Blogger’s note: You’ll find below that I use an anonymous source to support my attempt to dissect Someone [who] is wrong on the Internet.™ As always, anonymous sources are only as trustworthy as the writer who deploys them. You have been warned. (BTW — I do know that it’s cheating to do even minimal reporting on a blog post. Sue me.)
Dr. Manhattan is one of the McArdle guests feeding the wire whilst that blog’s proprietor is preparing what will no doubt be a never-before equalled work of economic and/or culinary erudition. His is the nom de blog of someone described as “a lawyer…who represents, among others, clients in the investment industry” — a connection that may prove significant below.
Up for dissection today: his post titled “A Modest Proposal” in which he promotes the idea of killing what he alleges to be the lead culprit in the crash of 2007-8: Mortgage Backed Securities.
What’s fishy here? Well — lots.
I’m not going to go full metal blogpocalypse on this, in part because life is too short, and in part because Dr. Manhattan gets props in my book for having written clearly and unequivocally against the vaccine-autism claimed link on his (now dead) personal blog — from the perspective of a parent of an autistic child. That kind of writing in that community takes courage, so this brush with the McArdle empire will be as free of my usual attitude in that direction as I can make it
That said, here’s the passage that set me wondering about this post:
…killing MBS will likely kill the 30-year fixed-rate mortgage with no prepayment penalty, which, in the words of Raj Date, “does not flourish in the state of nature.” And right now very few people can get one of those anyway, which is not a coincidence.
Hmmmm.
One of the benefits of hanging out at a place like MIT is that there is almost always someone around who actually knows stuff on just about any subject you’d care to check…and so it is with the economics of real estate. I dropped a line to a colleague up the street, and got confirmation of the obvious: the 30 without a pre-payment penalty (the clause that makes refinancing mortgages so straightforward) significantly predates the rise of mortgage backed securities (by decades). Such mortgages start to appear in the 30s; MBS start to become significant in the marketplace after 1970. That the end of the latter would kill the former is, as we say, an assumption not in evidence.
Oh well. And that “very few people can get one…” claim. I’m filing this in the life-is-too-short category to check fully, so I’ll just note that (a) 30 year mortgages remain by far the most common housing loan out there — roughly three quarters of all mortgages as of the most recent Census report (2011, on 2009 data).
Also, being as I’m someone refinancing for the third time a loan first taken out in 2009, I can in my anecdotage* attest that the no-prepayment-penalty mortgage is both alive and trivially easy to obtain. (At least in my market, it remains the default option.)
What bothers me about this passage is just the garden variety flaw behind so much glibertarian and/or right econ blogging: what they know** requires no actual data to confirm. This is kind of what you’d expect at a McArdle-branded blog: that which ought to be true need not be checked.
But the tricky bit is that plausibility is all; the moment the reader’s willing suspension slips — then you read everything else in the piece with attenae quivering. Hence, I was ready when I took a second look at this gem:
CDOs and credit default swaps don’t kill financial systems, mortgages kill financial systems.
Uh. No.
As it happens, I’m not operating out of my usual sea of ignorance on this point, as my current project involves a deep dive into the first debt-for-equity swap in financial history. The key fact most often ignored from that early period of finance is that though plenty went wrong, usually in ways that, frankly, aren’t materially different from the ways folks game and/or fail to grasp the system now, the core financial act of abstracting things into numbers is an enormously useful trick. It is, truly, an engine of wealth. See, e.g. Adam Smith, chapter IV of Book I of Wealth of Nations on the importance of a medium of exchange; currency is just the first step in the process by which finance mediates transactions.
In that vein, mortgage backed securities are like any tool; you can build a house with a hammer; you can also crush a harp seal’s skull. It is all a matter of the user and the constraints that user’s society places on the deployment of such tools. As my correspondent at MIT put it, there are three clear points of vulnerability inherent in the process of packaging individual mortgages into a big clump:
1). Originators do not have skin in the game and may try to pass off bad loans as good.
