more people spent.
This surge in demand, and the ability of people to pay more for a house, started a housing boom. A few years in, houses were going up faster and faster. People began to buy investment properties, either to rent or to "flip" (which is when you sell after holding for a short period of time), which added even more demand and drove prices even higher.
When people started to worry that houses historically have pretty much just kept up with inflation, and might be overvalued, others pointed out that the median U.S. house price hadn't fallen since the 1930's in the Great Depression. We weren't in a depression, so the party kept on going.
Everyone was getting rich. The mortgage brokers, the folks who actually help you fill out the paperwork and find a lender for you, were getting lots of fee income. So were the realtors, and the appraisers, and the inspectors, and everyone else involved.
Soon, the boom had exhausted the "normal" market, everyone who wanted a house had one. Mostly the folks who were left were not the sort that usually get loans, but after a boom period, expectations rise. The extraordinary becomes the routine, and there is great pressure to keep the good times rolling. What to do?
The list of things done ranges from stupid to fraudulent. Among them were loans called "NINJAS", which stands for "No INcome Job or Assets". Some lenders asked borrowers to sign the bottom of blank paperwork, and the numbers for income, house value, etc. were filled in later so the loan would go through. People were given loans not just for the price of the house, but for 120% of the price of the house, because it would surely go up another 20% and people "need" cash to furnish their homes. People signed up for adjustable rate mortgages (or ARMs) which start out with really low teaser rates, but a few years later "reset" to a much nastier one (which is happening now). And, appraisers valued homes well above their real value to justify larger loans.
All this is just the beginning of the story, because these irresponsible behaviors led to a whole host of other problems that I'll discuss shortly.
After 2001, the Federal Reserve lowered interest rates to 1%. This is ridiculously low, since inflation runs around 2.5%. Now, a lower interest rate could mean a lower house payment, but many people buy houses by asking the question, "How much house can I afford?" And they answer the question in terms of a monthly payment, which means that with a lower interest rate the same monthly payment can by more. So, people spent more, and more people spent.
This surge in demand, and the ability of people to pay more for a house, started a housing boom. A few years in, houses were going up faster and faster. People began to buy investment properties, either to rent or to "flip" (which is when you sell after holding for a short period of time), which added even more demand and drove prices even higher.
When people started to worry that houses historically have pretty much just kept up with inflation, and might be overvalued, others pointed out that the median U.S. house price hadn't fallen since the 1930's in the Great Depression. We weren't in a depression, so the party kept on going.
Everyone was getting rich. The mortgage brokers, the folks who actually help you fill out the paperwork and find a lender for you, were getting lots of fee income. So were the realtors, and the appraisers, and the inspectors, and everyone else involved.
Soon, the boom had exhausted the "normal" market, everyone who wanted a house had one. Mostly the folks who were left were not the sort that usually get loans, but after a boom period, expectations rise. The extraordinary becomes the routine, and there is great pressure to keep the good times rolling. What to do?
The list of things done ranges from stupid to fraudulent. Among them were loans called "NINJAS", which stands for "No INcome Job or Assets". Some lenders asked borrowers to sign the bottom of blank paperwork, and the numbers for income, house value, etc. were filled in later so the loan would go through. People were given loans not just for the price of the house, but for 120% of the price of the house, because it would surely go up another 20% and people "need" cash to furnish their homes. People signed up for adjustable rate mortgages (or ARMs) which start out with really low teaser rates, but a few years later "reset" to a much nastier one (which is happening now). And, appraisers valued homes well above their real value to justify larger loans.
All this is just the beginning of the story, because these irresponsible behaviors led to a whole host of other problems that I'll discuss shortly.
Monday, August 20, 2007
Credit Crunch - Part 2
I'll follow up with a longer post, but this is an interesting graphic from CNN. Jumbo mortgages are $417,000 and higher, and by law are not allowed to be insured by Freddie Mac and Fannie Mae, which are governmental institutions that guarantee to purchase mortgages that are "conforming", which means the borrower meets certain requirements and that the loan is a 30 year fixed rate mortgage for no more than 80% of the houses appraised value.
The government's guarantee for the conforming loans amounts to a serious reduction in risk for the lender if the borrower can't pay. You can see the risk-reward relationship clearly demonstrated in this chart.
Thursday, August 16, 2007
Credit Crisis (Part 1?)
Partly just to think this through on my own, I've decided to write a series of posts to see if I can coherently understand and explain the current credit and liquidity crisis on Wall Street. Here goes (remember that what follows is my best understanding):
The root cause of the whole mess is that there was a lot of money trying to find a good return, and investors started to ignore risks while seeking higher returns.
In fact, that is a good place to start. We've all heard people talk about "risk and reward". There is an intuitive sense to it: if you want to win big you have to take risks. Let's think through how that occurs in investing.
Suppose that we have an investment opportunity that provides an income of $100 per year. How much should we pay for that investment? In order to be rational about it, we have to understand the risks. For instance, is it $100 every year with high certainty? Or just once in a blue moon? Is $100 a good year, average, bad? All these help us understand the "quality" of the return.
In our free market system the price of this investment is set in the market, where there are buyers and sellers. If the return is pretty risky, the investment will not be as attractive as another investment that returns the same amount much more reliably. So, what happens? The price of the risky investment will have to be lower to attract a buyer. In other words, why would anyone pay the same price for an uncertain $100/yr as they would pay for a guaranteed $100/yr?
Perhaps people are willing to pay $1,000 for the low risk $100/yr, which is a return (or yield) of 10%. If people won't pay as much for the riskier version, let's say $500, then they would have a yield of 20%. Voila! The higher risk version has a higher return (20% vs 10%), and the law of risk and return is in effect.
It is important to notice that the relationship between the risk taken and the return (or reward) received is determined by the price the buyer paid for the investment. We will return to this.
To be continued...
The root cause of the whole mess is that there was a lot of money trying to find a good return, and investors started to ignore risks while seeking higher returns.
In fact, that is a good place to start. We've all heard people talk about "risk and reward". There is an intuitive sense to it: if you want to win big you have to take risks. Let's think through how that occurs in investing.
Suppose that we have an investment opportunity that provides an income of $100 per year. How much should we pay for that investment? In order to be rational about it, we have to understand the risks. For instance, is it $100 every year with high certainty? Or just once in a blue moon? Is $100 a good year, average, bad? All these help us understand the "quality" of the return.
In our free market system the price of this investment is set in the market, where there are buyers and sellers. If the return is pretty risky, the investment will not be as attractive as another investment that returns the same amount much more reliably. So, what happens? The price of the risky investment will have to be lower to attract a buyer. In other words, why would anyone pay the same price for an uncertain $100/yr as they would pay for a guaranteed $100/yr?
Perhaps people are willing to pay $1,000 for the low risk $100/yr, which is a return (or yield) of 10%. If people won't pay as much for the riskier version, let's say $500, then they would have a yield of 20%. Voila! The higher risk version has a higher return (20% vs 10%), and the law of risk and return is in effect.
It is important to notice that the relationship between the risk taken and the return (or reward) received is determined by the price the buyer paid for the investment. We will return to this.
To be continued...
Monday, August 13, 2007
Interesting
I found this graphic from the Economist sort of surprising. According to the article, there were 58 million deaths in 2005, which, with a world population of 6 billion people, works out to less than 1% of the population dying that year. When you consider all the wars, diseases, accidents, and crime, that seems amazingly low to me (in a good way!)The point of the article was that "rich world" diseases account for the majority of world deaths, which means they're more global than you might think.
One last note: diabetes, though only representing 1.9% of deaths in 2005, accounted for 11% of U.S. medical expenditures in 2002, which amounted to $92 billion according to the American Diabetes Association.
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