Thursday, April 2, 2009

Modeling the Meltdown; Part 1: Setting the Stage

The first step in building a model is to understand how the system to be modeled works in the real world. I’ve summarized what I know about the financial meltdown the following story. A caveat: I’m not an economist, and there are certainly errors in the description below. I encourage knowledgeable readers to provide comments to help improve the accuracy.

The economic situation that the US finds itself in today has resulted from the interaction of a number or processes that created in a “positive feedback loop” of declining home prices (in other words, falling home prices cause home prices to fall further. I’ll try to avoid jargon, or at least define it when it is used). Falling home prices generated additional undesirable side effects such as failing banks and unemployment. Here’s how:

  • Cheap money: After the burst of the Internet bubble, the federal reserve bank (“the Fed”) decreased interest rates to historic lows. The idea was keep the economy vibrant by making it inexpensive to borrow money, which lowers the risk of new investment in everything from starting a business to buying a home to spending on credit cards. As these lower interest rates stimulate more demand for things like houses, prices rise because supply is limited. This is called inflation. Between 2002 and 2007, there was very high inflation in the price of homes, oil and stocks. There was not much inflation in food, durable goods, and services—the traditional measures of inflation. Hence, no one (not the public, the media, or the government) reacted to the rise in housing prices, energy and stocks as if it was inflation. If we had reacted to inflation, the Fed would have probably raised interest rates, which would have slowed down demand. While this might have been fiscally appropriate, it was not politically palatable.
  • Lowered savings and increased borrowing. Many people judge their wealth by their home equity and stock investments. Thus, as home and stock prices increased, people felt wealthier. One result of feeling wealthier was a decrease in savings. Why put your “disposable” income (money you earn but don't need to meet your basic living expenses each month) in a savings account that increases by 3% per year when your house and stocks are increasing by 20% per year. Why not spend this disposable income? And, why not spend a little bit of your “winnings” in home equity and stocks too, by borrowing against your home equity and low-interest credit cards? After all, spending is god for the economy.
  • Loose loaning standards. As money became easier to access, so did mortgages. I’m not sure if there were any regulations that were relaxed to make it easier to borrow—that was not required in order for the following to have occurred: Mortgage companies would get a loan filled, and then sell it. Normally, a risky loan would be hard to sell to anyone unless the interest rate (paid by the borrower) was high (to offset the risk). But rather than make the interest rates high, which would have made it more difficult to get borrowers, the loans were made to appear to be low risk. This was done via financial engineering, the explicit design of investments derived from other investments (a.k.a. derivatives).
  • Financial Engineering: There are two derivative investments that played a big role: Mortgage-backed securities (MBS) and credit default swaps (CDS). Here’s how they work:
MBS: Financial business “B” buys a collection of loans from a number of mortgage companies. This portfolio of loans runs the gamut from low risk to high risk. The collection is divided in slices (known as “tranches”, French for “slice”) based on risk. The lowest-risk tranche is sold off with a rating of “AAA”, the highest credit rating. The next tranche would have a lower credit rating, such as AA, A, B, etc. The low-risk loans are called “prime” and the higher-risk loans are called “sub-prime”. It is harder to sell something with a lower credit rating—you need to offer a higher interest rate to offset the risk. Also, mutual funds can only buy assets rated AAA, so there is a whole big market to which you don't have access if you are selling risky investments. But thanks to the magic of financial engineering, you can turn a risky tranche into a AAA tranche by insuring it. This insurance is called a credit default swap.

CDS: The basic idea is that financial business “A” offers to insure a tranche. The contract states that if some amount of the mortgages in financial business B’s tranche default (the borrows stop paying the mortgage), then A will pay B. With this insurance the sub-prime tranche can be transformed into an investment rated AAA, and sold to anyone looking for a low-risk investment. This works fine as long as, in a given tranche, no more than the expected number of loans go into default. One of the ways this insurance was used was by having two banks insure each other. I agree you pay you if the defaults on your risky tranche get too high, and you agree to pay me if the defaults on my risky tranche get too high. We’re swapping insurance on mortgage (credit) defaults. We’re fine as long as both of our investments don’t fail simultaneously.
  • Leverage: The idea of leverage is that you borrow money to invest, with the expectation that your investment return will exceed the cost of borrowing money. For example, a consumer buys a house with 20% down—this means that four times as much money is being borrowed as is being invested. The consumer gets to keep the gain, so it is a great investment—If I buy a house for $100K, I put down $20K. If the house goes up by 20%, to $120K, and I sell it, I end up with $40K, a 100% profit, while I was paying less that 10% per year in interest. Who wouldn't take that deal? Financial firms also use leverage. There are various regulations—Mutual funds can typically not be leveraged, banks (such as bank of America, Citicorp, Wachovia, etc.) can be leveraged to (what was believed to be) a conservative degree, and investment banks (such as bear Stearns, Goldman Sachs and Morgan Stanley) and hedge funds have no regulations I am aware of on how much they can be leveraged—they just have to be able to convince someone else to lend them the money.
In Part 2, we’ll look at how these ingredients reacted to form the financial meltdown.

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