2). Rating agencies are paid by the pool creators rather than the investors (who are unknown at the stage when ratings must occur).
3). Special servicing needs a better business model. (TL: I.e., those who handle troubled or in-foreclosure mortgages need to do it right, which isn’t happening)
All of these are known flaws. All of them are subject to regulatory responses. My interlocutor again:
Until the 100 year flood #3 was never problematic. As for #1 and #2 as long as F&F were functioning as a public entity they monitored and disciplined originators and rating agencies with bad records. 800 lb gorillas can do that. So a huge monopsonistic mortgage conduit actually overcame the intrinsic problems with MBS – and in my view should simply be turned into a non-profit public utility!
The alternative to MBS is to return to individual loan underwriting, retention and servicing. We could certainly choose to say hello to all that, but at a cost — not a trivial one — that in the end would make the price of money for housing detectably higher.
This isn’t a terrifically complicated idea: from its emergence in the 18th century, the bond market has lowered the cost of capital applied to all kinds of stuff in the real world, beginning, more or less, with the British Empire. (See, for example, the brief essay buried about 2/3rds of the way through Volume II of Fernand Braudel’s Civilization and Capitalism, which gave me my first glimpse of the role of liquid capital markets and Britan’s rise to world-power.
All of which is to say that the derangement of the mortgage market in the United States was indeed a major and growing problem through the ‘oughts, compounded by an ideological commitment that prevented regulation everyone with an economics IQ higher than a plant’s understood to be necessary. But even if the collapse of the housing market provided the spark for global financial disaster, the fuel for that inferno came not from the securities constructed directly out of home loans, but from their derivatives. And as it is in derivatives that a whale’s share of the money can be made (at least until the music stops) those on Wall St. resisted and still resist not just regulation of those instruments, but any real discussion of their significance.
But here’s the blunt reality of modern finance: the scale of the derivatives market vastly exceeds that of the real economy that underlies it. The leverage — the number of dollars at risk in excess of the value of the real assets from which such bets are derived — is what makes for catastrophe. Dr. Manhattan’s airy confidence, as quoted above, that ” CDOs and credit default swaps don’t kill financial systems,” is more than wrong. To the extent that it reflects accurately what folks on Wall St. actually believe, it’s terrifying.
Or, as my MIT wise man says, more gently:
Not sure your writer fully understands how CDO and CDS markets work, and how counter party risk is basically unmeasurable – making them horribly subject to a systemic meltdown.
I’m betting none of this comes as a surprise to anyone reading this; reality based communities tend to be able to count on both fingers and toes. And I guess I’ve committed my usual sin of John Foster Dulles-ing what was, after all, a throwaway of a line and a thought.
But I do think it important to try to push over and over again one basic point: financial markets are essential; they fund real lives. They are also prone to failure in ways that are unsurprising, and are, at least in part, subject to constraint by design. To pretend that failure is at once impossible and inevitable, just one of those things (like cancer) that attends the messy business of being alive, is merely to ratify the transfer of wealth from most of us to those with their paws on the capital spigots.
Dr. Manhattan might say that he is merely directing our attention to the root cause of our ills — but it is to me notable that the instrument he wants to do away with is the one that lowers the cost of a mortgage to you and me, and those he wants leave untouched are what buys as 2008.
If it were McArdle herself who had written this, I’d add snark here. But as I said up top, Dr. Manhattan is someone who has earned some benefit of the doubt. He may simply have gotten this one wrong, which is a state that comes to us all; me certainly. So I’ll leave it here….
Over to you all.
*Credit for that coinage (at least in my first hearing) to the king of the three dot columnists, the gone but by no means forgotten Herb Caen .
**In the Mark Twain sense of knowledge.
Images: Frans Snyders, The Fishmonger, first half of the 17th century.
Benjamin West, The Death of General Wolfe, 1770.
