The Big One?

There is a point in a good party when you decide either to stop and get home at a decent hour, or you throw caution to the wind and decide that there is no time like the present. In the current mess of the financial markets, how is it possible that any sane banker would not have noticed until now that the outrageous lending practices with US mortgages were leading to an unsustainable bubble. No, the better answer is that everyone knew the party was going to end some time, but since the hangover was going to be a doozy, the party rocked on.

And so we read stuff like this in the Globe’s Subprime Primer (which does actually provide good overview for the lay reader):

Suddenly, portfolio managers at money-market mutual funds are asking whether they really want to be investing in commercial paper that is backed by assets such as mortgages when the housing market is going bust. As a result, the trusts can’t find buyers for their paper, leaving them short of money.

At some point, when this crisis passes, there needs to be some reconciliation. These guys have been raking it in with multi-million dollar bonuses, and now their irresponsibility threatens the entire financial system.

Anyway, some background on the state of the crisis, as I leave the digital world for the trees for a couple weeks. A good description of the mechanics of what has been happening comes from Vox EU:

As the US housing bubble is working its way out, mortgaged loans go sour. Since the institutions that granted these loans have promptly sold them on – this is the securitization process – to other institutions, which sold them on to others, and so on again and again, those who suffer losses are the ultimate holders. There are so many of them, all over the world, that no one knows where the losses are being borne. It could even be you, through your pension fund or some innocuous-looking investment.

The second observation that all agree about, is that the total size of the now-infamous subprime loans, even augmented by normal mortgages, does not add up to a huge amount. Normally, most financial institutions should be able to absorb them with much damage. Of course, a few may have bought too much of the stuff and they will go belly-up, but that is how things normally are. Most significant financial institutions should be able to absorb those particular losses.

In fact, no one can claim to be surprised by the mortgage crisis. For years now, the consensus view was that the US housing market was undergoing a bubble. The implication all along was that a correction would occur, with all the consequences. The correction has been underway for months, and in slow motion, which gave plenty of time for all to make adequate preparations. To be sure, some brave contrarians may have thought otherwise and bet accordingly. But it would be a momentous surprise if all respectable large financial institutions did not ready themselves. So far, so good. Why the interbank market crisis, then?

Here comes the securitization story, and it is not controversial either. The dilution of risk is a good thing, no doubt about it. But it is generally the case that any good thing has some drawback. In this case the drawback is that no one knows who holds how much of these bad loans. Where things got bad is that, the same as many other human beings, and maybe a little moreso, financiers are prone to mood swings. When all was going well, they trusted each other as if they had gone to the same schools, which in fact they did. When the situation soured, they went at light speed to the other corner and started to suspect that everyone else was more in trouble, especially those they knew best because they went to school together. So the interbank market froze.

What to do about it? There is an angry sentiment out there that the foolish need to be punished and that the financial system needs to clear out the rot that has accumulated. Their message is that central banks should just sit on the sidelines. But there is good reason to believe that intervention is needed to soften the blow for the victims on Main Street, and to ensure that the crisis does not spill over onto the real economy and lead to a full-blown recession.

Some of the latter may be inevitable given how high real estate prices climbed, but there is definitely justification for softening the impact. And while a modest interest rate cut may take the edge off the reckoning, it does not seem likely that it will do the wonders of last time around. If things get really bad and monetary policy is ineffective, we’ll need to pull out our copies of Keynes’ General Theory, and let loose with fiscal policy.

In the meantime, it is not clear how this is all going to play out, and how much Canada gets sideswiped by what is largely a US story. There is much we do not know, and even though it seems like Canadian mortgage excesses were more rooted in low interest rates than irresponsible lending practices, there are many troubling points of exposure to the crisis in US financial markets.

Here’s what Paul Krugman recommends:

Many on Wall Street are clamoring for a bailout — for Fannie Mae or the Federal Reserve or someone to step in and buy mortgage-backed securities from troubled hedge funds. But that would be like having the taxpayers bail out Enron or WorldCom when they went bust — it would be saving bad actors from the consequences of their misdeeds.

For it is becoming increasingly clear that the real-estate bubble of recent years, like the stock bubble of the late 1990s, both caused and was fed by widespread malfeasance. Rating agencies like Moody’s Investors Service … seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the ’90s, accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest-quality, AAA assets.

