[hotShot]

mike777, on Feb 3 2010, 10:25 AM, said:

I mean you may be correct but please say so....


1) owners of banks...loan reckess
2) management loan reckless
3_ loan officers loan reckless
4) borrowers reckless
5) government...lots of government....reckless.l....

so how does more laws help?????

Lets start:
3) Yes they get a bonus for every loan, even a reckless one
4) perhaps, they want the loan, they probably don't know yet that it's reckless.

2) Well they invented these bundled loan papers to sell the reckless risk to others and made insurances.

1) They implemented a board of director, why should the do something themselves?

5) What do governments know about economics. For decades it was always, "less regulation", "we need less regulation", "let the market forces sort that out".

We'll perhaps we would have been better off, if we had the market forces take care of those banks.... Some people need to touch the hot oven to learn it's hot.

[kenberg]

I only have to look at my own behavior to be skeptical of theories based on rationality. I am not confessing to insanity, but rather to a limited interest in market research. Take, just for a moment, two pillars of advice for investors: 1. Investigate before you invest 2. Diversify. Uh huh. Maybe (but unlikely) I can work up the ambition to thoroughly investigate one or two companies before plunking down some cash for their stock but if I have to invest in fifteen or twent in order to diversify I will not be investigating all of them thoroughly. Warren Buffett I am not.

Now to apply this to housing. I will say how things were. I know we cannot live in tge past but we may be able to learn from it. I forst bought in 1970 or maybe 1971. Housing prices were risiong faster than me salary and savings, it was very frusgtrating, a friend bought a townhous and that seemed reasonable. As it happened, prices continued to rise and so it was a good investment but the important point is that if prices did not rise I was living in a townhouse that I could afford, as long as I kept my job. Job loss is of course possible and will always be an unforeseen disaster, but minus that development, I could pay my mortgage and, perhaps, later move to a house. This was a stable situation.

Somehow the situation became unstable. Maybe discussing "reckless" or "not reckless" is the wrong approach. Blaming or absolving from blame is important only in so far as it helps with the fix. I assume we could all agree on the word "unstable". Somehow it developed that my solution, buying a townhouse if you cannot afford a house, has come to be seen as asking too much of people. Everyone is entitled to a house, a big house in a good neighborhood with good schools and so on. And if a guy can't afford it, then the banks will lend him the money anyway. I confess I do not know exactly who to blame for this but it is clearly unsustainable. But while admitting I don't understand the details of what happened, it is not crazy to take the financiers to task for this. They are the professionals, and when things go to hell they are the ones who were supposed to be on watch. There might be many reasons for the Redskins having a disastrous season, but it's the caoch that gets fired. He was supposed to take care of this.

Bottom line: "The loans weren't reckless" won't cut it. The situation spun out of control and led to disaster. Of course I would listen to those who have lived their lives in the world of mortgages and finance, but "not our fault" is an insufficient response.

[Al_U_Card]

Tantamount to "I was only following orders."

The issue of being able to understand the full impact and import of the various derivatives begs the question:

"If it doesn't make sense to me, should I be putting my money in it?"

And this definitely applies to the regulatory bodies of the industry, most of all.

[Winstonm]

Good stuff today from Barry Ritholtz at The Big Picture:

Quote

They’re back!

The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred.  As the mid-term election approaches, we should expect to hear more from this crowd.

The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors

The causative reasons for the crisis according to Ritholtz.

Quote

) Ultra low rates;
2) Unregulated, non bank, subprime lenders;
3) Ratings agencies slapping AAA on junk paper.

Why are these “But Fors?” But for these things occurring, the crisis would not have happened:

-If it wasn’t for ultra low rates, the housing boom would likely have been much more modest; further, bond managers would not have been scrambling for yield, and searching for alternative products to low yielding Treasuries;

-If it wasn’t for the sub-prime lenders, the credit bubble would not have inflated; further, millions of unqualified borrowers would not have been able to purchase homes they could not afford;

-If it wasn’t for the ratings agency fraud, the enormous market for this high yielding junk paper — mislabeled as AAA — would not have existed; further, the primary purchasers were firms that were only permitted to buy investment grade bonds. No A+ or better rating, no sale.

Hence, these factors are huge causative elements — BUT FOR them, there is no boom and bust, no crisis and collapse. Bond managers could not have owned all of these securitized sub-prime mortgages; the credit default swap market would have been much smaller, perhaps 1/10 its size; Sovereign wealth funds around the world could not have purchased all this bad paper; Iceland does not collapse. That is these are the big 3 — why I label them the prime cause of the crisis.

What happened at AIG?

Quote

Dinallo: What I Learned at the AIG Meltdown


1. Insurance policyholders at AIG were protected by reserves that each of the insurance companies are required to hold by state regulation;

2. Unregulated use of credit default swaps and other high-risk instruments by AIG Financial Products, [an unregulated] noninsurance unit with wildly insufficient reserves, caused AIG to stumble and threatened the financial system.

