Wednesday, April 20, 2011

S&P's tale told by an idiot...

full of sound and fury
signifying nothing:

linkie one

added linkie

(Added note for the added linkie article: ABS= asset backed securities; CDO= collateralized debt obligations; both are just nice sounding phrases created by investment banks to more favorably describe "vehicles" or "instruments" that were actually no more than a collection of mortgages originally sold by unscrupulous mortgage lenders. These mortgages that would otherwise have received terrible ratings by rating agencies like Standard and Poor's [S&P] were packaged into ABS or CDO [plural without the "s"] and rated AAA [the highest possible rating] despite the fact that any individual mortgage had a lot of risk attached and mostly had very low ratings of BBB. The logic given for this unrealistic rating of AAA for packages sometimes entirely composed of BBB rated mortgages was that it was unlikely that a lot of these mortgages, despite their individual risk, would default at the same time. Therefore the package would remain solvent and still pay it's interest even though a few of the mortgages would default in the package. After all, property was considered the safest investment. People would not simply walk away from their houses and the houses could be foreclosed upon and sold at a profit anyway. All of this assumed that the property market would continue to rise in price.  One thing the ratings agencies [like S&P] inexplicably did not factor in was the unscrupulous nature of the mortgage loans. Many were composed of loans that had "teaser" rates. Is there anyone who likes people who tease? Defined in my day it meant: "a person who tempts someone sexually with no intention of satisfying the desire aroused." In today's parlance, teasing meant that the introductory rate would expire at a certain time and a higher rate would kick in. Various techniques were used to soften the idea like "Your property value will increase by then and it won't matter." Sometimes the loans would have a balloon payment that kicked in at a certain time. That is, interest rates would be low (sometimes interest only) and all the money on the house loan became due at a specified date and the homeowner would have to refinance, or possibly sell at a profit. How could you lose? As insane as all this sounds now, in times of continually rising real estate values, a balloon payment could easily be refinanced at a profit to the homeowner because the value of the property would have gone up. So, the first overlooked factor was that many of the mortgages would be refinanced oddly around the same time [packages were grouped by time of origination and contracts were similar, loan terms were similar] a few years in the future. And also at similarly grouped time periods in the future interest rates would increase for those with teaser rates. Even if property continuously went up in value, these risks were inherent in the packages [CDO, ABS]. Upheaval in a few years. Overlooking this wasn't quite critical until the second overlooked factor actually happened: real estate could and did fall in value. Some of the effects of the first overlooked factor played into this. The more unscrupulous the loans became the more people decided to sell after reaching either the balloon or the end of teaser rates [also lending requirements were incredibly relaxed, many were encouraged to lie about their income, so that people were offered loans who had no known or logical ability to pay them back --all to keep the investment bank mill grinding with the profits on transactions, no matter how sour the transactions.] The more people sold their houses or mobile homes [no one was immune from unscrupulous lenders, especially the poor in their tornado prone houses] the more houses were placed on the market all "coincidentally" at about the same time. So, the more the supply, the more than sellers were in the buyers pocket, and  the less the price property would go for. The bubble of infinitely rising prices of property burst. Why had the investment banks been so willing to buy really crappy mortgages? They could sell them off to others and therefore pass the known risk on to someone else who knew less about the risk. Profits were made by fees on transactions, not by holding these obviously risky things and waiting for returns that might never materialize. Had that third party known the actual risk, they would not have paid high prices or more wisely they would have stayed clear of these packaged mortgage instruments. This is where the rating agencies came in. Pretending to be the unbiased third party, but actually paid by the investment banks to rate their own packages, the rating companies would help the investment bankers sell their sacks of used cat litter clumps by giving them the highest possible ratings. This is the recent legacy of the same Standard and Poor's who recently gave the sovereign nation of the USA a warning that it's AAA rating might come down in the future. Packaged stinky cat feces, rate those AAA--- United States - not so much. Thus the companies that were in the pockets of investment bankers and whose track record looks much like that of the guy at the dog track always throwing his tickets into the air with disgust, rated in their "regulatory role" the real regulators. It's sort of like hiring graduates of the Tobacco Institute to be officials on the FDA. Wait, did President George W. Bush already do that?  Maybe not.) *

What started as a note to define two terms undefined in the article led to my usual long-windedness. I have some requests of anyone who might read this (i.e.,nobody): 1) other than my characterizations of cat dung, if I have made a mistake in my narrative please let me know. 2) if you think I can improve this simple explanation of the cause of the collapse by adding or subtracting words, phrases or paragraphs, please also let me know. In fact we probably need to hold contests in schools for the best most succinct explanation of the crash that has cost our country so much in financial as well as moral terms. This should occur in a class on banks, credit cards, and personal finance (one semester would be fine.)

*Official winner of the longest parenthetical remark on a blog since April fools day.