Yet our desire to avoid letting bad actors off the hook shouldn’t prevent us from doing the right thing, both morally and in economic terms, for borrowers who were victims of the bubble.

Most of the proposals I’ve seen … are of the locking-the-barn-door-after-the-horse-is-gone variety: they would … have been very useful three years ago — but they wouldn’t help much now. What we need at this point is a policy to deal with the consequences of the housing bust.

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, … the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the … mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts. …

The mechanics … would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms. But I’m happy to listen to better ideas.


  • Your post is definitely right one and I appreciate you taking the time to address the issues we are having with loan modifications and loan workouts.

    On July 26th the SEC chairman declared that lenders and servicers would not suffer adverse accounting consequences by modifying loans where a default is inevitable. Before this statement, many lenders were reluctantly allowing loan workouts and modifications. Now, it seems like they are slowly ramping up their loss mitigation efforts and offering massive loan mods to everyone who qualifies.

    What needs to happen is that we went from a country with lenders and brokers originating mortgages like there was an endless supply of borrowers. That supply has dried up .

    Now we have an endless supply of delinquent and defaulted borrowers.

    The answer is simple. All of these lenders and servicers need to dedicate as much man power in their loss mitigation departments now as they did in their loan origination departments. I believe they can end up making more money by fixing these loans instead of letting them default. There needs to be a massive campaign to reach borrwers before they are late.

    Instead of commercials about no cost loans, they need to run commercials telling troubled borrowers to call and work things out.

    I have a website/forum where troubled borrowers can tell their story. It’s and there are some prime examples of the mess we are in.

    Thanks again for this article and it was on of the best I have read in a long time!

    Best Regards,


  • one of the key dimensions in this mess that requires some serious investigation and intervention, is how these raters and lenders flipped and passed on these sub-prime loans so fluidly. Seems from the Krugman article that some kind of funky business was going on with the ratings on these. One could say that something smells bad that in this age of information and data availability, that these loans could be flipped and bandied about the global financial markets without some notion of the amount of risk. Like any bursting of a bubble, it all comes back to who is holding the bag of bad news when the whistle blows. From the sounds of it, given the paranoid behaviour, nobody seems to know for sure where all the stink is coming from, and this, if the quality of information was above board should not be the case.


  • There’s an interesting letter posted here:

    “‘Real money’ (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to ‘mark up’ these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!

    “He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of subprime debt. Interestingly enough, these buyers (mainland Chinese banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, U.K. banks) possess the ‘excess’ pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the U.S. in U.S. dollars, 2) petrodollar recyclers. These two pools of excess capital are U.S. dollar-denominated and have had a virtually insatiable demand for U.S. dollar-denominated debt… until now.”

    These investors then had standing orders on Wall Street desks for any U.S. debt rated triple-A. Through the “alchemy of CDOs” and “the help of the ratings agencies,” the CDO managers collected triple-B and triple-B-minus subprime and repackaged them so the top tier got paid out first. Then leverage the lower mezzanine tranches by 10-20 times and, “POOF… you magically have 80% of the structure rated ‘AAA’ by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets.”

    The letter concludes: “This will go down as one of the biggest financial illusions the world has EVER seen.”

    And of course, the seeming collusion of the ratings agencies didn’t help (European Commission investigating)

  • It is curious how accounts flood the media, when the system exhibits a flop in the banking or manufacturing, or even the evanescent stock markets of how this or that unsound practice had been going round. I can recall that even in the years of the Depression you would read a bit in a paper or hear a politician say in confidence that the system really needed a douche from time to time, or how New Your had become thick with swarthy foreigners in the mining business.

    I think it is always true that this system is rich with bandits of every description and is always accumulating ill gotten gains in some unexpected quarter, or is just about to go splat in some other unexpected area. Always, however, it turns out that those who could be most expected to know better are right up there at the trough with the worst of the pigs. How could any banker now say they had no idea the sub prime market was being given a falsely positive description on financial soundness, yet they are. How could any bank be such an investment idiot as to get deeply into such a field. Yet the CIBC apparently is in it, up to over 1.5 billion. The Royal Bank, which recently dropped the name of Canada as it paraded around as an international financier, is too embarrassed to say. Only the Governor of the Bank of England is left to state the obvious, that those who foolishly throw away their money should not be encouraged by bank or government.

    However, is it not true that these bandits somehow get repaid out of the hides of the rest of us? How does that one work. Now that would be an account worth reading.

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