Sunday, April 19, 2009

The finance crisis as explained for the benefit of 16 year olds

A nifty Harvard Business School report explains the financial crisis in pretty readable form. But if even that is too scary, we fed it through the trusty ol' Analogizer, and threw in a few extra finance texts to boot. Here's what came out:

Maria is pressing her young beau Tony ("Tony the Stereotype" to his friends) to make good in life, become bona fide, and bring home some bacon (bacon bits, minimum). Tony figures he only has one useful skill, so decides he's gonna open up "Tony's Caah Shop." He figures he can make an ok living at that, only problem is that he needs a shop first... which means he needs to rent some space on Main Street, buy a car lifter, get some new wrenches, hire a pretty young receptionist whom Maria will hate... call it $40,000. But Tony only has $14.52 and a half tube of Bryll Cream to his name. He looks under both couches for spare change but still comes up 35 grand short.

So Tony goes to the bank, talks a good game to Michael the branch manager, reminds him that Mikey still owes him from that one time in Junior High. He gets a $30 grand loan, sets up his shop, and fixes a lot of cars, and in due time pays the damn thing off. Life is good, and he is now tha man, with all the bacon, fries, and cold brews he ever wanted.

Fast forward, oh, 30 years.

Tony is now his town's car repair magnate, with as much lite beer at his beck and call as Jane (wife number two) won't let him drink ("you're getting fat." "No I ain't" "Yes you are." Rinse repeat, repeat).

But the car repair business ain't what it used to be, as all the new cars have too many computers in them to be easily fixable... But ol' Anthony is a man o' the times (at least, when Janey pushes him hard enough to be), and comes up with a new better plan. He's going to convert people's cars from gas to electricity. Unfortunately, if he's going to convert enough cars for this to work out, he'll need more wrenches. A lot more wrenches. And some big machines. When he does the math on this (and Tony Jr. fixes the mistakes in it), he basically needs a small factory. Which costs, oh, let's call it 40 million bucks.

So Tony goes back to Michael the banker for another loan. "April first was last week." Mikey says. "Pull the other one. Forty million bucks, what are you thinking?" No amount of arm twisting is going to get this kind of risk past Mikey's bosses. But there's an answer. Tony's Caah Caanversion can get individual investors to give him the money instead of just one bank. An investor forks over, say, a grand, and Tony gives them an IOU (i.e., a "bond") that he'll get them back for twelve hundred bucks in two years. Sell enough "bonds" and he can get his 40 million, build his factory, and start rolling in the sales revenue to pay off all the bonds and their fixed amounts of interest. Play it right and he'll need fork lifts to get all his bacon back home.

In fact, Mikey the banker thinks he might buy himself some of Tony's bonds. He may only be a lowly branch manager, but by dint of living in a tiny apartment, and subsisting entirely on Ramen Noodles and Kraft Dinner (he's from Canada) he's managed to put Mikey Jr through college and still save up $30 grand. He figures a savings account would only pay him 1%, or so, but he could buy ten of Tony's bonds for $10 grand, and in two years he'd get back $12 grand. Boom boom boom, two thou new friends, just like that.

But Tony isn't the only person out there selling bonds. So is IBM. So Mikey thinks about this some. The problem with Tony's bonds, is what if the factory doesn't work, or the cars don't sell, and his operation goes belly up? If Tony goes out of business then Mikey doesn't get ANY of his nest egg back, he's just lost 10 grand. And let's face it, Tony is a good guy, but does he have it in him to run a whole factory? On the other hand, he's pretty sure IBM will still be there even five years from now, so it seems like a slam dunk to buy the IBM bonds instead. Or it would be, except IBM knows that Mikey knows that they'll still be there in two years. In short, IBM knows that Mikey likes their stability, so they know they don't have to sweeten the pot much to get him to bite. So their IOU bond offers only $1100 in two years, not $1200 like Tony's. So what's a wannabe investor to do? How can he (or she) figure out EXACTLY how likely it is for Tony and IBM to snuff it in the next year?