Tom
On this, I’d have to say that it’s a bit more complex. The 30 year fixed rate mortgage indeed would not exist in the state of nature. It’s important here to understand how it’s a construct that’s been encouraged by federal regulatory activities and persists, now, due to entrenched cultural norms.
Ella in New Mexico
Given that entire STATES have outlawed pre-payment penalties for mortgages, it seems this gentleman’s entire set of presumptions is flawed.
White Trash Liberal
Great post!
This is why government, especially representative forms of government are so essential.
No one in the financial sector wanted to hear the bad news. They just wanted to juice the margin loan scam and get out before the bottom dropped. There is simply too much pressure in an unregulated market to perform phony miracles. The consequence is systemic collapse.
We need strong governance bent on being the adult in the room and preventing the excesses orthodox capitalism. I weep for my country because so many don’t seem to understand this. Every single collapse of the domestic economy is due to malfeasance in absence of oversight. Yet we are told that the problem is oversight.
God, it’s enough to drive me bugfuck nuts.
El Cid
The real problem is this Susan B. Anthony $1 coin. I went and collected money from a bunch of people and bet $100,000 that it would be worth $1,000,000 in 2 years, and it totally didn’t work out that way, and now a lot of people are out of money. If it hadn’t been for that stupid coin, none of this wouldn’t have happened.
slag
@Tom: I’m curious to know what exactly in this system would exist “in the state of nature”. Can you be more specific about which aspects of our economy are created by nature and which are created by nurture?
Tom Levenson
@Tom: That’s a different question; the MBS and the 30 year are not inextricably linked. The 30 year and the crash of 2008 are not meaningfully correlated. That federal action encourages one behavior over another is not news. The notion that of all the examples of that (deposit insurance; agricultural subsidies…you get the point)the one we should whack is one of the prime supports of middle class housing is what gets my goat. That and the lack of economic justification beyond this state of nature nonsense. No financial transaction exists in a state of nature; it’s only the degree of artificial selection involved that differs.
Edit: What Slag said.
Soonergrunt
It’s almost as if logging into McArdle’s blog makes one somewhat less brainy.
Or maybe it’s exposure to McArdle herself that does it.
Quick, somebody check and see if Suderman is still forming complete sentences.
Odie Hugh Manatee
@Soonergrunt:
I heard a rumor that a brain scan for Blenderella consists of checking to see how many inches of manifold vacuum she is pulling. The higher the vacuum the better the economy, thus her claim to being qualified for economic analysis and commentary (economy = economics = close enough for McArglebargle).
That’s my story and I’m sticking to it.
Matthew Reid Krell
Finance is not my strong suit in economics (I’m much more a micro guy, particularly in incentives models), but I’ve always understood aggregation to be a mechanism for diffusing risk; and derivation to be a mechanism for ratcheting risk.
Thus, by aggregating anything (capital, transactional rights, labor), you reduce the chances that any one person can be faced with the total catastrophe. And derivatives enable you to set your personal optimal risk exposure:reward potential ratio.
So since the banks are full of people who misjudged the proper exposure:potential ratio, WHY HAVEN’T THEY ALL BEEN FIRED?!
PeakVT
CDOs and credit default swaps don’t kill financial systems, mortgages kill financial systems.
Never mind too much leverage, lousy risk management, weak regulators, or a corrupt campaign finance system. No, it has to be mortgages.
Let’s all start paying cash for our homes. I bet that will turn out peachy.
Matthew Reid Krell
@PeakVT:
You just made me smile. Stop that. I might start liking you.
jacypods
@Soonergrunt:
First you’d have to show proof that Suderman was ever forming complete sentences.
Suffern ACE
Ok. But if we lose the 30 year fixed, we all get sub prime mortgages. Whether we would call them sub prime if everyone had them, I’m not certain.
