The Total Stupidity of Crowds: Bad Mortgages and Circular Solutions

Dec 19 2007 Published by under Uncategorized

Reading the news lately, I've come across an amazing example of how ubiquitous bad math can be used. Most of you have probably heard about what's been called "the sub-prime crisis". Despite a lot of media hand-wringing about how complicated it all is, the sub-prime crisis is really a very simple phenomenon: basically, you've got a lot of banks that have loaned out money without worrying about whether or not it could get paid back, and now those loans aren't getting paid back, which is causing all sorts of grief to people who invested in them.

In the beginning of the mortgage system, the way it worked was: banks loaned people money to buy
houses. People paid back the loans with interest. The interest was pocketed by the bank as profit. All good so far.

Sometimes people, due to either interest rate changes, employment changes, or other circumstances,
couldn't afford to pay their mortgages. When this happened, the banks foreclose the mortgages, which is
a fancy way of saying "take possession of the house and resell it to make up the money owed to them." If the sale of the house after foreclosure didn't bring in as much money as the bank had loaned, then the bank lost money.

Banks therefore, when asked to make a loan, would assess the borrower, to try to determine whether
or not they would be able to pay back the loan. They sorted people into categories, based on just how
much of a chance they thought there was that they would not be able to pay back the loan. Some people
were a good risk: it looked like there was a minimal possibility that they wouldn't be able to repay.
These people are "prime" borrowers - the least risky. Beneath them, there are various categories,
ranging from "almost as good as the prime borrowers" to "no way in hell are these bozos going to be able
to repay this loan". The banks picked some threshold below which they would not make the loan; and above
that threshold, they would assign an interest rate to the loan. The higher the risk - that is, the more likely the borrower is to to fail to repay it - the higher the interest rate. Again, all good: you take
more risk, you might lose more - but if the risk works out, you make more. That's all nice and fair.

Investors like to get a cut of anything that's likely to make money. Mortgages are great from their perspective, because people will do almost anything before they let their home get taken away - so it was seen as a safe profit. So investors wanted a cut of the mortgage market. What the banks did then, was grab bunches of mortgages, and sell them as a sort of bond. If you bought $100 worth of mortgage bonds, what you were effectively doing is giving the bank $100 to loan out as a part of some mortgages. Then when the homeowners repaid the loan, you would get back your $100 with interest as it was repaid. This was considered a good thing - for the borrowers, it meant that there was more money available to loan people to buy houses; and for the investors, it was a safe investment that brought in a reliable profit.

Now, we start getting to the tricky part.

There's another kind of risk in the whole lending scene. The prevailing interest rate on loans fluctuates over time. If the bank gives you a loan at, say, 5% today, and then next week, the interest rate goes up to 10%, then what happens? If the bank can't change your interest rate, then from their perspective, they're missing out on the interest that they could have earned had they waited until next week to loan out the money. On the other hand, if the bank can change your interest rate, then your monthly payment on the loan will increase. The bank makes more money, but at an increased risk of
your not being able to pay the loan.

The loaner wants to be able to charge as much interest as possible - because interest is profit. So they want to get borrowers to pay as much interest as they can. But borrowers like to know what they're going to be paying. So the loaner hedges against the risk. If you don't want to take a chance on the rate changing, they'll charge you a higher rate, but guarantee that it won't change. If you don't want to pay that higher rate, they'll give you something lower - but that lower rate can change
over time, so it might go up.

Loaners really want you to take the rate that they can spike if rates go up. So they offer teaser rates - low rates for some period of time, after which the rate will increase to whatever is the current rate on the market. So you get a loan that's very cheap for the first couple of years, but unpredictable
after that.

Still, it's all fair. Everyone knows what's going on, and everyone is appropriately paying
for risk. The people with fixed rates are paying a little extra to protect themselves; the banks are paying out money in the form of lower rates to get people to take a loan that might pay more in the future; the borrowers who take out variable rate loans are getting a lower initial rate in exchange for taking some risk. That's how markets are supposed to work.

So you've got all of these different kinds of mortgages out there. And the banks realize that they're making a hell of a lot of money selling the mortgages. But it's a whole lot easier to sell the
low-risk mortgage than the higher risk mortgages. So what they do is try to find a way of massaging the risk. The idea is, if you take 10 different medium risk things, and put them together, the risk
is less - because one of them might fail, but you still have the other nine. They're independent, so the risk of one failing doesn't increase the risk of the others failing. So what you can do is take those
higher risk mortgage bonds, and wrap them in meta-bonds. Now, when you buy a meta-bond, instead of the money going directly into a bunch of mortgages, your money is used to buy a bunch of different higher risk mortgage bonds, and then those bonds are used to make loans. You get a higher interest rate, because you're investing in riskier loans, but because you've supposedly spread out the risk, they're as safe as the original low risk bonds.

The risk is considered low, because the loans are backed by the value of the homes. Home prices generally rise pretty reliably. So if the borrower defaults and you foreclose, you can still get back your investment. The only real risk if if home prices start to fall: then people can't get out of the mortgage by selling their homes, and you can't make back your investment by foreclosing and selling the property. But you've hedged that, by combining mortgages from New York City with mortgages from Cleveland Ohio and Dallas Texas and.... So you're only really screwed, even on the bundles of not-so-safe loans if the housing markets in Dallas and Cleveland and NYC all crater at the same time - and they're independent, right? So that can't happen.

