Trying to understand the subprime mess

Lately, I’ve been trying to understand the subprime mortgage mess. It’s not easy. I got interested in it after running across a lot of stuff on the web talking about McCain, and Phil Gramm, and the repeal of the Glass-Steagall act.

I’m no economist, so I may not know what the hell I’m talking about. I suspect the economists generally don’t really know for the most part what the hell they’re talking about either though.

Here’s about what I’ve managed to figure out so far.

In the old days, when you wanted to buy a house, you went to a commercial bank and got a loan. The commercial bank made their money off of the interest of the loans they’d made. They had depositors with savings accounts and checking accounts, and that’s about it. There were also investment banks which dealt in securities (think stocks), and the Glass-Steagall act, enacted in the 1930’s, prevented the mixing of the two types of banking.

At some point, somebody figured out that you could “securitize” loans. What this means, as best I can tell, is that you take a bunch of loans, say 100 or 200 loans, group them together and sell the package of loans to a “company” which makes its money by collecting the interest on those loans. At this point, the original lender is “out of the picture” as far as those loans are concerned — he’s made his money. This company that now owns the loans got the money to buy the loans by selling stock in itself.

So essentially the bankers found a way to connect the gigantic money pipe that is everyone’s 401k investments to the back end if the bank loan industry. The loans are “securitized,” that is, transformed into securities — stocks essentially — and an illiquid asset has been made liquid. Pretty neat trick.

Now, investors generally like to have some idea of the quality of the thing they are investing in. If you invest your money in the stock a traditional company, you might do some research, find out what the company does, how much it costs to make whatever they make, how much they sell it for, what the demand is likely to be for their product, etc. to get some idea of how the company is doing and what it’s worth so you might have some idea what the price of a share “ought” to be so you can try to buy it when it’s below that, and possibly sell it when it’s above that.

But, how do you evaluate one of these “securitized” loan packages? If there are 100 or 200 individual debtors scattered all over the place, it’s hardly practical to visit each one and evaluate how likely they are to continue paying their mortgage. Well, they thought of this too, so they have these credit rating companies, there are 4 or 5 of them, but the big ones are Moody’s and Standard and Poor. These guys rate them. How? By a proprietary process. “Trust us.” And if they get the rating wrong? Well, it was only their opinion of how much risk is involved, and the amount of risk involved is not really a thing which can be verified as definitely true or false. So, if they get it wrong, well, nothing.

So now we have a situation in which the lenders don’t have much incentive to make sure they don’t make overly risky loans — except to the extent that they can satisfy the credit rating companies — as they package the loans up and sell them right away to be securitized. The securitized loans have an unknown, and unknowable amount of risk involved — but there are a handful of companies making tidy profits rating the risk of those loans. The ratings companies have much incentive to rate things highly, and no real incentive to rate things accurately.

And so you get what we have here — lots of overly-risky over-rated cratering loans left in the hands of investors — possibly in your 401k, so possibly in your hands.

But, this may not even be the worst of it. There’s this other thing called a “credit default swap”, or CDS. This is sort of, kind of like an insurance polity. The owner of a loan (the lender) may wish to reduce his risk of the loan going into default. So he enters a contract with another party. According to this contract the loan owner pays this third party some monthly fee (say), and in return, if the loan goes into default, this 3rd party will pay it off. If the loan doesn’t go into default, then this 3rd party simply keeps the monthly fees, and makes out like a bandit.

Now we’re getting into an area I understand even less will than I understand what I’ve probably mis-explained already. My understanding is that people began to use CDS’s speculatively. I think that means, they wrote checks their ass couldn’t cash — that is, “insured” loans, which if they were ever called to pay on, they couldn’t — or, perhaps it only means they insured too many loans with an unrealistically optimistic expectation as to the fraction of those loans which would end up in default, esp. given the lack of incentive for lenders to bother with loaning only to credit worthy borrowers due to the securitization of loans.

So now, not only do you have a lot of loans going into default, you’ve got all these speculative investments in credit default swaps having to (try to) cover these defaults — which they can’t — not at the rate they’re happening.

And that is about the extent of my understanding, and I probably got some of it wrong, and notice I haven’t tried to talk about the magnitude of the problem, or what it really means to the economy, because that’s well beyond what I can understand.

Some links which might be interesting:

You can probably google up some more interesting links without much trouble.

~ by scaryreasoner on September 21, 2008.

4 Responses to “Trying to understand the subprime mess”

  1. It goes back the Clinton administration and the enactment of Community Restoration Act which pressured bank and lenders to make risky loans so anyone who wanted to buy a house could buy a house regardless of ability to pay. Barney Frank, Jesse Jackson and Barack Obama with his pals at ACORN are also involved.

  2. Arnold:

    Perhaps so. The republicans have had control of Congress and the White House for many years since then and did nothing to change it, so they are as culpable.

  3. […] More on the subprime mess — credit default swaps I’m certainly no expert on this topic, and don’t claim to understand it. I have written previously of my attempts to understand the subprime mess. […]

  4. […] on the subprime mess and credit default swaps I’ve written a bit previously about the subprime mess, and about credit default swaps. This past Sunday, Oct 26, 2008, Steve Kroft did a piece on the CBS […]

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