Friday, November 4, 2011

Mango Ripple GFC

Okay, listen carefully…
Once upon a time, if you wanted to borrow money from a bank, the bank had to HAVE the money to lend you. Then, as now, a mortgage was essentially the bank buying the house for you, letting you live in it, bang holes in the walls, clean up the vomit after too much fairy bread at kids’ parties and generally act like you own the place. Each month you’d give the bank a slice of your hard-earned, they’d put another little X on the “Months till your house is paid off” calendar on the bank manager’s wall and everyone would go home for ice cream.
Decades of crippling debt, hurray!

 And if you couldn’t pay them each month? They’d try to help you out, but if it became clear that you just couldn’t put away the fifty shillings a week to buy your Charming Doer-Upper In A Quiet Street Near Schools And Bus Stops, then they would take it off you. They wouldn’t want to; foreclosures are hard, expensive, ugly things. More than anything, they just wanted their steady fifty shillings a week, not a slightly run-down suburban house that smells of child vomit. But they could sell it, get back most of the money you owed them and carry on. Afterwards, they would try to figure out how on Earth they made the idiotic mistake of lending you money in the first place.
Loan defaults are banker’s kryptonite; it means lawyers, real people and endless harrowing stories about needing the money for little Timmy’s crutches. So the bank manager would go to the loan officer and say “Hey! We should never have loaned them the money for that Charming Doer-Upper In A Quiet Street Near Schools And Bus Stops! They have a Poor Credit Rating and a History Of Loan Default! No ice cream for you!” The loan officer would sulk while everyone else enjoyed their mango ripple, and resolve to be a bit more careful with credit checks in future.
It's a metaphor. Or something

This is sensible, cautious business. If you only lend to people with jobs, you’ll get less mortgages, but there’s less chance of your bank being used as a horror story to frighten first-year economics students. Everyone is careful and thorough, because the product you are selling is the bank’s money. Or at least it’s money that the bank manager is expected to take very, very good care of. It’s a good system, and it’s worked for a long time.
Let’s see if we can break that system...
First. No shareholder likes to see red ink. Mortgages are red ink. That’s money the bank gave to someone else, on the promise that they’d pay it back slowly. Those people might get sick, die, lose their jobs, invite the Mythbusters round for coffee and explosions, all sorts of risky stuff. So let’s get rid of that risk by SELLING the mortgage.
You don’t sell it AS a mortgage of course. You don’t sidle up to some small business pension fund manager and whisper “Psst! Wanna buy a mortgage?” Nothing so crude. Instead, you set up an investment THINGY that’s sort of got the mortgage in it. It’s roughly like this: in return for money, say, a hundred thousand dollars, they get the Thingy. Much like buying shares, they are buying a little piece of your bank, and you are promising to pay them a dividend each month. If it’s got a nice safe mortgage in it that you know will keep getting paid off, you offer them a little bit of interest. If it’s a dodgy one, you offer them more money each month.
Why offer them more if it’s dodgy?
Because if the mortgage stops getting paid, the Thingy disappears. They might lose their hundred thousand dollars.
In other words, the more risk they are willing to take, the more return they get.
So, now the bank is still taking mortgage repayments from home buyers. But rather than putting that into the bucket it came from, they are now giving it to the people who bought the Thingy. The bank might keep a little bit, but the really good thing for the bank is no more red ink. If you suddenly can’t pay the mortgage because your meth lab exploded or your idea for a Pimp My Bicycle shop fell through, they just cross you off and forget it ever happened. However, the poor little pension fund who bought the Thingy is now out a hundred thousand dollars. To quote a banky guy: “Banks made plenty of money putting [Thingies] out on the marketplace. But they could explode a day later and [the banks] are not impacted one single iota."
Sound dodgy? It’s not. Buying and selling debt  is at the core of the world’s money market. Doing this does not break the system. And if it’s done right, it’s perfectly legitimate. If it’s done right…
Care to guess how we break the system? It's easier than you'd think.
Doing it right means two things:
1)      Do some checks on the borrower. Make sure they can pay the mortgage
2)      When you sell the investment Thingy to someone else, make sure they know EXACTLY what they’re buying, and how likely it is to Chernobyl on them.

"He looks legit. Sign him up."

Doing it wrong means two rather different things.
Credit checks are expensive. Loan documentation processes are slow. And, even worse for a hungry mortgage broker with a wife and two Porsches to feed, If the customer has a poor credit rating you might not be able to seal the deal. Soooo, let’s just skip the credit check, shall we? Why don’t you just TELL me how much you earn? Oh no, no need to show me a pay slip, you’ve got an honest face. And since house prices only EVER  go up, you can always sell the house and get your money back if you lose your job at the Betamax video store! Oh, you’re a bit skint right now what with the kids and the price of Nascar tickets? How about a nice low starting interest rate? After a year we’ll have to increase it to WOW LOOK AT THAT SHINY THING! Sorry, what was I saying? Never mind, sign here.
Congratulations and welcome to your subprime mortgage.

"'s nice, but a bit pricey. Have you got anything sub-subprime?"

