Unmoored Part IV

[continuation of the Unmoored series]

I made an allusion to “baiting hooks” to get people who couldn’t afford them to take out loans.  Some of it was with teaser rates.  Some of it was with balloon interest payments. No down payment.  Somewhere along the line they came up with the idea of an “interest only” loan, where you make interest payments only, never paying down any of the principal. I’d heard of these well before the crash and wondered who in God’s name would sign up for such a “deal”?  But we’re not done yet.  There were also negative amortizing loans.  Yeah. Look that one up.  Most of these look like they were designed to fail.  And maybe they were.  (Still doesn’t excuse the idiocy of taking someone up on a deal you can’t afford).

I suppose there’s one born every minute. And on Wall Street, I think many actually take pride in screwing each other over. I imagine that’s what Michael Lewis’ book “Liar’s Poker” is about.  Don’t have that one yet.  But when he brought it up in one of these other books (written from his own experiences inside of one of these firms) he meant it as a warning.

He was shocked and dismayed to find that people were using it as an instructional resource.

In “The Big Short”, he runs down character profiles for two people involved. The first guy started out as a real self-interested go-getter who came to despise the system but kept working under it just to screw over people he thought were screwing other people over.  The second was a bright introverted medical student who was bored with medicine and had a knack for researching and subsequently picking stocks in a manner that made a lot more money than anyone else was able to.  These two people end up being ground zero of an epidemic that exploded sometime in 2006.

Both were certain, after looking at the numbers of BBB loans packaged in AAA-rated packages along with a stagnant housing market and the nature of especially the ballooning and teaser rate loans, that enough of these loans would soon go bad to sour the packages. I’m not sure who came up with the mechanism … I think it was that medical student … but someone came up with the idea of Credit Default Swaps.

This one finally gave me no choice but to ask… what. the. hell?????

Suppose I was worried about my house being destroyed by fire or flood or a tornado.  Most people are concerned about these things enough to buy insurance (their lender makes them buy house insurance while they have a loan, as the lender has a vested interest in keeping your house viable for collateral).

Now insurance is about risk-spreading, and it makes sense to do it.  If, say, 1 in 500 houses will experience a disaster like this, it’s nice to be able to pay a relatively small amount a month into a pool so that if any one of your houses gets hit, the huge sums of money it takes to fix a house will be there to fix yours.  Risk spreading adds efficiency to ensuring that your investment in your home is protected.  Insurance company makes money on the surplus.  Win-win.

Credit Default Insurance, one would think upon first hearing the term, would be similar to the mandatory insurance your lender makes you have on your home to protect their interest in it. I’m not sure if anything like it existed in the market before this, but the next twist is truly bizarre.

The new mechanism allowed people to buy insurance on stocks in which they had no vested interest in the first place.

It would be as if I took out fire insurance on YOUR house.  And I don’t mean buying the insurance on your behalf.  I’m the beneficiary if your house burns down.  Talk about a conflict of interest.

This completely decouples the risk from the reward as far as the original loan transaction is concerned, and even as far as the sale of packaged mortgages were concerned.   I didn’t make the loan, I didn’t buy the package, but I get money if the package goes belly up (if I rember right, they even came up with a way to get the money as the individual loans went belly up rather than wait for the whole package to go bad).

It isn’t risk free, but the potential payoff to investment ratio made it quite akin to gambling.  It *was* gambling.  And with a housing bubble that had clearly peaked, the odds were pretty much in your favor.  But man, how does this even enter someone’s head as an idea?

So who did they talk into insuring other people’s bonds on their own behalf?

Well, it was mainly AIG.  At first.  I guess the folks at AIG were talked into creating a product that they could sell to insure person A against person B’s risk, and they were further convinced that person B’s risk was low because the bonds were rated AAA.  And nobody at AIG stopped to think, “Hey … what’s THEIR angle?!  What are we missing?  And why are we selling so many of these things?”

If they did, all they ended up with was “selling GOOD!!!!”

So now we had people making money selling bad loans in with good loans, and packaging ever increasingly large numbers of bad loans in with those loans — and selling those packages and making a fortune.  And we had people buying lottery tickets with good odds betting that the loans in the packages would go bad, and they’d get big payoffs.  And we had people thinking they were making (well they were in the short run) lots of money selling “insurance” to that second group of people for loans they didn’t even own.

The insurance is an abstraction of an abstraction of an abstraction of an abstraction. There is no value being produced at this level. The people involved in the original loan transactions are lucky to be colored dots on a screen. It was all a game of hide the turd between financiers now.

To make matters worse, when the few people who did understand that the more bad loans, the higher the payoff from the insurance …

.. they actively scared up more bad loans to buy “insurance” on.

Now we’ve gone from sinkhole to blackhole.

If all of this had had remained private obligations between private parties with no government bailouts, it would have been bad for those people and those companies.

But millions of regular people had those companies and those bonds in their investment portfolios.

The Libertarian in me says, “well they should have looked into their investment companies’ strategies”.   Never a bad idea.  But my heart wouldn’t really be behind that statement.  The reason I go with a broker in the first place is — it’s all too complicated for me.  I don’t have the time or the inclination for it.  It shouldn’t be. But it is.  That leads to problems like this.

I myself am pretty unmoored from the underpinnings of my own investments.  I can look, and sometimes do, at the ones my broker is in charge of.  But I never look at what the company pension looks like.  I don’t have any control over that.

Still, I disagree with the government bailouts.  As Rick Santelli put it, it’s rewarding bad behavior.  Sometimes the best way to learn the permanent lesson … don’t touch a hot stove … is to get burned by one once.

[one more part coming, I think]

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2 thoughts on “Unmoored Part IV

  1. Pingback: Unmoored Part III | Rotten Chestnuts

  2. Texan99

    I’m far from expert in these matters, but I don’t think it’s necessarily a good idea to judge all hedges or shorts against the standard of insurance. The idea is not to insurance against one’s own potential loss, but to make a bet on which way the market is going to go, often involving investments made entirely by other people. Some hedges even turn on non-market events like weather; my utility clients often do those as a way of smoothing out the irregular impact of weather on the price of energy. As long as people use their own money to place such bets, I don’t have a problem with it.

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