3. By September 2008 the Federal Reserve acted to protect the financial system from what it believed to be an imminent risk of catastrophic damage from AIG Financial Products;

4. In November 2008, when the Fed restructured its AIG financing, including the termination of tens of billions of credit default swaps and the widely criticized purchase (at par) of the underlying securities, the Fed had over $70 billion already at risk with AIG and was appropriately considering the value and operations of AIG’s insurance companies.

Dinallo further notes that “the essential lesson of AIG is the need to reform financial regulation.” Stating the obvious, he notes that “Financial institutions should be required to hold adequate reserves so they can deliver on their [derivative and swaps] guarantees.

Dinallo concludes: “Oh, and financial institutions should not be allowed to select their own regulator.”

[barmar]

Al_U_Card, on Feb 3 2010, 09:55 AM, said:

Tantamount to "I was only following orders."

The issue of being able to understand the full impact and import of the various derivatives begs the question:

"If it doesn't make sense to me, should I be putting my money in it?"

And this definitely applies to the regulatory bodies of the industry, most of all.

That's like saying, "If I don't understand how a catalytic converter works, should I be driving?" The world has gotten too complicated for everyone to expect to understand everything that impacts them. So we defer to so-called "experts". If someone with lots of credentials in economics and finance tells me that CDS's are a reasonable investment, who am I to argue with them?

And it's not like the reckless advice was coming from one crackpot. Lots of Wall Street pros were promoting these financial instruments. There were some naysayers, but people are always more interested in looking for good deals than heeding warnings of doom and gloom. That's basic behavioral economics.

As I have before, I'll again recommend predictablyirrational.com.

[hrothgar]

MathWorks had its annual meeting today.

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.
Strangely enough, his comments didn't address many of the same themes...

[kenberg]

hrothgar, on Feb 3 2010, 06:48 PM, said:

MathWorks had its annual meeting today.

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.
Strangely enough, his comments didn't address many of the same themes...

You could refer him to this thread to help him get up to speed.

[Winstonm]

I don't care who you are or who you think you are - making a 100% LTV loan to someone with no income, no job, and no assets and expecting the spread of the risk throughout the MBS to absolove you of risk and blame is not only stupid but reckless.

Making loans on homes without determining if the buyer had the capability to pay the mortgage payments was reckless. Making loans to people who could afford the interest-only payment but could not afford the reset payment was reckless.

Subprime lending from around 2006-2008 was clearly reckless. There should be serious jail time for the major offenders but I doubt there will be.

[Al_U_Card]

Winstonm, on Feb 3 2010, 07:40 PM, said:

Subprime lending from around 2006-2008 was clearly reckless. There should be serious jail time for the major offenders but I doubt there will be.

When they say "Follow the money" it tends to show where the incrimination is and where the punishment should go.

In all of these "losses", where DID the money go?

[Winstonm]

hrothgar, on Feb 3 2010, 06:48 PM, said:

MathWorks had its annual meeting today.

Dr. Andrew Lo from MIT's financial engineering lab was the guest speaker.
Strangely enough, his comments didn't address many of the same themes...

Do you want my home number?

[hrothgar]

Al_U_Card, on Feb 4 2010, 03:50 AM, said:

In all of these "losses", where DID the money go?

To folks holding the so-called toxic waste...
(Mainly hedge funds)

[hrothgar]

Here' an analogy that will help describe what happened to much of the wealth that was transfered:

Assume for the moment that you hold a pair of IOUs. Each IOU promises that the lender will pay you $100 in a years time. Each IOU has a 20% chance of default. To make life simple, I'm going to assume that you are risk neutral (you are indifferent between holding the IOU and holding $80). Furthermore, I'm going to also assume that the time value of money is zero (this is a simple example and I don't want to deal with discount rates). Last, but not least, I am going to assume that the pay off for the two IOUs is independent. The chance that one lender defaults is unrelated to the chance that the second lender defaults. (This is the big assumption. We're going to come back to this one in a bit)

You decide that you you're going to repackage those two IOUs and create a pair of securities that are backed by the IOU. The first security is the senior tranche from the two IOUs. The first security will pay

$100 if neither IOU defaults. (A 64% probability)
$100 if one IOU defaults but not the other. (A 32% chance)
$0 if both IOUs default (A 4% chance)

The second IOU will pay

$100 if neither IOU defaults (a 64% probability)
$0 if one IOU defaults but not the other. (A 32% chance)
$0 if both IOUs default (A 4% chance)

You go off and sell senior tranche for $96 and the junior tranche for $64...

The senior tranche is is a very secure asset. It gets purchased by banks and pension funds and other institutional investors that are required to purchase high grade securities.