This is where credit rating agencies come in. These are companies like Moody's, and Standard and Poor. Their whole gig is to look at company's like Tony's and IBM, and judge what the exact chance is that they'll be able to pay back their bonds down the road. They work out what the percent chance is, and then, because some investors are afraid of numbers, they turn it into a pretty letter grade like AAA or A- or B+. And they're pretty good at it, having been doing this for a hundred years and change. The riskier they say that your company is, the more you're going to have to offer as a return on your bonds if you want anyone to give you money for them. If IBM is an AAA rated company, their bonds are considered as good as money. If they say they'll pay you $1100 in 2 years, then darn it you're going to get your cash. If they say Tony is a B+, then they're letting you know that he's probably good for it, but you're definitely taking your chances.

Now let's move a little further up the food chain. Mikey Jr.'s dad didn't just put him through any old college, he finagled him into Harvard. And nobody ever really fails out of the Ivy League once they are enrolled, so Mikey Jr. graduated and was hired by an investment bank. Unlike dad, he spends all day every day toying with stocks and bonds and similar.

When you're a bank you've got two types of clients. One type gives you money to look after, and the other type you loan money out to. Having these two types of clients is basically what makes you a bank. So in that first column, there's the pension fund that Tony set up for his employees. He pays a bunch of cash in now, and expects to get it back with some interest when his employees retire so they can afford properly negligent and abusive hospice care. So Mikey Jr has that money to look after. This is where his other type of client comes in. He can check out businesses, and lend to them if he likes whatever project they need cash to get going, demanding a big payback down the road. Or, if he doesn't want to do all the work checking this company out himself, he can ditch the boring world of savings and loan banking and just start buying bonds from these companies based on what Moody's says. And the best part of this is that if he has a bond that pays back $1500 in 5 years but he needs the money now, he doesn't wait, he can sell it for $800, and whoever buys it can be the one to sit around and wait for the big payout. He just needs to sit at his little computer, and he can buy and sell bonds all day.

From his point of view, buying a bond is just giving someone some money now in return for getting more money later, and a mortgage is exactly the same thing. You give someone money to buy a house now, and then they pay you back in little drabs every month for the next 30 years. Cash goes out now, and (more) cash comes in later.

But then Mikey can get even smarter still. Why bother holding on to all those bonds and mortgages when he can just sell them (for a fee naturally) to the pension fund, and THEY can hold on to the suckers themselves? But there's a problem here. Lots of pension funds, and other such organizations don't want to buy mortgages because they're too risky. Last thing they want is to buy up a bunch of mortgages (meaning they pay someone for the privilege of receiving all the monthly payments that will be made on it in future) and then have a bunch of those houses default on them (as home owners are wont to do), and then they have nothing for their people to retire on. A lot of these funds have explicit rules saying things like "we only buy things rated A+ or better."... but mortgages aren't rated by credit agencies. And even if they were, they wouldn't be rated that high.

Here comes the game changing wrinkle. This is the bit that this whole story has been leading up to. This is the big idea. What some overly smart person realized is that while any given mortgage (or bond, or whatever) might go bankrupt and default on you, if you take a whole bunch of them and pipe the incoming money into one bucket, then the bucket might not end up fill all the way up as high as it should if EVERYONE paid, but it's certainly not going to end up empty either. SOME of those payments are bound to work out. So here's the clever plan: You take this bucket into which all the mortgages are paying, and you label the bottom third of it the "senior tranche." That means that when it's time to empty the bucket, people who have bought rights to the bottom third get first dibs on whatever is there, and they are pretty much guaranteed to be in luck. Then you can call the middle third the "mezzanine tranche" and the top third the "junior tranche." If you buy the junior tranche, you're only getting paid back if enough mortgages paid in enough cash for the bucket to get filled up high enough. The junior tranche therefore sells pretty cheap. The senior tranche OTOH will cost you. It's like buying IBM's bond instead of Tony's, you pretty much KNOW it's coming through.