El Cid
@PeakVT:
It’d be a lot more like the early 20th century, when most Americans rented, or lived in the home of the extended family, and a bit fewer than half of Americans owned their own homes, which includes those people who inherited or built them.
And then the federal government expanded or created many programs to help white Americans be more able to purchase homes, and banks to be more stable to survive mortgage default risk as local economies often waned.
Ben Wolf
@Tom Levenson
It gets worse. Today Captain Bronx announced that free market competition is the best way to improve regulation, confirming he doesn’t understand that either.
Tom Levenson
@Ben Wolf: Not getting out of the boat, but boy does that sound like epic fail.
beltane
@Ben Wolf: Captain Bronx? Is there a Commander Brooklyn in the house?
Does wingnut welfare exist in a state of nature? All these McArglebargles would make inferior hunter-gatherers. In their infinite stupidity they would ingest poisonous mushrooms, thus removing themselves from the gene pool. Invisible hand and all.
Ben Wolf
@Tom Levenson:
Not at all. Commander Hell’s Kitchen is of the opinion regulators should be like restaurant inspectors and award businesses grades. Then Mr. Market will have all he needs to clean house and police himself with no further oversight.
Don K
While it’s true that the 30 yr fixed originated in the dim dark past, they almost killed off the S&L industry in the late 70’s-early 80’s. Before then, S&L’s originated almost all mortgages, and held them on their books. Now, the funding for these mortgages was pretty much entirely from passbook savings accounts, which money could be withdrawn from the S&L at will. This all worked fine as long as interest rates on savings were regulated at low levels. S&L’s had a guaranteed margin (no interest-rate risk), and withdrawals vs new deposits were pretty predictable (very low liquidity risk).
Then came the inflation of the late 70’s. People began to realize they were getting ripped off on savings rates (I’m only getting 2% on my passbook account, but inflation is 8%!). Thus was invented the Money Market Mutual Fund, which invested in commercial paper and the like, and offered to average Joes a realistic interest rate, along with the ability to write a limited number of checks per month.
As a result, S&L’s were seeing pretty large, unanticipated, withdrawals from savings, which threatened their liquidity (there’s only so much money coming in every month from the mortgage payments). They got permission to increase the interest rates they offered, which eliminated the liquidity problem, but put their margins underwater (I’m borrowing at 8% and my portfolio lending rate is 6%!).
It’s the old problem of borrowing short and lending long, which was solved by mortgage securitization. I’m guessing the 30 yr fixed wouldn’t go away immediately in a world without securitization, but a future interest-rate spike would put the nails in the coffin.
I agree mortgage originators should have some skin in the game. I worked for a company that originates auto loans, and we made use of securitization. The thing is, we always kept the bottom tranche (“the toxic waste”) for ourselves, and did our own servicing. So we incurred the first loss. could benefit from having lower losses on the securitization, and controlled the servicing that (along with proper underwriting in the first place)determined the level of losses. And our servicing personnel had no way of knowing which loans were securitized versus which were held on our books.
So there are ways to fix the problems in mortgage securitization, only nobody in the industry wants them fixed.
James Gary
@beltane:
Is there a Commander Brooklyn in the house?
No. If there’s one thing Brooklyners have in abundance, it’s a low tolerance for the kind of windy bullsh*t peddled by McArdle’s current epigone.
Mark S.
Dear fucking god that might be the stupidest thing I’ve ever read on the Internet. And I’ve read a lot of stupid stuff.
Mark S.
Well, I got to hand it to McMegan. She’s found the biggest collection of the boringest fucking bloggers in the universe to cover for her while she’s gone. I defy anyone to read the front page without falling asleep.
Warren Terra
@Soonergrunt:
I am confident that, as ever, Suderman is issuing forth the patently dishonest sentence his Koch overlords pay him to disseminate. Whether he’s forming them himself, I don’t know, but it hardly seems to matter.