Investors love these higher interest low risk bond packages. So the banks start to put together more of them. And they realize that they can cobble together even higher yield bundles if they cascade them: they take a bundle of 10 different kinds of shit loan bonds, and turn them into high risk loan meta-bonds. Then bundle 10 different high risk loan meta-bonds (which were formed from the shit loans) into medium risk meta-meta-bonds. Then bundle 10 different medium into a low. And so on. So now you've got something labeled as "high quality, low risk" which is formed completely from a collection of shit. But, by golly, it's marketed as high quality, and it's got a nice rate of return! And it's really low risk, because you've distributed the risk into a bunch of independent places, and you're only in trouble if they all fail. (This is bad math point number one: false independence. This scheme only works if there is truly no connection between the failures of the components.)

You bundle them together according to a complicated scheme called tranching to make them look like they're really, truly safe. And you take out insurance, so that if something goes wrong, it's all insured.

Investors love it. They're buying things that they were told are really low risk, and they're paying a great return. And they investors are happy, because it's low risk and it's insured! But the banks have to make lots and lots of shit loans in order to satisfy the demand from investors. So they start to make loans to pretty much anyone who asks. Hey, want to borrow a million dollars? No problem! The bank will happily make the loan, so long as you promise them that you've got a salary of $200,000/year. Just promise - the bank doesn't need to see any proof, you're clearly a trustworthy fellow!

This creates a feedback cycle. People can borrow pretty much whatever they want, so they can pay
more to buy a more expensive house. This means housing prices go up. Rising housing prices mean that
the risk of a loan is smaller - because if the value of the house increases, you can make more by
selling it on foreclosure. And because the prices are going up, people see houses as a good investment, and decide to borrow more to buy a house. It's a nice cycle, up to a point.

The problem comes about when the prices get to the point where they're totally disconnected from
anything resembling the real value of a house. Then when interest rates go up, you've got a lot of people who can't afford to make their mortgage payments - and they paid so much for the house that
there's no way to sell it for enough money to pay back the loan. And that happens not just in NYC, but
all over the country. Suddenly the shit bonds are worth, well, shit. And the supposedly safe bonds formed from bundles of bundles of bundles of shit bonds? They're worth shit too.

That's the current situation. There are who knows how many billions or trillions of dollars tied up in what are, quite likely, bundles of shit. The economy is slowing down, interest rates are going up,
and most importantly, housing prices are falling. So you've got tons of loans where people borrowed more that the house is currently worth. And tons upon tons upon tons of fancy bonds which are supposed to be safe, but which are ultimately based the values of houses that aren't worth what their owners borrowed to buy them.

So what happens next? Well, the bonds are worth shit. But they're insured! The insurance companies
will take the hit, and cover the loss, right? Well, that's where we get to the specific bit of bad math that inspired this here rant. The insurance companies based their calculations on the same ideas of "safety by distribution"
that the banks used when they bundled things together! So the people who are
guaranteeing the safety of the loans are relying on exactly the same assumption
of safety that they're supposedly insuring. If the insurance is ever needed, it's
because the assumption of safety was wrong. But because the insurance company
used that same assumption, they're not going to be able to pay it back. (This is big bad math point number two.) So that didn't work out. So the insurance companies are crashing and burning. And when the insurance on your bond that allows you to rate it low-risk disappears, because the insurance company failed, then you're in deep trouble. Your bond is no longer considered low-risk. And that means that a shitload of investors are going to get out and sell your bonds. But no one wants to buy them - because they know that they're a pile of shit, and no one is really sure what they're worth, because no one knows how many mortgages under the umbrella of that piece of shit are going to fail. So the prices of the "safe" bonds totally collapse. And all of the other investments that relied on those bonds - those start to fall apart too.

So - the banks know that they need to stop the insurance companies from collapsing. How can they do that? Here's a truly brilliant idea, which was floating yesterday by a bunch of big banks like Merrill Lynch and Bear Stearns: loan money to the insurance company.

So - the insurance company is guaranteeing the value of the banks mortgage loans, using money that it borrowed from the bank, which the bank had to borrow because it's got these bundles of leans insured by the insurance company. In other words, the banks are insuring their loans themselves, using the loans to pay for the losses on the loans. It's circularity on circularity on circularity - cycles within cycles of stupidity, relying on stupidity to prop it up.

And there are people - lots and lots of them - who are falling for this as a scheme
to save the banks from the bad loans.

No responses yet

  • Kristine says:

    The higher the risk - that is, the less likely the borrower is to to fail to repay it - the higher the interest rate.
    Sorry, but did you mean to say that?

  • Chris' Wills says:

    Well as with all such things guess who'll eventually take the hit.
    In Britain the goverment has thrown 20 billion pounds ($40billion) at Northern Rock to prevent it collapsing and no one wants to buy it at anything like that price.
    The bosses of the banks & insurers will still get their Christmas bonuses and the goverment (i.e. tax payer) will end up bailing them out.
    It would be a salutary lesson for the banks & insurance firms if a few did go belly up. They might learn that profits can go down as well as up and that shit is shit however prettily you wrap it.

  • bwv says:

    Nice summary.
    There is nothing inherently wrong with tranching (literally slicing) up a pool of assets to create higher and lower risk pools, the key thing, as you say, is the assumption of non-correlation within the pools. Thanks to the rating agencies, 80% of a typical subprime CDO of 2005-2006 was able to qualify for a AAA rating (meaning that the AAA tranch was protected from roughly the first 20% of credit losses of the pool). This was all based on historical data, and failed to take into account the effect that the volume of subprime lending would have on the market. The other stupidity is now that the loans are going bad, the bank have to realize that if they all foreclose at the same time, then they will flood the market and impair their recoveries.

