Tuesday, February 10, 2009

Destroying the Economy in Five Easy Steps

The President was in Ft. Meyers Florida today seeking to build support for his stimulus plan while his Treasury Secretary was back in Washington doing everything he could to erode whatever confidence the American people have in the administration's ability to handle the current state of affairs.

Most of the reports that I saw, read, or heard described Ft. Meyers as having the highest home foreclosure rate in the nation during 2008. Here is a sample of the coverage:
In 2008, the Coral-Fort Myers area had the highest foreclosure rate in the United States, with 12 percent of home units being hit by a foreclosure related notice, Real Estate groups said.
High rates of home foreclosures are often cited as the spark that ignited the current economic conflagration, but the scope and magnitude of the current crisis seem out of proportion with a foreclosure rate that, in the hardest hit part of the nation, is only 12%. No doubt housing makes up a major part of our total economic activity, but don't we have sufficient other output to offset a foreclosure rate that is barely in the double digits? Obviously, the answer is no (just look around). Based on my (admittedly limited) understanding of events, I have listed below the sequence of events that turned a relatively small foreclosure rate into a global economic meltdown.

1. Mortgages were offered to and accepted by people who had no means to pay them under the terms agreed to. This is idiotic in all cases and in some cases was no doubt illegal.

2. Financial institutions realized that the revenue streams from these mortgages could be securitized. This involves bundling them together and then selling a share of the bundle to investors. The bundled mortgages give the appearance of less risk for the investor because he owns a piece of many mortgages, rather than just one mortgage that could go bad if the borrower, say, loses his job. The bundled mortgages give the appearance of less risk for the financial institutions since they are no longer holding the mortgages. After all, they bundled the mortgages together and sold them to the investors.

3. Rather than just sell securities based on the entire pool of mortgages though, banks sliced the pool up into something called tranches (I'm pretty sure tranche is French for 'not worth the paper its printed on'). The institutions then sold securities based on each tranche.

4. The tranches were often organized by risk. That is to say, the loans most likely to default were in one tranche, then the next likely to default were in another, and so on. Amazingly, the financial institutions often kept the securities based on the most risky tranche themselves! In essence, giving insurance to the folks in the later tranches against the most likely losses. Why would they do this? Some possibilities: 1. They didn't even realize this is what they were doing; 2. They deluded themselves into thinking that home values would always rise and losses could be stopped through refinancing; 3. Keeping the riskiest tranche made it much easier to sell the others and the profit motive was greater than the perceived risk; 4. All of these.

5. Finally, the financial institutions looked around at all the securitized mortgages and realized that they could start buying and selling insurance against loss on these securities to each other. These are the dreaded Credit Default Swaps. But since nobody put away enough money to pay for the losses if loans started to default, nobody could pay the claims on these insurance policies. So the swaps didn't offset anybody's risk and they became a drain on the resources of the companies that acted as the insurers.

There you have it. How to take too much of a good thing and distill it to a highly unstable, and quite possibly lethal, risk cocktail. Financial institutions ended up holding securities based on the riskiest mortgages out there and then writing insurance policies on the risky mortgages that other institutions were holding. Now I've heard that uranium enrichment requires centrifuges and aluminum tubes. Enrichment on Wall St., however, appears to require little more than the dream of home ownership, some motivated salesmen, and a few math majors. In both cases, this enrichment process leaves behind a dangerous residue that can make you very sick and is not very easy to dispose of. If anyone asks you when things will turn around, just ask them if they know the half-life of a toxic asset?

No comments: