I was hoping you and/or your readers and contributors might be able to shed some light on the current credit market conditions. The sum of what I know is that sometime in the spring of last year, investors began to notice that a particular segment of the credit community was not it’s usual healthy self but these same investors were slow to act. Part of the sluggishness might be explained by the unwillingness to accept the inherent trade-off. Investors were unwilling to give up the returns from investments in various asset and mortgage backed securities and collateralized debt and mortgage obligations in all their various flavors by continuing to purchase and hold the securities. Meanwhile headlines continued to speak of liquidity and the endless chase for yield, in stock repurchases, m&a, leveraged buyouts, transactions in commercial real estate and landmark properties, etc. So long as this continued, there was no immediate rush to recognize the true risks involved. As the summer approached, the appetite for risk waned. The turn in the credit currents didn’t seem to be caused by a single event or cause– neither high oil and commodity prices, the wars in Iraq and Afghanistan, softening of residential property market, nor the weakness in the dollar. Some financial news media, however, repeatedly reported on the high cost, often adjustable-rate mortgages (generically called subprime) that many people had, the risks that these borrowers had also taken, and partly on how the mortgages were underwritten and holders of the securities. So long as the liquidity was free flowing, the risk of a spike in interest rates was not apparent or immediately tangible. Homeowners with those mortgages assumed that refinancing options were readily available, if only they chose to go that route.
Somewhere along the line, the models used to price the various exotic securities stopped working. Where once the principal challenges of the cash flow models used to underwrite subprime mortgages were prepayments and refinancings, banks and other suppliers of the prior liquidity realized that default and foreclosure were more pressing modelling risks. There also came the recognition that the exotic securities were on their books and the books of many others. The ratings agencies began to act with the release of numerous reports on the underwriting of the high cost mortgages. Investors began to realize that they were somehow exposed but could not quite place where the exposure was nor quantify the amount. We’re now in a situation where a couple hundred billion or so in wealth has disappeared from the books of banks and investment funds, with the lost equity value of property owned by homeowners with subprime mortgages perhaps also totaling in the hundreds of billions. The credit crunch/squeeze/illiquidity is affecting fairly obscure areas of finance like bond insurers who guaranteed payments on the various exotic securities and tax-exempt issuers of debt whose bonds are also insured by the same bond insurers. Once the dust settles, there may be only one or two bond insurers left with AAA/Aaa ratings, affecting the market values of investments of millions of investors.
In the fall/winter of last year, there were ideas floated that might have isolated the impacts of subprime mortgages. Among the more noteworthy include the structured investment vehicle bailout fund and proposals to overhaul the mortgage underwriting and regulatory processes. Months have past, however, without any real changes aimed at limiting the subprime effects on the wider economy, except for the Fed which has lowered the funds rate by 225 basis points. It’s not obvious if these actions have enabled distressed homeowners to refinance out of high cost mortgages. It might be futile if the hope is that the cuts will prevent a general decline or correction in residential property values nationwide. For now, it seems to be the faster, cheaper and cleaner approach than government-backed/-sponsored mortgage modifications for all homeowners experiencing difficulty repaying their current mortgage. If cuts to the funds rate is all the economy and homeowners need, we might be in the clear. But there is still a lot of concern about liquidity and some might say that the current, extreme risk aversion will continue at least through the end of the year. In the meantime, the subprime contagion will creep into other investment areas, perhaps commercial real estate next.
What does dumb agent theory have to say?
I started a business. On my recent trip to Australia, I saw something called the Slingshot. It’s this contraption that acts like a reverse bungee jump and basically shoots you up into the sky like you are in a slingshot allowing you to then you bounce around afterwards. I was so scared when I did that thought I was going to die. But it was fun so i decided that maybe I could make some money by setting up my own ride.
I bought all the equipment I need. I even added some additional safety features. I have added a parachute to the seat that people sit in, an additional three safety lines, and more support structures. I also wanted to make sure that design was safe so I sent it to a design firm to check the integrity of the design. I then thought that I should get a second opinion and hired a Japanese engineering firm to look over the designs. Yeah, they are expensive but they are good at that stuff. Then I wanted to be extra sure so I asked an Indian firm to look at the designs again. Thankfully, all of them agreed that the design is safe. But, you never know. So I decided to spend an additional million dollars just to make sure it’s safe.
The problem is that no one wants to ride my Slingshot ride. Apparently, people think that $1000 a pop is too much to pay for safety. Meanwhile, my competitor who sells it for $20 a pop is making a ton of money. My ride is way safer than his. I just don’t get it. They’ll see though. Someday my competitor’s ride is going to go awry and someone will be killed. They will wish they had paid $1000 instead of $20…Of course, I am sure that my competitor will be sued and that the government will come in and close down the entire industry. Oh well. Maybe there’s a future in gold mining in Arizona.
I think this is the big lesson from the current crisis involving the securitization of mortgages. As in many new things that seem to work remarkably well at first, there is a lot of hype to them and how economic forces simply don’t apply. Much like how bungee jumping is somehow risk free. I think people believed that the massive securitization market had some how eliminated risk and therefore, giving mortgages to people who did not appear to have the wealth or income to pay for them had become risk-free. However, securitization relies on a buyer and a seller. The seller of risk is unloading the risk because he knows it’s risky. The buyer is buying the risk because she thinks that the return is greater than the risk. (The likelihood of me dying today in a bungee jump is pretty low so I am only going to pay $20 for it.) Theoretically, it should find a balance that creates a market signal that allows the seller and buyer to know what the true value of taking on the risk is. Somehow this failed or maybe the market finally decided to behave in a way that economics suggests it should.
Many people have pointed out the various and sometimes esoteric reasons for the current crisis and why people are now losing their shirts and homes. I think, however, the reason is much more simple: people failed to realize that buying something like a security is essentially a bet on whether someone will pay their mortgage on time, during a period of rising interest rates is, wait for it…..risky. Why is this? I think that since the securities market had grown so quickly and remained so stable for so long people became complacent. People started to think that somehow the model had changed much as people did during the dotcom period. So remember this. Models don’t change. Just the suckers that lose their shirts.