  • Jeremy says:

    Another issue is that housing prices in communities with many foreclosures typically fall, therefore compounding the potential losses for investors.
    I used to work for Bear Stearns. I was a code monkey managing the data updates for securitized loans (not subprime). Finding the amount of outstanding debt in securitized loans is easy, since only three agencies secure loans (Fannie Mae, Freddie Mac, Ginnie Mae) and they all provide monthly updates on all their loans. Before I left that number was approx. 2 trillion.
    My educated guess is that the sub-prime market is smaller, but not by that much. It is much harder to estimate the size because sub-prime loans are tracked by individual banks that don't share their data.
    Note that a small to medium whole loan or subprime "deals" consisted of maybe 500 million dollars in debt. Big CDOs could be in the billions. New deals came out monthly, usually in series. Investors could not get enough.

  • Yeah, Chris. It would sure teach Chase a lesson if they went under because of their overzealous lending practices. And those honest people with their savings and checking accounts with Chase like, well, me? Collateral damage. It's worth it to wipe out a few thousand people's life savings to show those silly bankers what's what!

  • Mark C. Chu-Carroll says:

    Kristine:
    Thanks for catching that; a few too many negatives get confusing.

  • Lassi Hippeläinen says:

    In my simple engineer's mind this reselling of loans (i.e. risks) seems like a sophisticated version of the good old pyramid scam.

  • Chris' Wills says:

    Yeah, Chris. It would sure teach Chase a lesson if they went under because of their overzealous lending practices. And those honest people with their savings and checking accounts with Chase like, well, me? Collateral damage. It's worth it to wipe out a few thousand people's life savings to show those silly bankers what's what!
    Posted by: John Armstrong

    http://www.guardian.co.uk/business/2007/nov/23/northernrock.bankofenglandgovernor
    So what do you suggest to stop bankers doing stupid things? At present they believe/know that they'll be bailed out by muggins the tax payer and so they can happily go on doing silly things and paying themselves absurd amounts of money.
    In the UK depositor funds up to a fixed amount are guaranteed by the state so unless you have a lot of money on deposit you won't lose out (if you have over the limit put it in seperate accounts; each account is covered).
    The insurance companies will have their profits reduced and so will the banks.
    Yes, some people will lose their jobs.
    Don't see goverments rushing to bail out car manufacturers or steel makers, when they go under whole communities die a slow death.
    Didn't see anyone rushing to support the oil industry back when oil prices dropped below US$10/barrel. No goverment support or care for all the people laid off then.
    Why should bankers and insurers be protected from their own stupidity?

  • Flaky says:

    Good post. Having heard about this crisis in the news briefly, I was under the impression that poor homeowners were just being screwed. I had no idea that investors were also getting the shaft, while banks were tying their own nooses. These sorts of things lead me to wonder how any sane person can believe that the true value of anything may be determined by, and only by a free market.

  • Eric Lund says:

    Nice summary. I'd heard most of this stuff, but you assembled it into a neat package.
    The only thing you didn't cover was the role of leverage. Many investors didn't merely buy pieces of what Atrios aptly calls Big Shitpile, they borrowed money to buy pieces of Big Shitpile. This works great as long as prices are stable or rising: your interest and (where applicable) capital gains received exceed the interest you pay on the loans, giving you an excellent return on investment. But if the price of your investments declines, you can be wiped out that much more quickly: if you put in $1 and borrow $9 to invest $10, and the price of the investment drops to $9, your capital has been completely wiped out. Often you will be forced to sell the asset into a declining market, which reinforces the trend. It doesn't help that many institutional investors who can only invest in super-safe securities are forced to sell at the same time because people realize that their allegedly super-safe securities are in fact pieces of Big Shitpile.
    In a way, it's like the Roadrunner cartoons in which Wile E. Coyote runs off a cliff but does not start to fall until several seconds later when he realizes that he has in fact run off a cliff. Real-world physics doesn't work like that, but financial markets sometimes do.

  • NoAstronomer says:

    Re: Insurance Companies
    I'll also point out that several insurance companies (including the one I work for) sell what is called Directors & Officers insurance. D&O insurance protects the CxO level people from shareholder lawsuits accusing them of mis-management. Those lawsuits have been flying thick and fast the past few months.
    Once again the issue of false independence arises. What if all the CEO are mis-managing their companies the same way because 'everyone else does it'?

  • Everyone involved did something stupid. What's missing from this assumption is the fraud. The fraud was, primarily, mortgage lenders concealing from prospective homeowners, primarily African-American and Hispanic-American, that their credit rating entitled them to regular mortgages, and then selling them overpriced as overly risky sub-prime mortgages.
    This is more than stupidity combined with Bad Math. It is more than corporate greed. It is more than homeowners who didn't understand compound interest, nongaussian distributions, and the like. This is massive ongoing criminal activity. Yesterday's New York Times detailed how many high-level people warned how many mortgage companies and government officials how long in advance, and how nobody in charge did the right thing when warned.
    "Who knew that the dikes could be breached?" [Bush a few days after being briefed on that specific possibility]
    "It's nothing to look in to particularly because we knew there was a number of such practices going on, but it's very difficult for banking regulators to deal with that..."
    [Federal Reserve Chairman Alan Greenspan, interviewed by correspondent Lesley Stahl for his first major interview, defending himself against the criticism that he should've done something to stop the shady practices in subprime lending. In this rare admission, he told 60 Minutes he missed its significance.]
    I am not objective here. In the southern california 7 counties, where I'm a homeowner, this month marked a 43% decline in home sales over the same time a year ago.
    My home equity is plunging, each month, approximately as much as my wife earns as full-time Physics professor in a year.
    Captain Renault: I'm shocked, shocked to find that gambling is going on in here! [a croupier hands Renault a pile of money]
    Croupier: Your winnings, sir.
    [Casablanca, 1942]

  • Russell says:

    To someone who lived in Texas during the 80s S&L crisis and real estate crunch, this all looks strangely familiar. BTW, the word is "lender" not "loaner," unless you're referring to a car your borrowed. 😉

  • Office Drone says:

    John Armstrong [#5] might be sorry to hear that Chase's exposure to Subprime bonds is far lower than that of CitiGroup or Merrill Lynch, for instance. Good luck or good management means that Chase won't get the lesson it deserves in this round.

