Thursday, April 2, 2009

Modeling the Meltdown; Part 2: Putting the elements in motion

In part 1, we were introduced to the ingredients of this recipe for a meltdown: Cheap money, lowered savings and borrowing, loose loaning standards, financial engineering and leverage. Let's see how this all can produce an explosive (toxic?) result…
  1. The riskiest of the mortgages started to default. These were mortgages where the buyer put no money down, did not have to supply proof of employment, and the interest rate was artificially low at the start. When this artificially low “teaser” rate ended, the “homeowner” (and I use the term loosely here) could not longer afford the mortgage, so he or she stopped paying on it, and was eventually evicted. The house goes back to the bank (foreclosure) and the bank puts the house back on the market (called a “short sale”). Short sales often occur at below-market prices.

  2. Housing prices start to drop. Aside from short sales typically being "below market", the law of supply and demand says that as the supply of houses goes up, the price will drop. If there are a small number of defaults, there is not much impact to the market. But the number of risky loans was not small, partially because there was a lack of regulation, and also because mortgage companies had little incentive to avoid writing risk loans. The loans were being sold as soon as they were written, which meant that the mortgage company writing the loan had no long-term interest in the results. Like a game of “hot potato”, the loans were passed from the mortgage company to the financial business that turned them into MBSs, divvied them into tranches, insured them with CDSs and sold them off the others who though they were buying AAA-rated investments.

  3. Once prices started to drop, less risky, but still subprime, loans started to go “underwater.” In other words, the house was worth less than what the borrower paid. Some of these borrowers defaulted, increasing the number of foreclosures and resulting short sales, which drove prices lower. You can see the positive feedback loop forming (where dropping housing prices cause further drops in housing prices).

  4. As prices drop, people who are not defaulting start to feel less wealthy. The psychological factors that encouraged them to borrow more and spend more when housing prices and stocks were rising start to work the other way and they start to spend less. For some people, the decrease in spending can be applied to paying down debt (credit cards and Home Equity Lines Of Credit, aka HELOC). But others (who were increasing their debt each month, but maybe more slowly than their homes and stocks were appreciating) may stop borrowing to spend, but can't pay back the debt. The consumer debt issue is somewhat of a sidebar here, except that as the housing market began to drop, some HELOCs were “called” by the banks—this means the borrows had to pay back the money. Not all borrowers can afford to do this. Those who can pay it back probably took it out of the stock market. Those who can’t probably defaulted.

  5. The stock market too follows the law of supply and demand. Even if the performance of all companies is unchanged, if people need to sell stocks to get money, the prices for the stocks will go down. This adds to people feeling less wealthy because stock prices are falling, and so they decrease their spending further. Unfortunately, because people have been decreasing their spending, company performance is not unchanged—it is decreasing. This puts additional downward pressure on stocks. (As we’ll see in step 8, the banks are getting into trouble, which also depresses stock prices).

  6. Another effect of decreasing company performance is cost cutting, which comes in the form of layoffs and decreased purchase of supplies. So unemployment goes up, and the price of the raw materials (commodities, another popular investment) goes down. And unemployment drives more defaults, which drive lower home prices.

  7. While all this is going on, potential first time homebuyers become reluctant to enter the market. First, because housing prices are dropping, one does not want to buy a house today that will be worth 20% less next year. Second, with a deteriorating economy, people do not feel secure enough to commitment to large mortgage debt. So there is less demand for houses, further driving down prices, generating more defaults, creating more unemployment… You get the picture.

  8. Meanwhile, what’s happening with the banks? MBSs are dropping in value faster than expected, because there are a lot more defaults than expected, and the CDSs don't work, because banks that were insuring each other needed to pay up to each other but can’t, so their AAA rated sub-prime tranches are decreasing in value. By the way, remember leverage? Those with leveraged positions in MBSs might lose 10% of their investment for every 1% drop in value for the MBS. Once the MBSs drop more than 10%, things start to look bad—so bad that these financial institutions now face bankruptcy. They would like to sell these toxic assets before they drop further, but no one wants to buy them, which makes them worth even less-- another positive feedback loop. This lowers the value of bank stocks, which drive the stock market lower (as mentioned in step 5).

  9. But wait; there is a night in shining armor—AIG to the rescue! It turns out that to "reduce risk", when one bank insured another through a CDS, they often bought insurance on this insurance policy. This is called “reinsurance”, and AIG was one of the biggest providers of reinsurance. But everyone wanted their reinsurance payout from AIG at the same time, and AIG could not pay up. (While the inability to pay up had nothing to do with bonuses, those highly bonused managers at AIG were ultimately proved incompetent at their prime responsibility to their customers: reducing risk). With the inability to sell the toxic assets (the MBSs), the banks' assets drop below the federally regulatd minimum, making the banks technically insolvent (unable to meet their financial obligations). The government can;t let this occur, as it is generally accepted that the economy can't function without a solvent banking system.

  10. Enter the bailout, where the government prints money (technically it does not print money), gives it to AIG, who then gives it to the banks that were insured (known as AIG’s “counterparties”). The government also gives money directly to the banks. Now the banks are solvent again-- sort of. With all the money being handed out, there are responsibilities generated to pay it back. But if the banks gets a loan, then its finances still look bad (more on this below in step 11). So it would be better for the banks to give the government equity (stock) for the money they receive instead of debt. But this would mean that the government starts to own the banks (nationalization). This is not something the banks want, nor the government wants.

  11. Strangely, the banks actually had enough money all along—it was only “on paper” that the banks looked insolvent, because they held investments that showed a huge loss. But the loss is not realized until the assets are sold. Think of it like this: If you hold a stock that is down now, until you sell the stock you have only lost money in theory. If you wait until the stocks go back up, you can sell at a gain, and life is good. You did not lose anything, and your life proceeded normally while your stocks were low. Likewise, if the banks just wait until housing prices recover, everything will be OK. But, housing prices might not recover, and banks have regulations that say they have to account for their assets at the current market price (called “mark to market”). So the bank’s financial statements (called balance sheets) show the banks to be in bad shape. The bailout money can help “shore up” the balance sheets and make the banks look solvent, but as mentioned in step 10, this starts to look like the government owning the banks. What to do?

  12. One possible solution to taking the pressure off the banks is to no longer require them to “mark to market”. In other words, they don't have to account for their “toxic” assets at the current low price. Rather, they can just wait it out, like we did with our stocks in the example is step 11. Another solution is for the government to buy, or to subsidize purchase by private parties, the toxic assets (which by the way now have been given the euphemistic name “legacy assets”) at a price higher than what they are currently worth. Then the bank balance sheets get healthy without the government owning the banks. Both of these solutions have their own problems, among which they tend to be rewarding risky behavior by the banks.

You probably have a sense that this is pretty complicated and, though in hindsight the sequence of events looks logically plausible, nobody noticed it before it all came down. Likewise, the solutions for the bank’s problems, described in steps 10 through 12 above, can have unintended side effects. And once we patch up the current problem, we need to change the rules to prevent it form occurring again.

The model we are building will
  • Improve the explanation above, because the moving parts will need to produce the real-world outcome, which will highlight anything we’re missing
  • Reveal possible side effects of the short-term fixes to the financial market
  • Be a test bed for future policy and regulations designed to prevent a repeat performance, to make sure that the regulations not only achieve their goal, but don't allow other undesirable outcomes down the road
Stay tuned as we create the model!

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