Friday, October 3, 2008

Who is to blame for the mortgage crisis?

The house and senate passed the bailout bill today, which will save the American Way of Life; that is, allowing us to keep borrowing money to buy things we want. Now that it's resolved, we can get back to the interesting question of "who is to blame?"

There are really five players in what has passed for the home mortgage value chain.

The Homeowner: They want to borrow money to buy a house.

Example:  You.

The Mortgage originator: They create the paperwork for the mortgage, borrow money from CDO packagers to give to the homeowner, and then give the completed paperwork to the CDO packager.  They collect a handsome transaction fee.

Example:  Countrywide, "the fourth largest subprime mortgage originator in the U.S."

The CDO packager: They give their own money to a bunch of mortgage originators to buy the mortgage assets.  They then wrap a few hundred thousand of them into a single package, and slice and dice it into different tranches (A French word meaning, "I am much more sophisticated than just saying 'slices'").  They then sell all of it to CDO buyers for the same amount of cash that they gave to the mortgage originator.  They collect a handsome transaction fee.

Example:  Lehman Brothers, "long the leader in selling bonds backed by risky mortgages, often referred to as subprime loans".

Rating Agencies: Each slice needs to be rated by an independent referree.  The ratings agency looks at each slice and then put a stamp on the relative riskyness of it.  They collect a handsome transaction fee for rating them.

Example:  Moody's," the deal could be structured by cows and we would rate it."

The CDO buyer: These are organization with tons of dollars sitting around, for things like selling oil or cheap plastic toys to Americans.  They buy all the slices of the package from the CDO packager, because it returns a higher interest rate than comparably risky assets.

Example:  The Bank of China, "holding almost $9.7 billion (U.S.) in securities backed by subprime mortgages, about 3.5 per cent of its portfolio."

Market Plays:

In consulting and banking you find very smart, hardworking people who believe completely in capitalism, the profit motive, and proper incentives will lead to the economic dominance of whichever species best captures their motivating principles.  For Example:
Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work. - Equity Private
In considering incentives in this situation, we can ask ourselves 3 questions:
1) Who makes money in the short term?
2) Who makes money in the long term? 
3) Who owns the risk? 
In this case, it's fairly simple.

There are really 2 market plays given this dynamic:
Potential Market Play 1: Take on the risk, but only if it's commesurately balanced with the long-term reward, behaves on the efficient frontier of return, is completely understood, can be insured against external risks, and is aligned with the asset class allocation for your particular needs.
Potential Market Play 2:  Take the no-risk, immediate upside choice, and flog that baby for every red cent you can squeeze out of it before it blows up.
Any committed capitalist loves game theory, and game theory predicts that the optimal strategy is to follow market play 2.  Anyone who takes market play 1 will inevitably be blown up by players  following market play 2, which is what's happening now in the US mortgage market.

Insight 1: Bubbles have been regular occurances in financial markets for at least the last 400 years.  

Insight 2: The people who make money in bubbles are those who make immediate money, without taking on long-term risk.

Conclusion:  If you're looking for someone to blame, blame the mortgage originators, the investment bankers, and the ratings agencies.

1 comment:

Anonymous said...

good one. short and sharp

Friday, October 3, 2008