  • Chris: we're on a computer scientist's weblog here, so how about I try a CS analogy. What we want to do is a graceful error recovery, not a crash. No, I don't know how to do it, but the simplistic "they should just crash and that'll teach 'em" isn't a good answer either.

  • Kristine says:

    BTW, excellent summary, Mark.
    Chris - remember the savings and loan scandal in the U.S.? Who paid for that mistake? The taxpayers, not the savings and loan folks. Who bailed out the savings and loans? The taxpayers, not the savings and loan folks. Why would it be different with banks? We're talking about the depositors' money (like mine). "So what do you suggest to stop bankers doing stupid things?" Good question; however, making their customers (like me) suffer won't work. That's like saying, "Yay, Enron failed." Enron's employees were shafted no matter what happened to the top execs.

  • For some reason, this didn't post, so I'm resubmitting it. The New York Times article really should be seen, but I didn't want to include the length text or a hotlink.
    Everyone involved did something stupid. What's missing from this assumption is the fraud. The fraud was, primarily, mortgage lenders concealing from prospective homeowners, primarily African-American and Hispanic-American, that their credit rating entitled them to regular mortgages, and then selling them overpriced as overly risky sub-prime mortgages.
    This is more than stupidity combined with Bad Math. It is more than corporate greed. It is more than homeowners who didn't understand compound interest, nongaussian distributions, and the like. This is massive ongoing criminal activity. Yesterday's New York Times detailed how many high-level people warned how many mortgage companies and government officials how long in advance, and how nobody in charge did the right thing when warned.
    "Who knew that the dikes could be breached?" [Bush a few days after being briefed on that specific possibility]
    "It's nothing to look in to particularly because we knew there was a number of such practices going on, but it's very difficult for banking regulators to deal with that..."
    [Federal Reserve Chairman Alan Greenspan, interviewed by correspondent Lesley Stahl for his first major interview, defending himself against
    the criticism that he should've done something to stop the shady practices in subprime lending. In this rare admission, he told 60 Minutes he missed its significance.]
    I am not objective here. In the Southern California 7 counties, where I'm a homeowner, this month marked a 43% decline in home sales over the same time a year ago.
    My home equity is plunging, each month, approximately as much as my wife earns as full-time Physics professor in a year.
    Captain Renault: I'm shocked, shocked to find that gambling is going
    on in here! [a croupier hands Renault a pile of money]
    Croupier: Your winnings, sir.
    [Casablanca, 1942]
    Posted by: Jonathan Vos Post | December 19, 2007 3:50 PM

  • SLC says:

    The real problem here is that everybody acted as if housing prices would continue rising forever. If that had been true, there would have been no problem as foreclosed properties would have been sold at higher prices then the mortgages on them. Unfortunately, everybody forgot that what goes up can also go down and that was exactly what happened. The fact is that housing prices really didn't reflect the actual value of properties; they reflected the artificial demand generated by historically low interest rates. When interest rates rose, demand fell and thus values also fell and people who got into the market recently suddenly found themselves upside down, owing more then the property could sell for. This was compounded for the lenders because they were providing mortgages with little or no money down (a reflection of the belief in ever rising housing prices). Somebody who is upside down and can't meet the mortgage payments is then better off letting the lending institution foreclose rather then trying to sell the house at a loss.

  • Ugly American says:

    Anti-discrimination laws in the US require lending companies to make loans to minorities and in economically disadvantaged areas.
    Before such laws, banks didn't make such loans because they often don't get paid back.
    I never would have required those junk loans. I never would have allowed unhedged adjustable rate loans. I never would have allowed brokers to originate and then sell loans with no responsibility for them. I never would have allowed NINJA (No Income, No Job, Application) loans. And no loans without legal status check, many loans in CA, TX & FL were made to illegal aliens.
    Moving forward, I'd make all those changes and also track down the crooks who took huge bonuses and resigned just the past year or so. Several of them 1 quarter before the bad 'surprises' were admitted. I'd also file charges against guys like Mitt Romney who used offshore shell companies to hide the BS finances on the junk mortgage biz and then resold the secondary SIV bonds to pension funds.

  • Pierre says:

    Very entertaining and well put! If and when the bottom falls out, we can point people to your Web page for a layman's explanation.

  • Chui Tey says:

    There is an argument to bail out the banks though, no matter how negligent they were. The wildfire needs to be contained before the effects spread beyong the investors of the loans to the general community.
    If the power generation company lost a substantial amount of money on oil futures speculation, they still need to be saved by tax payers because of the critical role they play in society.
    If a doctors is at home but "on call", they generally don't drink, lest they be called out to work. Similarly, institutions which play an indispensable role (or have some kind of barrier to entry) have to be bound by hard rules.
    The news laws proposed to prevent fraudulent mortgages from being made doesn't really solve the previous problem. Only laws which restrict designated institutions to particular roles can insulate the general public from this style of commercial booms and busts.

  • Mike says:

    This article is truly a masterpiece, worthy of being hanged in the Louvre.

  • sys says:

    clusterfuck!

