Is this mortgage crisis a good thing?

[Voyager]

@D_Odds

Additionally, any workable FICA plan must include enforced divesification; not just of securities, but of asset types and classes. It must also use absolutely no leverage. What is killing hedge funds and others locked into mortgage investments is a lack of diversification (the whole portfolio is mortgage securities, with the thought that the risks are spread out across multiple securities) and that firms are borrowing to invest in the securities.

True, but the investment houses were diversified as a whole, and still suffered tremendous losses.

Attempts to increase the return on FICA assets does not mean engaging in a crap-shoot. While all investors are adversely affected short term by the fallout, strong, diversified investment portfolios will have the best short-term retention of value and the stronger longer-term prospects.

Great, but who defines this diversified portfolio? It sounds like you want to limit investment options severely, which makes sense. However unless the investments are limited to very broad index funds, there is the possibility of distorting the market by pouring all this money into it. The there is the problem of loading these funds. Today there is practically none. Is the government going to get into the brokerage business, or are we going to steer billions of dollars of business to existing brokers?

Plus, see iamthewalrus(:3= on risk. While I think the state finance officers weren’t doing anything that unreasonable, given the pressures, there is no reason at all to increase the risk factor for Social Security. In addition, I heard on Marketplace yesterday that the gap just got defined down, because they weren’t factoring in payments from immigrants who aren’t going to be around to take their money out at the right levels.

People without much money need to be the most insulated from risk, since they are the least likely to weather a downturn. Those of us with money can be as risky as we desire in our 401Ks and IRAs.

[John_Mace]

@Voyager

The problem with this is that long term increases include short term fluctuations. Hitting retirement age during a down period is going to be painful. Wanna bet if this happens a bailout is going to be politically necessary?

First, I don’t know of anyone seriously floating the idea that we should invest the SS funds in subprime mortgage securities. As was noted, you put them in highly rated investments that are also highly diversified. And you don’t withdraw it all at once, so the idea of crashing because of some temporary downturn isn’t really an issue. The goal would be to get something better than the typical 2% return that it gets. You could very safely inflate that to 3% and make a 50% upside.

[iamthewalrus_3]

@Voyager

And it is easy to criticize decisions in hindsight.

I agree. At the same time, it seemed to me like, during the buildup, people were basing their financial strategies on two points:

1. Mortgages have always been a stable, long-term, low-risk/low-return investment in aggregate.
2. Holy crap, look how much money we can make by heavily leveraging into repackaged mortgages!

Obviously, those two won’t both stay true for long.

ETA: Which doesn’t mean that the state financial controllers were doing this speculating, but it is a contradiction to think that you’re somehow getting a magically better return and there’s no extra risk associated with it.

Do you have any money in uninsured money market funds? They can go under at any time. I assume you are willing to assume that risk to improve on returns vs T-bills or Passbook savings accounts.

I don’t, but I do have money in stocks, which I know can go down, potentially all the way to 0. But, if they did, I wouldn’t be going around claiming that I was duped into investing without knowing the risks. I also think that a quarter-percent is well worth it for FDIC coverage when comparing a savings account with an uninsured money-market account.

[Voyager]

@John Mace

First, I don’t know of anyone seriously floating the idea that we should invest the SS funds in subprime mortgage securities. As was noted, you put them in highly rated investments that are also highly diversified. And you don’t withdraw it all at once, so the idea of crashing because of some temporary downturn isn’t really an issue. The goal would be to get something better than the typical 2% return that it gets. You could very safely inflate that to 3% and make a 50% upside.

I didn’t think you were suggesting that - but remember that some of this crap was AAA rated, and only looked risky in retrospect. It would be interesting if a deregulated environment would prevent people from “making more money” on this kind of investment.

The problem with the downturn is that it forces people to sell low, since they’ll need the money. Downturns when you’re buying are good things, so long as you don’t panic. A lot of people I knew at IBM had a lot of their retirement investments in IBM stock, thinking it was safe. When they got laid off during the downturn, the stock was very low, and they got clobbered because they needed the money.

Happily this is all academic, since if Bush couldn’t sell this when he was at his most popular, I don’t think anyone else will.

