One story that's going around on Wall Street is that the financial industry
landed itself, and us, in the fix we're all now in by erecting a massive
structure of derivatives and interlocking claims which no one really
understood, and which now has the effect that a collapse anywhere
puts the whole structure at risk of toppling like a house of cards.
Viz. the quote of the day:
Mr. Blinder, the former Fed vice chairman, holds a
doctorate in economics from M.I.T. but says he has only a "modest
understanding" of complex derivatives. "I know the basic
understanding of how they work," he said, "but if you presented me
with one and asked me to put a market value on it, I'd be
Which is to say, the soi-disant rocket scientists of Wall Street gave
themselves a complicated job, and then did it badly.
Me, I'm not so sure. Some of the mistakes involved no math at all.
And in cases where the math should have been easy, they still blew it badly.
To begin with, a lot of the structure was based on implicit trust
in ratings agences which, as others
were blowing the simple stuff. Consider "mortgage-backed
securities," which is where the rot first set in. This is a field
in which conventional wisdom had been that buyers
who didn't put in a substantial down payment, relative to the
cost of the property, were at elevated risk of default; financially, they'd
have nothing to lose if they defaulted, and if the value of the property dropped at
all, they'd even have something to gain. In the year 2000, as
Conan O'Brien would say, Standard and Poor's decided to set aside
decades, if not centuries, of experience, and say that arrangements
with no down payment were not at elevated risk.
By the time they went back on it, the collapse was already
But beyond that, let's consider cases where a little math
was involved: the now infamous mortgage-backed securities.
The basic idea of these is that when you've got a lot of
risky loans with more or less similar properties, you can predict
roughly what's going to happen to them in aggregate, and take
advantage of that. So, let's say you think that there's between a 10% and 30%
chance that any individual borrower will default. That means that 70% are very likely
to keep making their payments, another 20% are in doubt, and the last
10% are toast --- but you don't know which 70%. So, how can
you get certain returns? By creating a security that gets payments
from whoever's still paying, up to 70%, no matter which loans those
are. (So long as more than 70% of the borrowers are still paying,
the other payments go to buyers of riskier "tranches" of the
payment pool; when they stop, the buyers
of those tranches are out of luck, but they knew they were buying
concentrated risk going in.) Since you're assuming that
no more than 30% of them will default, it's basically a sure shot
that enough of them will keep paying to keep that first-dip revenue
stream going, which is how you make an absolutely solid, AAA-rated
security out of a whole bunch of individually bad loans.
That is, in fact, the basic argument for the AAA-ratings on a whole
bunch of mortgage-backed securities. It's all entertainingly outlined
in this well-circulated slideshow, or if you want
more detail with musical accompaniment look here.
And yet losses on these things are now bleeding major banks white.
So, could there be something wrong with the analysis?
In fact, the argument contains an elementary
mathematical error that bites a lot of people hard on the
ass in probability 101. If you haven't seen it already, you
might want to go back and see if you can spot it, because I'm
going to spoil it for you in the next paragraph.
Here's the problem: The whole arrangement implicitly
assumes that the failures of the individual loans are independent.
That is, we're assuming that each borrower has between a 70% and 90%
chance of keeping up with the payments whatever the others do.
And the world might just not be like that. Let's suppose, instead, that
there's some event --- let's say, just for kicks, a meteor strike on
the town --- that might (with between 10% and 30% probability) make
all of the borrowers default, all at once. In this
situation, each individual loan still has the same chance of defaulting
as it does if they're independent. But pooling this
risk buys you nothing: if the meteor hits, the loans default all at
once, and it doesn't matter how the payments have been divvied up,
because they've all ceased.
That's a nice mathematical curiosity unless someone can point to
events likelier than meteor strikes which might have this kind of mass
effect. But by the time the real estate bubble was really going,
there was such an event, which was almost certain to happen:
a rise in interest rates. Lots of borrowers, particularly in the
subprime range, were taking loans with variable interest rates which
would "reset" up at some future date. If they couldn't pay after the
reset, they'd have to sell the house fast. But, at the same time, it
was common in the bubble to judge affordability by the monthly
payment, and if rates go up, the same monthly payment buys you less
house. So, in the event of a rise in rates, the borrower can't make
the payments (because the rates have gone up), and they can't sell to
a similar buyer for as much as they paid (because any similarly
situated buyer can now afford less). In such a case, default is
what's going to happen, because it's the only thing that can
happen. To all of them. All at once.
By the way, did I mention that interest rates in mid-bubble were
at historic lows, and had nowhere to go but up?
Were the soi-disant rocket scientists of Wall Street and the
Connecticut hedge funds trying to defraud anyone with this stuff? I'd
say probably not. As others
placing big bets against nasty events is a great strategy for a fund
manager, even if you're sure to lose big eventually, so long as you
don't acknowledge what you're doing. (In the meantime, you
get to pocket your fees, which can be colossal.) And the easiest way
to do that is to convince yourself that you're doing something else
that genuinely does "add value" --- which is a particularly easy job
if the flaw is concealed within pages of ornate mathematical
bafflegab. As someone once said, it is difficult to get a man to
understand something if his salary depends on his not understanding
I'll admit I'd be slightly more credible here if I had scribbled
this down a few years ago, so I could be quoting myself now. Instead,
I just decided to stay the hell out of the real estate market. But
I think the argument stands on its own. [Update: Then again,
here's somebody else who did call it at the time. But he's got a Ph.D. In economics!]
One last note on housing questions --- my last post on the subject
got a few comments blaming people who put themselves in hock up to
their eyebrows, borrowing more and more against houses they already
owned to pay for vacations, fancy cars and glitzy junk. And they
exist. From the depths of Orange County, IrvineRenter
dredges up a spectacular examples on a regular basis.
But that wasn't everybody. Probably not even most of 'em, except
in isolated enclaves like Irvine (where most of the buyers weren't
really subprime, though many made the same mistakes, and where there's
reason to believe that the real bleeding hasn't even started yet).
So, I hope before posting one of those again, folks will take a good
look at a
story of another type. (And yes, the poor woman signed legal papers
in a language she didn't understand. She speaks Spanish, and lives in
the U.S. Does she have a choice?)