  • Andrew Dodds says:

    Excellent summary..
    One point I'd like to add is that (as Ugly American said above), the incentives for the sales of these bonds - bonuses and comissions - were all completely front-loaded. You make the loan, you get the 2% comission; you make the quarterly target, you get the bonus. There are cases of agents making the first 3 payments on the loan themselves, in cases where this was required to trigger comission payments.
    There is a desparate need to reform this whole area, because the short termism of rewards in the financial sector hits us all.
    John..
    As fas as CS analogies go, it's a bit like a 'graceful error recovery' that leaks a bit more memory every time.. so instead of a process crashing ever so often, the entire system goes down occasionally.

  • Frank D. says:

    I actually feel like I understand economics now.
    Don't worry, I'm sure the feeling will pass once I pick up The Economist.

  • mj says:

    Of course, as SLC, pointed out is that the scheme required perpetual rise of the prices. However, most people of course knew that this was not gonna happen. Insted what was seen was a chicken race where everybody was careening through the tunnel hoping to make it out with a good profit on the other side before the train came. Well, now the train is there!
    I'm not going to try to stretch the analogy further, but it's not just ignorance and mischief involved, but a whole lot of (mis-)calculated risk.

  • Fraud may be the tip of the iceberg, but it's still fraud.
    "You really have to go through on a case by case basis to see who was defrauded and who just made bad decisions."
    Or, for the longer story in this morning's local paper for me:
    Foreclosures drop; experts still cautious
    By Michael Rappaport, Staff Writer
    Article Launched: 12/19/2007 07:44:01 PM PST
    http://www.pasadenastarnews.com/ci_7763899
    Foreclosures in California dropped in November 2007, according to a report released Wednesday by Irvine-based RealtyTrac.
    One of every 325 homes in the state was in some part of the process, the fifth-worst rate in the nation, but that was a 20.65 percent decline from the previous month.
    James J. Saccacio, chief executive officer of RealtyTrac, warned against making too much of the news, which also included a 10 percent drop nationwide.
    "The drop in November is the first double-digit monthly decrease we have seen since April 2006," he said in a release. "This could indicate that foreclosure activity has topped out for the year, but the true test of whether this ceiling will hold will come early next year."
    That's when a seasonal surge in filings and another wave of resetting mortgages could put further pressure on the market.
    "But if the trend of flat or decreasing foreclosure activity we've seen over the past three months continues in the first quarter, it would certainly bode well for 2008," Saccacio said.
    The year-over-year numbers aren't as impressive. Nationally, foreclosures in November were 67.8 percent higher than in the same month in 2006, while California was 107.8 percent higher.
    The possibility of some sort of federal bailout adds to the uncertainty of the situation.
    "The major problem with deciding what to do and who to help or not help is that 2008 is an election year," said Jack Kyser, chief economist with the Los Angeles County Economic Development Corp. "You really have to go through on a case by case basis to see who was defrauded and who just made bad decisions."
    The hardest-hit state in the nation was Nevada, with one of every 152 homes in foreclosure. Florida, Ohio and Colorado were also worse off than California.
    The state with the fewest foreclosures was Vermont, which had only six homes in the entire state in any part of the process.
    Even that was a 500 percent increase over November 2006, though, when only one home in Vermont was in foreclosure.
    Stockton and Modesto were the two metropolitan areas with the highest rates, while Merced was third and Vallejo-Fairfield sixth.
    Riverside-San Bernardino, which was sixth in October, fell to ninth in November.
    "Before this is all over, we are going to see a blizzard of lawsuits," Kyser said. "There will literally be a ton of lawsuits from people saying they were defrauded."
    m_rappaport@dailybulletin.com

  • Chris' Wills says:

    Chris: we're on a computer scientist's weblog here, so how about I try a CS analogy. What we want to do is a graceful error recovery, not a crash. No, I don't know how to do it, but the simplistic "they should just crash and that'll teach 'em" isn't a good answer either.
    Posted by: John Armstrong

    John: I did point out that depositor funds are protected up to a limit in the UK and this is a good thing.
    I am not in favour of depositors losing their money, I am against those making the decisions getting off scot free, keeping all their bonuses and not learning.
    As for the difference between a graceful error recovery and a crash, that's why I agree with protecting depositors to a limited extent.
    As for the bank or insurers going belly up, so what?
    They're businesses like any other not people.
    Yes, people will lose their jobs, it isn't nice but it happens all the time. Why are bankers/insurers a protected species?
    GM didn't start improving their cars until Toyota took most of their market. If GM was going to go belly up should the tax payer bail them out to the detriment of Toyota?
    If the bad bankers/insurers/lawyers suffered for their actions perhaps more honest and reliable people would gain market share.
    As for the investors;
    1) those using pension funds it will be hard on the people who trusted that company or investor but really shouldn't those investing on behalf of pensions be more careful.
    2)Those who invested on their own behalf or on behalf of companies, not a worry as far as I'm concerned. The value of investments can go down as well as up.
    Those who took out the mortgages, well the early buyers won and the laggers will lose.
    Rather than having the tax payer bail them out perhaps you would take the money off the early winners in the game.
    Again it ill behooves bankers/insurers etc to use the suffering of those they conned to try and take tax payers money.
    Oh yes, I think it was a con job.
    A mix of junk bonds and pyramid selling.
    Just wrapped in a fancy parcel.