[Voyager]

@iamthewalrus(:3=

I agree. At the same time, it seemed to me like, during the buildup, people were basing their financial strategies on two points:

1. Mortgages have always been a stable, long-term, low-risk/low-return investment in aggregate.
2. Holy crap, look how much money we can make by heavily leveraging into repackaged mortgages!

Obviously, those two won’t both stay true for long.

Quite true. So why did these guys getting million dollar bonuses, and thus by definition smarter than you and I, do it? I think they convinced themselves

1. The mortgages were sliced and diced, so that even if some defaulted they’d be such a small part of the package no one would care. After all, there had never been a nationwide decrease in home prices since the Depression (and I’m not even sure about that.)

2. The bank across the street was doing it, so if we don’t we won’t make as much profit and our stock will go down and we’ll only make a bonus of $750K. Of course you can make even more by leverage.

Bank runs. People losing big by buying on margin. Where have we heard that before? Maybe MBA programs in investment banking should have a required course on the Depression that includes living in a shanty and selling apples to give these guys a real feel for the downside.

[D_Odds]

@Voyager

True, but the investment houses were diversified as a whole, and still suffered tremendous losses.

They weren’t as diversified as they thought.

Sure, Bear Stearns business lines were diversified. But there was a section of the investment bank that was investing in securities they didn’t really understand (like so many other investment banks) because they were chasing returns. They leveraged their positions (borrowed to make investments). The problem with leverage is that when things go south, the effects are multiplied. No one at any of these investment houses was managing risk properly. And if anyone was pointing out the risks, no one was listening - too common when chasing returns to compare favorably with one’s peers.*

This isn’t the first time this has happened. Orange County, CA was brought to its knees because they, too, invested in derivative instruments they didn’t understand. And the financial system had to be bailed out before when Long Term Capital Management imploded due to excess leverage. The pressure to outperform makes smart men take dumb risks.

Great, but who defines this diversified portfolio? It sounds like you want to limit investment options severely, which makes sense. However unless the investments are limited to very broad index funds, there is the possibility of distorting the market by pouring all this money into it. The there is the problem of loading these funds. Today there is practically none. Is the government going to get into the brokerage business, or are we going to steer billions of dollars of business to existing brokers?

Plus, see iamthewalrus(:3= on risk. While I think the state finance officers weren’t doing anything that unreasonable, given the pressures, there is no reason at all to increase the risk factor for Social Security. In addition, I heard on Marketplace yesterday that the gap just got defined down, because they weren’t factoring in payments from immigrants who aren’t going to be around to take their money out at the right levels.

People without much money need to be the most insulated from risk, since they are the least likely to weather a downturn. Those of us with money can be as risky as we desire in our 401Ks and IRAs.

I wouldn’t even try to define the policy. I’m not against trying self-directed Social Security, but it must be implemented to reduce risks greatly. I’ve heard some talk as if they would be able to take their Social Security withholdings and invest them in their brother-in-laws hot tip. I’d fight that tooth and nail.

@iamthewalrus(:3=

ETA: Which doesn’t mean that the state financial controllers were doing this speculating, but it is a contradiction to think that you’re somehow getting a magically better return and there’s no extra risk associated with it.

Preach it. I don’t know why people, from intelligent money managers to the below-average investor can’t remember this. Risk and reward are a tradeoff.

*We could delve even deeper into the reasons for Bear Stearns collapse. In its simplest form, which I believe you acknowledged in a later post, it was a run on the bank that killed it more than anything else. I’ve heard rumors that certain Wall Street players were doing everything short of rubbing their hands together and gloating about being able to pick over BSC’s corpse. Not only did they know what was happening; they were contributing to it.

[D_Odds]

@Voyager

I didn’t think you were suggesting that - but remember that some of this crap was AAA rated, and only looked risky in retrospect. It would be interesting if a deregulated environment would prevent people from “making more money” on this kind of investment.

Sad but true. Money market funds were invested ‘secure’ derivatives based off of sub-prime loans, and had to be bailed out by their parent companies or risk dipping below $1.00/share.