And when Tony Jr. takes a bunch of bonds or mortgages (or bonds or whatever) and does this, he has now "structured" them into a "structured investment vehicle." In this case, specifically, it would be a "collateralized debt obligation" (yep, the CDO's we hear so much about).

And what is so great about doing this? Well, those rating agencies who wouldn't touch mortgages were fine with putting AAA ratings on those super safe senior tranche's, and when those tranches have AAA ratings, pension plans and mutual funds and suchlike are now comfortable buying them. Tony Jr. has put himself on the gravy train.

But what does he do with those middle and junior tranche's? They are kinda risky because heaven knows SOMEONE is likely to default. But not to worry, another smart banker figured he could just pull the same trick all over again, and roll a whole bunch of junior tranche's into a new bucket, and label that new bucket with it's own tranches. So the senior tranche in this new CDO bucket (a CDO2 if you will) gets first dibs on whatever money comes through from the bottom tranches of the original CDO's, and so on. And the innovative free market jumped all over these new opportunities with alacrity, pumping more and more money into these wildly profitable "instruments." And yea, did business ever boom.

Now in the bad old days a bank would give you a mortgage, and then live off the money that you paid them for the next 30 years. That meant banks didn't want to give you a mortgage if they didn't have a pretty shrewd idea you were going to pay it back. But with the advent of CDO's they didn't have to do that anymore. They could make a mortgage, and then turn around and sell the rights to the mortgage payments to someone else, take their cut, and wash there hands of it. Most banks would try and sell their mortgages to the quasi-government organizations Fannie Mae (FM) and Freddie Mac (also FM). But the FM's had standards. They wouldn't buy up a loan unless it was made to someone with a job and a respectable credit rating. But a few private investors would buy up loans that the FM's would turn their nose up at. These 'sub prime' loans were pretty dicey of course, but the magic of structuring them into a CDO made a whole lot of that risk go away. After all, even if half of them defaulted, your senior tranche was going to be basically ok.

And these CDO's became big big business, to the point that more money was being spent on trading them back and forth than was going into building the factories, and other "real world" activities that all of this was supposed to be supporting. And to feed this market, a bunch of private sellers got into real estate, writing mortgages as fast as they could talk people into buying a shiny new house. And who cared if these people even had any money down, an income, or a credit history, just so long as they could be signed up for a mortgage that could be packaged into a CDO and sold on to some investor. And the junior levels of these dicey dicey CDO's? Well, just roll a bunh of 'em into a CDO2 and you can sell them for even more. And, of course, all this extra house buying meant there weren't enough houses to go around for all the people who wanted them, so the prices went up and up and up... which, of course, made real estate look like a fabulous investment ("prices have gone up 30% in 3 years!"), so people got into buying houses just for the rising values... This is what economists call a "bubble." Bubbles have two properties. They inflate, and they pop.

Now here's another wrinkle on the wrinkle on the wrinkle: Credit rating agencies normally consider companies separately when they rate them. Odds of them going bankrupt may fluctuate up or down with the business cycle, but the credit rating companies just give you the long term outlook, regardless of what other company's are doing. And for investors who are just buying stocks and bonds from individual companies, this is fine. But the thing about these CDO's is that for them it really DOES matter if something bad happens to the other mortgages feeding into the same bucket. If you bought from the middle level of a bucket, you might not care if any one of the mortgages goes bad, but you do care a whole lot if they all go bad at once. You only get paid if enough money pours into the buckt that it fills up to your level. But the odds of a whole lot of mortgages independently folding up are small, right? Like, it's possible to flip a coin and get 40 heads in a row, but surely it's a pretty safe bet that it won't.

But let's say those houses are all in the same town, and lets say that the factory closes which used to employ most of the people in that town. All of a sudden you really do have almost all those mortgages defaulting at the exact same time. Rating agencies didn't really think about this much, because they weren't used to considering systematic risk. Or what happens if the economy suddenly goes into a recession...