    Chris - remember the savings and loan scandal in the U.S.? Who paid for that mistake? The taxpayers, not the savings and loan folks. Who bailed out the savings and loans? The taxpayers, not the savings and loan folks. Why would it be different with banks?
    Posted by: Kristine

    Bailing out the S&Ls was silly, it convinced the bankers/lawyers that whatever stunts they pulled when it went pear shape they wouldn't suffer.
    The S&Ls are interesting, I recollect something called whitewater. Involved a politicians wife or some such.
    I did suggest before that a depositors guarantee (with a cap) would be a good idea. It exists in a number of countries just for such eventualities, that's why I'm peeved at the UK goverment throwing good money after bad.
    Northern Rock could be interesting, seems they sold on their good mortgages to an offshore company. I wonder who the directors of that company are and if any other banks have done the same thing.

  • pef says:

    It is certainly maddening that high rollers could get rich from irresponsible practices and then expect to be bailed out which would only encourage such irresponsibility in the future when its taxpayers money thats being used for it and not for other more legitimate purposes. But could it make more sense just to let the markets boom on false pretenses because the investors have confidence they will be bailed out? Would that encourage more growth than keeping investors cautious and responsible?

  • Mark C. Chu-Carroll says:

    Ugly American:
    What you're saying is a storyline which has been pushed by a lot of the right wing, but it's not one that I find particularly convincing.
    First of all, the whole storyline about "forcing banks to give bad loans" is nonsense. Banks have a long history of engaging in discrimination against minorities. They've always used the excuse that the minorities were less likely to repay the loans. But if you look at actual statistics, the excuse doesn't line up with the facts.
    A black borrower and a white borrower with the same income and same credit history, buying houses of the same price, with the same downpayment have historically had dramatically different experiences getting loans. The white borrower could get a loan more easily, with better terms and lower interest rates than the black borrower. The "anti-redlining" laws, which is what you're talking about, do *not* require banks to issue riskier loans. What they do is require the bank to give the same loans, with the same terms, regardless of the color of the borrower, or the primary ethnic group in the neighborhood. The loans are judged on real risk issues: borrower income, credit history, home value, downpayment.
    To the extent that there was any greater risk in loaning to the minority borrower, it was largely an artifact of the banks themselves. If it's harder to get a loan for a house in a minority-dominated neighborhood, then the borrowers in that neighborhood will get worse loans, which increases the risk of foreclosure; and the difficulty of borrowing also means that in the case of foreclosure, the bank will have a harder time reselling the house. So it's harder to buy and sell homes in the neighborhoods the bank discriminates against, because the banks have made it harder, and then the banks use the fact that it's harder to justify their past history of making it harder.
    In other words, more circularity, this time being used to cover up for the fact that too many banks are run by rich, corrupt assholes.

  • Chris' Wills says:

    But could it make more sense just to let the markets boom on false pretenses because the investors have confidence they will be bailed out? Would that encourage more growth than keeping investors cautious and responsible?
    Posted by: pef

    I don't think so.
    The shares and financial markets should reflect the underlying state of the economy however on occasion (such as recently) this is not the case.
    We have a financial market that has been booming, house prices rocketing and so on. However the real market (manufacturing, farming, non-financial services etc) has not been growing at a similar rate.
    The take home wage of the modal (not average as that is easilly frigged) person has not been rising quickly; for various reasons it has actually been falling in some areas.
    So the general person cannot afford to buy products at the high prices, less goods are sold, more layoffs etc.
    At some point the financial markets must reflect the true economy; having a booming financial sector with tax payers funding even more thieves than normal would just make the disjoint worse and the resultant reality crunch more painful.
    The fact that objects are bought and sold and the sellers/buyers don't even know what they're buying makes it even worse.
    When Baring's Bank went down because of what they called a rogue trader it didn't destroy the market. It did make bank directors try and learn what was in the derivatives they had purchased. Directors actually admitted that they didn't know what derivatives were.
    Now derivatives are useful items if used as designed but like anything traded on the markets they became objects to buy/sell rather than safe guards in short order.
    What might be helpful would be if interest rates weren't changed all the time. But friends have advised that central banks have good reasons to change them.

  • Joe says:

    Very interesting article. I was not aware of exactly how all of this worked, other than a bunch of people who couldn't afford houses, were buying houses.
    Again, very interesting and informative.

  • RickD says:

    Mark, you've covered this affair fairly well, but you are neglecting the role played by real estate appraisers. They have played a huge role in the real estate bubble's painful collapse.
    Andrew Cuomo, New York's AG, is investigating a number of appraisers who have apparently colluded with lenders to inflate the value of homes. When an appraiser overrates the value of a home, that makes it easier for the person owning said home to borrow a large amount of money against it. But if that mortgage goes into default, then the bank is faced with the disparity between the true market value of the property and its bogus appraised value. That disparity is yet another source of loss in the current mess.

  • Jon H says:

    RickD beat me to it.
    The appraisers supported the inflation of home prices far beyond what was justifiable, leading to bigger loans, and probably more profitable terms for the lender and bigger commissions and bigger fees for the mortgage broker.
    Ugly American wrote: "Anti-discrimination laws in the US require lending companies to make loans to minorities and in economically disadvantaged areas.
    Before such laws, banks didn't make such loans because they often don't get paid back.
    I never would have required those junk loans. "
    Loans to minorities and people in economically disadvantaged areas aren't the problem, the problem is when loans that are way too big are made in such circumstances.
    Race and economic status are clearly beside the point when many of the bad loans went to well-off people in well-off neighborhoods and real estate speculators who bought up many houses.
    To the extent that race and low economic status were important, it's probably that many poor or ethnic minority people were seen as easy marks by unethical predatory lenders, so were targeted with bad mortgages and bad refinancing deals. They went looking for poor people who were financially naive and would leap at offers of giant piles of free money to buy a nice new house, or offers of second mortgages on a current house that would provide money for luxuries.
    They were not loaning money to these people just because they were required to. They were loaning money because they wanted to, because all the mortgage brokers cared about was the short term. Whether the person ended up homeless or the mortgage was ever paid off was of no concern.