[gonzomax]

You are ignoring the individual reasons for sub primes. Companies that originated the mortgages were paid well for their services. Nice salaries and bonuses. Then they sold the mortgages off . Their liability was over. They had no incentive to make good loans. They had no exposure.
Companies that bought them showed huge wealth. They got big salaries and bonuses. The financial institutions were cleaning up. They were kind enough to spread the exposure around. They packaged them around the world.
No one was regulating them.

[D_Odds]

You’ve got the basics gonzomax.

While I don’t think there is a ‘definitive’ order, here is the consensus opinion:

• Securitization teams determined that they could increase returns with little increase in risk by increasing the %age of sub-prime mortgages into their bond pools.
• Portfolio managers snapped up these new pools, which had greater returns for little additional risk. Demand for these pools grew.
• To meet demand, securitization teams started seeking out more and more sub-prime loans. Demand increased the that the bond underwriters were willing to pay for sub-prime notes.
• With prices and profits rising, mortgage brokers did their part, increasing the supply of sub-prime mortgages so that they could get their share of all the money being thrown around. With a steady market for their mortgages, there was little incentive to vet the loans. If bank A wouldn’t buy, bank B would.
• In the “they never learn” category, bad money followed good, creating a bubble.

Full disclosure: I consulted for a investment bank that spun off a multi-billion dollar hedge fund primarily focused on mortgage trading. I work mostly on the operations side, but I deal with everything pre-trade analytics (front-office) to month/quarter end reporting (back-office). The hedge fund was only active for a few months before it collapsed, one of the first (if not the first) victims of the current mortgage crisis. IMO, the fact that one of their main sources of funding was pulled so early saved them from even more disastrous losses.

[mazinger_z]

@gonzomax

You are ignoring the individual reasons for sub primes. Companies that originated the mortgages were paid well for their services. Nice salaries and bonuses. Then they sold the mortgages off . Their liability was over. They had no incentive to make good loans. They had no exposure.
Companies that bought them showed huge wealth. They got big salaries and bonuses. The financial institutions were cleaning up. They were kind enough to spread the exposure around. They packaged them around the world.
No one was regulating them.

There is no individual reason, no easy reason for the sub prime mess. Behind the current liquidity crisis is mismanagement (really, it was bad guessing and profit chasing) of mortgage backed securities, collateralized debt obligations and other derivatives, cheap cash, house bubble bursting, speculators in the housing market, and overall lack of consumer and investor confidence (really, it’s much more complicated than this). As many others have pointed out to you in other threads, it takes two to tango. People knew or should have known the risks of getting into a mortgage. Yes, I will not deny that there was bad loans made, but for the over all system, it was not an act of predatory lending that you make it out to be.

It’s not entirely true that there is no liability once the loan is sold. They still have their own contractual promises to uphold to the buyer of these loans. In addition, these companies have a future to look out for, right? If it is exposed that they are indeed doing bad loans, the future of their business and their license to originate these loans, you know, the very core of their business is in jeopardy.

Ultimately, the reason for all this mess can be attributed to sub-prime mortgage holders paying back their loans (thus making their loans look attractive to the secondary market) as it can be to fund managers looking for an easy way to hedge their bets on the open market.

What kind of regulation are you looking for? Investors up and down (from lowly brokerage houses to Wall Street giants) were not doing their due diligence in buying this kind of sub prime paper. When these sub prime mortgages were really performing, auditors (at least according to my friend’s firm in LA) were examining 2%, i.e. reviewing the documentation and underwriting process for 2 out of every 100 loans (down from 50%). Investors of these derivatives, MBSs, CDOs, whathaveyou, were buying them up and couldn’t even wait for the review process to be completed quick enough. In retrospect, if they had eager buyers, why wait? The purchase price was as low as 6% (remember these are risky loans, though 6% was considered high). These are not new financial instruments. Markets already internalized the risk. The fact that borrowers were paying these back and not defaulting along with the rise in the housing markets only expanded Wall Street’s appetite for this type of loan.

Where would you put the regulation in these types of transactions? Prevent sub-prime mortgages? Would you forbid the derivative market all together? Are you only going to allow the sale of mortgage backed securities if the buyer has completed a review process of a minimum of 50%?