Now let's put these two things together. One, we've got people buying stakes in buckets of money that are filled up as mortgage payments pour into them. Two, we have a housing bubble where prices go up and up in a self-sustaining cycle... which makes people want to give mortgages to anybody possible so they can package the mortgages into a CDO bucket, which makes the price go up even more. Oh, and did I mention that income for middle class earners had been stagnant for a decade (thanks Dubya!), so families were piling on debt, and taking out second mortgages (now rebraded as "home equity loans," which sound way less threatening, right?) just to maintain their standard of living... So, all of those mortgages feeding into those CDO buckets weren't really as independent as rating agencies assumed them to be (as they assume about everything).

So... when people finally got to the point that they wouldn't pay any more for houses, the prices stopped going up. And that meant that all the people speculating in real estate lost money. So they stopped trying to flip houses. And then there weren't enough real actual home buyers to keep prices up at their astronomic levels. So house prices went down and when that happened, lots of homeowners found themselves with freshly bought houses on which they owed considerably more than they could ever get by selling it (they were "upside down" in finance speak). So a lot of them walked out and defaulted on their mortgage payments, and all of a sudden, the cash flowing into those CDO buckets suddenly slowed to a trickle. People holding mid level CDO tranches, who had thought that it was almost impossible for so many people to default at once, found themselves looking ashen faced at their books, wondering what just happened.

And it was even worse for people holding a CDO2, because even the "senior" tranches were made up of the left-overs from the bottom levels of groups of other CDO's... and the bottom level of all those CDO's were disappearing wholesale. Which was bad news for sub-prime assets, and bad news for pension plans and middle class guys like Mikey who had bought in to them to provide income to retire on.

And banks, who had taken in lots of people's money, with promises to pay more of it back later found that a lot of the money that they had been holding as nice profitable CDO's was now pretty much worthless. These are the "toxic assets" we hear so much about. It's not that they're toxic per se (really, a bank could throw them out their window tomorrow, if they wanted, and pretend they never saw them before), it's that they took the money they were supposed to be looking after and bought magic beans that stopped being magic, and now they don't have the cash to pay out what they owe. As the old saying goes, "it takes money to make money." A bank without money is therefore in a whole world of hurt.

And now we're at the end of the story. But before you go read that Harvard report (which hopefully you're now even better positioned to understand), there's one last question to consider. Why were these CDO's so overpriced?

Well part of it was that credit agencies were only used to considering companies in isolation, and weren't very good at considering systematic risk, like we just discussed. According to these Harvard guys' simulations they only had to be a little bit wrong about how much the odds of one mortgage defaulting were related to the odds of other mortgages defaulting (or bonds or whatever) for the predicted default rates to go badly wrong (especially for the CDO2's).

But another part was because nobody had really thought through how even the top tranches would be affected by recessions. Imagine you're Mikey Jr., and you're buying stocks and bonds. When the economy does well, you do well, and when it does badly you take a hit. But what you really want is for your wealth to grow steadily, rather than shooting up and crashing down all the time.

So what you really want to find are a couple of stocks that might not grow as fast in the good times, but that are pretty immune to recessions - maybe beer companies, or movie theaters (people need to escape from bad times, right). If a stock move the opposite way most other stocks move, then it's a valuable one to have, because it smooths out the peaks and crashes in your portfolio (in finance jargon, it's a hedge, because it hedges your bets). But CDO's are the opposite. They are pretty much guaranteed to do well when the economy as a whole is doing well (because companies don't default on their bonds, and people don't default on mortgages when it's easy to make sales and get hired). But they reliably run into a whole lot of problems when the economy does badly (companies run out of cash to pay bonds all at the same time, people get kicked out of their houses en masse). That should make CDO's less attractive to own, but because people just hadn't thought this through (CDO's hadn't been invented last time there was a really big crash - or at least, they weren't widespread then). This lack of thought helped hype up the market into a bigger bubble full of enthusiasm wild success--the pop from which is still hurting us.

Congratulations, on reading all the way to the end here. You have earned the fabulous prize of late-onset myopia :)

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