  • Anonymous says:

    Thanks for the great explanation!

  • BWV says:

    Now I would argue against any stupidity on the part of those responsible for the mess. At every link in the change was a rational financial decision. The rating agencies made big money blessing this stuff, and while the banks who originated the paper are taking big losses, the execs within the banks reaped huge bonuses (big enough to retire on) based upon the initial revenue created by this activity. Not to mention those at the retail end of the supply chain making all their money at origination, with no responsibility for the long term performance of the loans

  • Holly says:

    Great synopsis, Mark. I didn't really understand all the in-and-out's and now I do! Yunno, the thing that REALLY upsets me (aside from this, obviously) is that companies are advertising and going about business as though everything is ok. It could be argued that keeping a positive outward appearance is important and saying your business is going under will not bring people in, but they need to face the facts. By pretending that everything is ok, people THINK that it's ok and they too continue to purchase and borrow as if nothing is wrong. Not only do we have a mortgage crisis because banks are stupid, but people are getting farther and farther into debt, which then sparks new companies to come out and say "oh hey! we'll swoop in and help! we're not REALLY going to help you, rather, we'll be a third party and suggest a debt counselor! even though you might be $30k in the hole, we can suggest bankruptcy!" All the cash advance companies are making it worse, especially with their 400% interest rates. Suggesting you declare bankruptcy or using those pay advances isn't teaching people HOW TO GET OUT OF DEBT. It's only furthering their problem. People need to take responsibility for their actions, take control of their lives again, and get the HELL out of financial corruption.

  • bwv says:

    Who would have thought that Dr. Seuss could explain this all better than anyone:
    http://www.keepandshare.com/doc/view.php?id=297331&da=y

  • Marc says:

    I think your understanding of floating & fixed interest rates is a bit simplistic. The difference between the two is prepayment (the ability to repay the principal of the loan in advance before the "end" of the loan). The problem with fixed rate loans is not:
    >>
    If the bank gives you a loan at, say, 5% today, and then next week, the interest rate goes up to 10%, then what happens? If the bank can't change your interest rate, then from their perspective, they're missing out on the interest that they could have earned had they waited until next week to loan out the money
    >>
    There is a symetry here: if interest rate go down, the banks will have to lower the interest payment on a floating loan. In that case they are better off it was a fixed rate loan, and they where still receiving 5% when the prevailing interest rate is 2%. So this is not the big difference between fixed & floating loans.
    From the banks point of view, the problem of fixed rate loans is prepayment. If fixed rate loans where made at 5%, and the rate goes down to 2%, many people are going to prepay. They take out a new loan at 2% and pay off the old one with the money. So the banks, instead of getting their 5%, now have to reinvest at 2%. On the other hand, if the rate go up to 10%, guess what: very few people are going to prepay (but some will still do of course: they sell the house because they move, or other reasons).
    But if the rate was floating, with rates starting at 5% then going down to 2%, and some loans are prepayd, then the bank can relend the money and still get the 2%. The same goes if the rates go up to 10%. The bank does not care if you prepay a floating loan, but they do for a fixed rate loan: it will most of the time be prepayed at a bad time for them.

  • Sue W says:

    For many, many years it has been an economic miracle, defying all the "rules": Americans don't save enough, but for some reason it didn't seem to matter. Everyone was getting and spending and people were just getting richer, darn it.
    We live in interesting times.

  • MikeB says:

    Excellent article, and one which bank shareholders might like to read, to see what is being done with their money.
    The idea that the problems with the sub-prime market were unknown is strange, since Mother Jones had an excellent (and frightening) article on this very subject in 2006. http://www.motherjones.com/news/feature/2006/09/prime_suspect.html .
    As the article points out, greed on an enormous scale, bankers who didn't care as to the quality of the loans, middlemen whose only objective is to get their cut, incredible ignorance on the part of would be mortgagees, and the blindness of regulators all made this mess a certainty.
    To quote from the article -
    'Stewart was the first person ever in her family to buy a home, and she was beyond ready to leave it. The heat never came on. The kitchen pipes froze. The electric bills were up to $400 a month in the winter from the space heaters. And the dining room wall resembled a gallery installation, with wet rot oozing down from a busted pipe upstairs.
    When the decay started, not long after she moved in, Stewart called the mortgage company. She expected Argent to be responsible for the product she bought, just like her landlord once was. "They said it was on me to get it fixed!" she says incredulously. "I don't know what I'm paying the mortgage for." Hearing nothing back, she stopped paying. Argent went to Cuyahoga County Court that November and filed for foreclosure. Stewart had borrowed $85,000, and still owed $84,795.87.'
    After reading the article - which should be read by everyone with a mortgage, is anyone surprised by what happened? Of course the greedy sod who was head of the main lender in this debacle didn't suffer - as a 6 million dollar donar to the Republicans, he got made an ambassador to the Netherlands instead.
    Chris Willis does have a point about the way in which banks and other fincial institutions, no matter how badly they screw up, do seem to escape the consequences of their actions. 'Moral hazard' was one of the reasons given for the Bank of England refusing at first to step in over Northern Rock (although incompetence with all three main regulators does also have played a major role). The problem with moral hazard being invoked is simply that the collapse of one bank tends to pull down the rest, and much as I would like to see a bank go to the wall over a business stratergy which seems to border on incompetence (if only to make shareholders do other things than count their money), Northern Rock gave me a mortgage, so its not in my best interest!
    George Monbiot wrote an interesting article http://www.monbiot.com/archives/2007/10/23/libertarians-are-the-true-social-parasites/ on the free market zealots who ran Northern Rock, who suddenly needed my (taxpayers) money when the business went bad. Perhaps a more effective stratergy would be to ban these people from running companies once they've screwed up , as well as more effective control by the regulators in the first place. Oh, and Tazering them repeatedly...