So that’s number one taken care of. Mortgage broker guy wants his commission, so he skips over nitpicky details like whether they can ever pay the thing back. Since it’s a risky mortgage, the bank charges higher interest to compensate for the fact you’re probably going to do that annoying going-broke thing to them. And yes, you read it right, the people who are LEAST likely to be able to pay are the ones who get the HIGHEST interest rate. And the bank is totally cool with all of this because they’re going to turn the mortgage into a Thingy and sell it to a pension fund or something. Hurray, ice cream!
But what kind of idiot would buy a Thingy that had a horrible stinky mortgage like that inside it?
Simple. An idiot who didn’t know.
These Thingies are so complicated that not even the bank understands them. This might seem crazy, but finance is so scary and so confusing that even if you created the Thingy, you can’t be sure what it’s worth. One Thingy might have bits of a thousand mortgages all stirred up inside it, and knowing what that’s worth, and the chance of it vapourising, is simply too hard.
And obviously the pension funds can’t check this stuff. They assume the bank’s done its homework. So they buy the Thingies, loving the ten percent interest rate and the confidence of a big bank’s name behind it. The bank gets credit rating agencies to cast an eye and say “HELL yes! That is a triple-A Thingy!” So the pension fund managers cough up, pat themselves on the back and go home for ice cream.
And when they watch the evening news over their bowl of strawberry surprise, they start seeing stories about something called a Global Financial Crisis.

The Global Financial Facepalm.

This isn’t a metaphor. This isn’t made up. This is how the whole thing happened. There are names for every bit of it:
-A mortgage without paperwork to show you can afford it is called a No-Documentation loan, or an “I don’t care, I just want my commission. Sign here peasant” loan.
-A mortgage without having to prove how much you earn is called a Stated Income loan, or Liars Loan.
-A mortgage to someone with No Income, No Job or Assets is called a NINJA loan. Not making this up. To add to the Awesome, when NINJA borrowers couldn’t afford to pay they would sometimes just disappear into the night.
-Signing people up for mortgages that the bank is going to sell as Thingies is called the Originate-To-Distribute Model, or the “We don’t care, it’s not our money” model.
-The whole Damn-The-Risk-I-Want-My-Commission routine is called Predatory Lending, or There’s One Born Every Minute lending.
-A Thingy is called a Mortgage-Backed security. Lots of them sold at once is called a Collateralised Debt Obligation, or a “Look at the interest rate. Now look at me. Now back to the interest rate” investment.
-The collapse of the world’s banking system, the loss of trillions of dollars of innocent people’s pensions, the loss of homes, jobs and futures, and the expenditure of trillions of taxpayers’ dollars to bail out the idiots who caused this mess in the first place is called a GFC.

"I am here. To apply. For a HOME LOAN ahh.

We all know how that one turned out. We dodged the worst of it here in Australia, but even if you didn’t lose any investments, you still took a hit. Your superannuation almost certainly went backwards. Interest on your savings nosedived. Your bank suddenly got all weird about lending you money. Wages slowed, jobs got harder to find, the economy got smaller and just about nobody got to go home for ice cream for a year. Whole industries went bankrupt because of this disaster, millions lost jobs, and most of them haven’t got them back even now, four years after it hit.
But this thing wasn’t a complete disaster. The mortgage brokers got to keep their commissions. The managers of the banks still got their bonuses. The credit agencies who said the Thingies were good buys are still doing a brisk trade. And the people who defaulted on their loans are good and bankrupt, living in nice free cardboard boxes and no longer cluttering up the system with their stinky mortgages.

Sure it's damp. But at least it's drafty

So how did we let this happen?
Quite simply, we cut the brakes. We let banks loan more than they could afford to lose, we let mortgage brokers give unemployed broke people loans, we let banks sell investments that were probably going to implode and we let credit agencies charge people for terrible advice. The government regulators who allowed all this simply couldn’t imagine that the banks would let things get so horribly broken that it could destroy them.
Amazingly, they ignored one thing: human nature.
If bank managers can get fifty million in bonuses for something that has a teeny chance of destroying the bank, most won’t do it. Some will. If mortgage brokers can make twenty percent commission, even if they sign up people who can barely feed themselves, most won’t do it. Some will. And if investment bankers can make fifty million dollar bonuses to sell those broken mortgages to pensioners, most won’t do it. Some will.
Enough did.
Turning off the controls, telling people they were allowed to take huge risks then letting them do it with other people’s money meant greed could go wild. These people knew what they were doing, and they did it as hard and as fast as possible, socking away the cash as the train gathered speed. By the time the wheels came off, they were at the station, smiling and waving at the taxpayers still stuck on board. And the bankers who hadn’t bailed out in time were given a nice soft landing in a huge pile of nice soft taxpayers’ livelihoods.
Ah, Other People's Money. Like sleeping on a cloud.

 And best of all, since their bonus clauses said nothing about whether the bank was imploding or not, a slice of the public bailout money went straight into the pockets of the people who caused it. Retrenched staff were walking out the doors with their cardboard boxes at the same time the seven-figure bonus cheques were being handed out fifty floors above. Banky Guy again: “Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm.”
This cancer was spawned in the United States. Nobody there has gone to jail. Others did: German banker Stefan Orteifen, who lied about how many dodgy Thingies his bank had bought, got a ten month suspended sentence and a hundred thousand euro fine. Other bankers in Europe suffered the same fate. Their counterparts in the US are still free, still working and still getting bonuses. Because the regulators cut the legal brakes on the system, the people who sold the CDO time bombs broke no actual laws, and are currently floating about in yachts off Long Island, wondering how to make money out of Greek misery.
"Darling? Let's go further out. I can still see poor people."

This didn’t cause the mess we have in Greece now. But it sure didn’t help. Banks are behind the Eurozone mess too; they loaned money to people who couldn’t pay it back, then screamed and wailed until they got bailouts. The problem is now so big that even if Greece comes good, it will be centuries, if ever, before they could make back what it cost to fix them. People are now talking seriously about letting the country go broke, rather than getting dragged into the meatgrinder with them.
But that’s a tale for another blog. Maybe I can write that one from Greece. Assuming it hasn’t been sold to Warren Buffet by then.

Still not clear on what happened? Here’s what I just said, with less ice cream but more stick figures.
Or try this one for some banky guys' take on it.
Watch Inside Job to hear the whole story in Matt Damon’s voice.