Thursday, September 8, 2011

Financial crises for the Compleat Idiot

"You really should read this", said my son-in-law after he perused The Big Chill by Michael Lewis. "These guys figured out a way to get rich during the sub-prime mortgage fiasco. You won't believe how they did it".

As little as I know about micro-economics, it would dwarf my understanding of macro-economics. I ordered the book and polished the whole thing off during the Labor Day weekend.

Getting through the book required little effort. It's well-writing in a very compelling narrative style. I wanted to know which political party the author would place the blame for the whole mess, and I was pleasantly surprised how apolitically Mr. Lewis presented the events.

We all lead very busy lives so I will take the liberty to offer a synopsis of the book. If you think I mess up any of the points, please let me know. As I said, I claim no expertise in this subject.

How to destroy an economy in a few easy steps:

15 years ago Big Banks (BBs) were centers of capital investment, providing businesses and institutions with the credit needed to allow them to function.

During the 1990s and 2000s the BBs discovered that they could make even more money by engaging in Market Speculation. They developed an appetite for speculative ventures that would make lots of money for them.

Mortgage companies, especially loan originators underwrote loans to darn-near anyone who could fill out a form. People with poor credit scores had to pay more than the prime interest rate, called the Sub-prime interest rate (since the rate is higher than the prime rate, logically it makes more sense to call this the Supra-prime rate. Get used to this).

Loan originators didn't worry if the debtors could never repay the debt, because they turned around and sold the loans which were called Asset-based securities. BBs bought them. The loan originators made lots of money on the origination fees.

Moodys reviewed these securities, and for reasons that defy all reason, rated the lions' share of these securities AAA.

The securities that were not rated AAA were repackaged by a system that can only be described as alchemy into Collateralized Debt Obligations (CDOs). No one really knows what that means.

The CDOs were resubmitted to Moodys, where the lions' share were rerated AAA. How this was done is a greater mystery than abiogenesis.

The BBs liked them because they were rated AAA by Moodys so they bought lots of them and made lots of money on them initially.

A few investors, upon reviewing these ASBs, determined that these securities weren't worth the paper they were printed on. Everybody told them they were stupid.

The investors wondered how they could make money by "shorting" these securities. They turned to yet another weird investment tool called Credit Default Swaps (CDSs). Credit default swaps are really inexpensive (relatively) insurance policies that allow the bearer of the swaps to collect the total value of the ASB if it defaulted.

What's weird is that you didn't have to own an ASB to buy a CDS. Why should this be? No one knows.

The small group of investors bought all the CDSs they could get their hands on. The BB that sold the most of them was AIG-FP. They were happy to sell the CDSs because the ASB they were insuring were all rated AAA by Moodys.

In early 2008, predictably almost down to the month and maybe even the day, the sub-prime mortgage loans defaulted in huge numbers. The ABSs became worthless. This was bad for the BBs because they held billions and billions of dollars worth of them.

This was even worse for AIG-FP because they had to pony up for the CDSs, which made the investors who held them a blue fortune.

All of a sudden the BBs realized they didn't have much money. The entire US economy was screwed. They went to the Federal Government for a bail-out, which they got for the most part (TARP).

On retrospect, it seemed unwise to offer a migrant worker who made $14000/year a $750,000 home loan. This really happened and it's what led one investor to take an interest in this market.

It seems criminal to have allowed predatory lenders to have originated these loans in the first place.

It seems beyond stupid that the BBs did not perform due diligence when they were purchasing massive amounts of these ABSs and issuing CDSs.

It seems that the people who took BBB ABS and mysteriously turned them into AAA CDOs should be arrested for market fraud.

And you, dear reader, if you are one of the 55% of American voters who actually pay Federal income taxes, have underwritten the entire thing.


  1. Dear Dr. Bailey,

    For several years I followed you on your older blogspot account. Just now, when I went to log in, your new blog popped up, much to my delight. We are nominially complete opposites, politically, but I feel a strong link in the "uncommon sense" area.

    Here's my latest, for a sample:

    I guess what seems to be the missing piece here, are the clauses in the contracts with the various unions, in which it is clearly spelled out that they are the ones in charge of keeping the governments' books straight, and giving them the power to tax as needed to generate the income to guarantee that the government lives up to its side of the bargain.

    If you can show me ONE SINGLE UNION CONTRACT, in which such oversight and taxing power is included as part of the deal, then indeed, I will agree, the budgetary problems ARE THE FAULT OF THE UNIONS. However, since you can't, then the responsibility for the budgetary problems is the fault of every single US of A citizen out there, including all those who waited until Obama was elected to start complaining vociferously and blaming the issue on him and the public employee unions.

    Passing on the debt to future generations is just one possible solution. Taxing the assets of the wealthiest is yet another. I can't conceive of any reason why one person needs to own more than $100,000,000. Yes take care of the obligations incurred 30 years ago, with the money from the richest and therefore the MOST CULPABLE, as they could afford the experts to do the needed analysis way back when, but waited until Obama was elected to make their moves. In the meantime, they harvested the cash, free of any pesky taxes. Time to pay up is now.


    I note in passing that the Tea Party Right is beginning to back off blaming people (unions) and is now concentrating on blaming all the rules and regulations. As I have pointed out before, the government needs to maintain a help desk, staff by US citizens, living in the USA, of course, that answers the phone within 3 minutes with a human who has the final authority to walk the business person through filing out the forms correctly. Given today's online screen sharing capabilities, this should be a no brainer, and will put at least 100,000 people to work. All phone answerers must have a four year degree, and be well trained.

    The robotic pre-screener will determine the type of business, using the standard codes, and then pass the person on to an appropriate screener, who can then alert the caller via email to all possible regulations, for that code, which will of course be online, and each one will include a common English translation from the governmentez. If after two hours of active communication, the form remains incomplete, the business person is excused from that law for one year, subject to review for sincerity and prep on the callers part.

    BP cannot have a driller attempting to answer environmental regulation questions. BP must hire a regulation specialist for each major subdivision.

  2. I assume an exellent summary. Been meaning to read it, thanks for the time saving synopsis.