  • melior says:

    Stupidity, or avarice? Piling on commenters above, another eye-opening story on the astonishing level of fraud underlying (and arguably driving) this trainwreck is here.
    It may surprise you to learn that the FBI is tossing around numbers like a 700% rise in reported mortgage fraud in the last few years, and that up to half of foreclosures in some regions are linked to criminal activities.

  • Chris' Wills says:

    .......Chris Willis does have a point about the way in which banks and other fincial institutions, no matter how badly they screw up, do seem to escape the consequences of their actions. 'Moral hazard' was one of the reasons given for the Bank of England refusing at first to step in over Northern Rock (although incompetence with all three main regulators does also have played a major role). The problem with moral hazard being invoked is simply that the collapse of one bank tends to pull down the rest, and much as I would like to see a bank go to the wall over a business stratergy which seems to border on incompetence (if only to make shareholders do other things than count their money), Northern Rock gave me a mortgage, so its not in my best interest!

    Mike,
    It might be in your best interest if Northern Rock went and died.
    Your mortgage would be part of the saleable assets (not your home just the mortgage) and as I recall it is sold with the same terms and conditions. So as long as you keep up the repayments you shouldn't notice any difference, except the name of the recipient on the cheque you write.
    .... Oh, and Tazering them repeatedly...
    Posted by: MikeB

    Tasering seems like an excellent idea.
    The possibility of a cascade effect hadn't escaped my notice, I just ignored it as this type of excuse is always made by the banks whenever they balls it up.
    I really don't believe that all banks will die, their profits might fall (say only making 20 billion instead of 100 billion)a little but not all of them have the same level of exposure and a number of them have already written of large ammounts of bad debts in this years accounts (my bank, Clydesdale, for example or more accurately the parent of the group it is part of).
    Having just one bank fall and its directors be banged up for fraud would send a very useful message to the others.
    Even if they are eventually bailed out, the directors of all the banks, insurers, property agents etc involved should be banged up for a long time and not in an open prison.

  • Op-Ed Contributor
    The Original Subprime Crisis
    By LOUIS HYMAN
    Published: December 26, 2007
    The New York Times
    http://www.nytimes.com/2007/12/26/opinion/26hyman.html
    "Structurally the program could not work because it tried to solve a problem of wealth creation through debt creation. Homeowners cannot build equity in an overvalued house, no matter what the terms of the mortgage. Whether that inflated value comes from corrupt inspectors or frenzied markets is immaterial. The crisis, now as then, is a symptom of inequality -- not its cause."
    see also two more Op-Eds on the same subject, same place, same date.

  • Only after reading this piece (excellent editorial btw, best and most honest article on the subprime clusterfuck I've read so far) did I realize just how far up shit's creek the American real-estate market is.

  • Anonymous says:

    WSJ Thursday 12/27/2008:
    Wall Street Wizardry Amplified Credit Crisis
    A CDO Called Norma Left 'Hairball of Risk';
    Tailored by Merrill Lynch
    By CARRICK MOLLENKAMP and SERENA NG
    December 27, 2007; Page A1
    -----excerpt------
    In its use of newfangled derivatives, Norma contributed to a speculative market that dwarfed the value of the subprime mortgages on which it was based. It was also part of a chain of mortgage-linked investments that took stakes in one another. The practice generated fees for a handful of big banks. But, say critics, it created little value for investors or the broader economy.
    "Everyone was passing the risk to the next deal and keeping it within a closed system," says Ann Rutledge, a principal of R&R Consulting, a New York structured-finance consultancy. "If you hold my risk and I hold yours, we can say whatever we think it's worth and generate fees from that. It's like ... creating artificial value."
    Only nine months after selling $1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit-rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk.
    ...
    ... The CDOs held chunks of each other, as well as derivative contracts that allowed them to bet on mortgage-backed bonds they didn't own. This magnified risk. Wall Street banks took big pieces of Norma and similar CDOs on their own balance sheets, concentrating the losses rather than spreading them among far-flung investors.
    "It is a tangled hairball of risk," Janet Tavakoli, a Chicago consultant who specializes in CDOs, says of Norma. "In March of 2007, any savvy investor would have thrown this...in the trash bin."
    ----end excerpt------

  • kiriel says:

    This was plain excellent! Good work Mark. You really have a gift of understandable concise communication of issues that are otherwise clouded in veils of deceptive jargon (probably to create artificial barriers of entry to understanding of [what is at the core] simple issues).
    I sometimes get the impression that most jargon is created for the purpose of disagreement rather than the purpose of agreement. Something akin to a need of creating artificial abstract niches.
    Your blog posts are like wonderful bridges that connects pure thought with understanding. Your blog posts are like neuronal growth hormone!
    Keep up your wonderful contributions to the human condition.

  • Jovita Padua says:

    FYI

  • matelot says:

    the article has an nice easy flow until the paragraph ending "That's how markets are supposed to work."
    Then there you CRASH-DIVED right into "mortgage selling" --- I got a whiplash from that and I'm gonna sue you.
    Otherwise this is an excellent, informative article

  • Tom says:

    Yeah New Orleans foreclosures are very high