The junior tranche is a very risky asset. It gets purchased by hedge funds and the like (folks who prefer to invest in risky assets)

Now, lets consider what happen if the payoff from the two assets isn't independent of one another: For simplicity, lets assume that the two assets become perfectly correlated. In this case,

The probability that neither IOU defaults increases to 80%
The probably that one IOU defaults but not the other drops to zero
The probability that both IOUs default increases to 20%

Lets consider what happens to the expect value of the two securities

The expected value of the senior tranche has just dropped from $96 to $80.
The expected value of the junior tranche has just risen from $64 to $80.

People who purchased the senior tranches got destroyed. People who purchased the junior tranches made out like bandits.

Now think of the IOUs as mortgages and ask yourself whether the assumption that the chance that multiple mortgages defaults are independent events.

This should give you a basic idea about what happened....

[helene_t]

Spot on, Richard. Very illustrative example.

kenberg, on Feb 3 2010, 02:43 PM, said:

I only have to look at my own behavior to be skeptical of theories based on rationality.

If you define the word "rational" in a sufficiently general way it becomes almost a tautology that we are all rational.

Say that I have a pile a donuts for lunch today. That sounds irrational given that I have low blood count, ought to be lose some weight, and since I didn't bring my toothbrush I shouldn't be eating sugary things at work. Besides, I could have found alternative food on the campus which is not just healthier but also cheaper and better tasting.

But obviously all that information wasn't available to me (I must temporarily have slipped the info that donuts don't contain much iron, for example) since otherwise I would have chosen some different food, wouldn't I? Maybe the info was available but it was a temporary lack of information processing skills. Maybe I was stressed and couldn't think so clearly. Well, information processing capabilities is just another scarce resource. Just like a house may collapse due to lack of good clay it may also collapse because of lack of architect's brain cells. Or lack of project developer's brain cells.

I think economics could be an interesting science if it were based on assumptions that could be tested. What occurred to me after I had been doing mathematical economics for a year was that the assumptions have no interpretation in terms of predicted observations. So I thought, if those theories haven't any practical use, why not study pure mathematics instead, that may be equally remote from the real world but at least I would get to do with some elegant theories. Anyway, I was too stupid for pure math so I decided to do neither, and specialize in engineering math instead.

To be fair, there are lots of good books that deal with economics at an academic level, making it intellectually satisfying and applicable at the same time. But this "physics envy" trend to axiomatize fields that just aren't even remotely ripe for axiomatizing ("economic man", "efficient market hypothesis" and similar nonsense), don't waste time on it.

[hotShot]

Great example, Richard!

[hrothgar]

hotShot, on Feb 4 2010, 04:16 PM, said:

Great example, Richard!

Wish I could claim that I came up with it myself...

[kenberg]

Richard, I also offer my thanks for the investment example. I have felt I have a reasonable grasp of some of the push for bad loans: Here, sign up for this ARM, don't worry about the adjustable rates, the value of your house will go up and you can renegotiate. Oops. But the purchase of the bundles has remained a mystery. Presumably, or at least hopefully, the folks buying the bundles were not total idiots. Your example, basic though it may be, sheds some light on how this could come about.

Casinos get rich by running games with a positive, for them, mathematical expectation. But they are also smart enough to keep thie individual bets small enough and spread enough to give the probability laws the time needed to work their magic. If all of the wealth is clustered in one bet, a positive expectation would still make a professional very nervous.

[hrothgar]

Hi Ken

Couple points that are worth considering:

The senior tranches of Collateralized Debt Obligations were all rated to be equivalent to triple A. Most of folks who really got hammered were the ones who were following the safest / most conservative investment strategies.

Moreover, many of these same professionals decided to be even more paranoid: The bought insurance to protect themselves in case something did go wrong. Moreover, the all went out and bought insurance from a very large, very reliable insurance company (Aka AIG)

Sadly, one of the fundamental assumptions about the system proved to be wrong... All the brains in the world aren't going to help if you don't have an good idea what the covariance matrix looks like.

[kenberg]

It's been my claim for a long time that one of the benefits of being in mathematics is that you get a solid close up view of the limits of mathematics. And of logic. These tools are immensely valuable for reasoning your way from point A to point B. But are we at point A? Ah, that's another matter. Here is from the Wik on Black Scoles:

Quote

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is widely employed as a useful approximation, but proper application requires understanding its limitations – blindly following the model exposes the user to unexpected risk.

. The same can be said about many or all models I'm sure.

If If IF we can somehow keep the bets from clustering we will all be a lot safer.

[Al_U_Card]

So, the bookie laid the odds, our best friend had a tip, we borrowed from the mortgage to make the bet and.....They shoot horses, don't they?

I am still not quite clear on the money flow for the "re-imbursements". The conservative investors (with insurance too) got their money back?

[hrothgar]

Al_U_Card, on Feb 4 2010, 05:47 PM, said:

I am still not quite clear on the money flow for the "re-imbursements". The conservative investors (with insurance too) got their money back?

In theory, the money should have come from AIG

In practice, AIG was severely over-leveraged so the Federal Reserve Bank had to step in...