Warren Terra
Also, why would a lawyer choose a their ‘nym “Dr. Manhattan”? I’m not ignorant of the graphic-novel reference, but the character in question was a PhD, as this guy presumably is not. Shouldn’t he have called himself Judge Dredd or something?
MosesZD
Years ago I read that prior to the government stepping in and making the 30-year fixed mortgage available, a typical mortgage required a 40% to 60% down payment and a 3-to-5 year term. This all changed with the FHA and Fannie Mae in the 1930s.
The first mortgage backed security, at least according to Wikipedia, was 1968… Thiry years later.
Considering my parents first house was purchased before the first MBS on a 30-year-note, like millions and millions of others, I kind of find the premise laughable.
MosesZD
Years ago I read that prior to the government stepping in and making the 30-year fixed mortgage available, a typical mortgage required a 40% to 60% down payment and a 3-to-5 year term. This all changed with the FHA and Fannie Mae in the 1930s.
The first mortgage backed security, at least according to Wikipedia, was 1968… Thirty years later.
Considering my parents first house was purchased before the first MBS on a 30-year-note, like millions and millions of others, I kind of find the premise laughable.
Err.. Delete the first duplicate… Please…
JGabriel
@beltane:
Sure. Before the free-market system, wingnut welfare recipients were known variously as courtiers, hench-men, or minions.
.
Joey Maloney
@JGabriel: Look up the historical roots of the position of Privy Councilor some time.
Xenos
30 year mortgages do not exist in a state of nature, but then, neither do property rights.
As for financial stability, there are few things as corrupt and corrupting as unregulated insurance schemes where reserves are not kept (see, eg. AIG). The idea of starting anywhere other than that is stunningly idiotic.
AA+ Bonds
So a lawyer feeding from the scraps of bankers says they must be better fed.
Homes are good for society if people are in them. Our society has a real problem putting people in them.
That seems like a crisis to me.
AA+ Bonds
@Xenos:
How about how we’re all charged money to have a working civilization that meets our basic needs and transfers information well, and a tiny fraction of people gather that money up for themselves and use it to buy politicians?
There are serious and practical policies in response to that starting point, if you’re willing to entertain it.
Downpuppy
It all goes back to The Atlantic’s sponsorship business model.
Dr. Manhattan’s special pleading to weaken the proposed rules treating carried interest as ordinary income just has to be paid advertising. I mean, what kind of magazine lets a tax lawyer anonymously plead for a loophole using deliberate deception?
Barry
@Tom: “On this, I’d have to say that it’s a bit more complex. The 30 year fixed rate mortgage indeed would not exist in the state of nature. It’s important here to understand how it’s a construct that’s been encouraged by federal regulatory activities and persists, now, due to entrenched cultural norms.”
‘The state of nature’? What does this have to do with human societies?
Barry
@slag: “Can you be more specific about which aspects of our economy are created by nature and which are created by nurture?”
That’s easy:
I like it – it’s ‘natural’.
I don’t like it – it’s ‘unnatural’, ‘a crime against nature’, a violation of Rand’s Will’, etc.
Barry
@Tom Levenson: “The notion that of all the examples of that (deposit insurance; agricultural subsidies…you get the point)the one we should whack is one of the prime supports of middle class housing is what gets my goat. ”
Standard right-wing politics – if it helps the elites, keep it/expand it; if it doesn’t, then trash it.
dmbeaster
Two points worth adding.
Mortgage backed securities were a great invention that fueled modern home ownership because it significantly decreased the cost of borrowing. In their original Fannie Mae and Freddie Mac incarnations, they enabled the expensive retail home loan market to get wholesale prices for funds, thereby significantly lowering home loan rates. It actually costs a lot to do a retail mortgage loan, which involves very little capital per loan, so the expense to place one billion dollars in retail mortgages costs a hell of a lot more than investing in the same amount of corporate bonds, with more risk. And as noted in the linked article, what made them work was that these mammoth public entities enforced underwriting discipline, thereby insuring the predictable legitimacy of a pool of one thousand loans. Part of the oughts downfall is attributable to making these agencies quasi-private (to “improve” their performance allegedly), thereby inducing them to become part of the cesspool instead of a check on it. (their troubled corruption performance since their semi-privitization has been well covered).
Second, one easy way to understand the risk created by unregulated credit default swaps (CDS), etc. is to view them as what they really are, and that is unregulated insurance. I think everyone understands the problems of allowing insurance to operate without regulation in which the insurer writes as many policies as it wishes and without assets to cover the assumed risk.
That is the key role that AIG played in the melt down. Cause there were voices that warned of the risk associated with massive amounts being bet on all the fancy new mortgage backed securities. To sell those things to staid institutional investors, Wall Street got AIG to back them (with credit default swaps or similar instruments), thereby lending AIG’s triple A rating to the mortgage backed securities. The alleged genius at AIG heading this small part of its business (Cassano, who as a sort of reverse Cassandra, still defends what he did) was in fact betting the whole company on these things. This is actually a form of financial lunacy that has been repeated many times over the decades – I can remember the meltdowns created in the 80s when loan performance guarantees were issued by banks or insurers to back construction loans.
What happens is that when the insurer underwrites the risk, the equity players in the game go hog wild with the risk. In the 80s construction loan debacle, all sorts of crazy high risk construction got funded because the stupid insurance company was footing the ultimate risk. Of course, this skewed the risk that the things would default in the first instance, thereby exposing the backstop to systemic risk. AIG never expected its entire portfolio of CDS to crater, but the fact that it underwrote the risk meant that it hugely increased the likelihood that it would. All standards of underwriting got thrown out the window as everyone wanted to make more loan product to wrap into highly profitable mortgage backed securities, that got sold with the AIG ribbon to big lazy institutional investors. Toward the end, the issuers knew they were issuing crap – hell, Goldman Sachs started making money off shorts who wanted to be sure of failure and stuffed the greatest crap into mortgage backed securities to insure their failure (while it also sold the crap to the investors).
Barry
@Soonergrunt: Quick, somebody check and see if Suderman is still forming complete sentences.”
Well, McArdle is (minus sense and facts). And given the sheer amount of right-wing boiler plate available for copy-and-paste, how would we tell?
Barry
@Don K: “While it’s true that the 30 yr fixed originated in the dim dark past, they almost killed off the S&L industry in the late 70’s-early 80’s. Before then, S&L’s originated almost all mortgages, and held them on their books. Now, the funding for these mortgages was pretty much entirely from passbook savings accounts, which money could be withdrawn from the S&L at will. This all worked fine as long as interest rates on savings were regulated at low levels. S&L’s had a guaranteed margin (no interest-rate risk), and withdrawals vs new deposits were pretty predictable (very low liquidity risk).”
This risk is always a potential risk for anybody who lends long and borrows short. From what I’ve heard, the scandal was not to deal with the S&L problem when it was a $70 billion problem, but to f*ck it up further until it was $250 billion (and that was at as of the last I heard; it probably ended up more).
draftmama
In Canada you get a 5 year mortgage amortized over 30 years. When you go to renew you get the prevailing interest rate. The bank holds the mortgage and it is therefore in its interest to make sure that it does not issue a mortgage which is unsustainable. We bought our first house in 1972 and I believe it was about 5%. Renewed at 8%. Then things went horribly wrong and the next 5 years were at 13% if I recollect. Sanity returned and it varied between 8% and 5% until it was paid off. If I recall there was a small penalty if you wanted to prepay a chunk of principal. This all meant the banks weren’t stuck with interest rates which couldn’t support the prevailing rate paid on savings. All in all a much saner way to handle the issue. Also too, you can’t deduct your mortgage interest in Canada.
Downpuppy
I didn’t believe that bit about the elephant in a jeep, but yep, there’s a picture.