Subprime, CDOs and the threat to home ownership

In a well-documented recent paper (*), Joseph R. Mason of Drexel University and Joshua Rosner of Graham Fisher & Co. ask if a chain of events has not begun unfolding that will end up in a situation where funding for the mortgage industry is massively curtailed. In their paper, Mason and Rosner draw a parallel between the role played presently by subprime loans within Collateralized Debt Obligations (CDOs) and a situation that arose in 2003 leading to the demise of the main collateral types used in those days to enhance CDO credit. These sectors were: manufactured housing, aircraft leases, franchise business loans and 12-b1 mutual fund fees. Should Mason and Rosner’s parallel be justified, then securitization of subprime loans will similarly be in for a major setback in the years to come, the effects of which would ripple through the whole mortgage capital markets and dry up their current main source of funding.
Collateralized Debt Obligations which, as the authors show, were issued in 2006 at a volume nearly equal to that of the three prior years, provide investors with access to high-yield debt, bypassing through the packaging inherent to securitization their otherwise lack of liquidity. CDOs often simply re-securitize low-grade certificates belonging to Asset-Backed Securities (ABSs). CDOs allow putting to their best possible use as credit enhancers these low-grade certificates. A Moody’s analysis in October 2006 reported collateral for outstanding CDOs comprising 28% of subprime and home equity loans and 12% of prime loans. Unlike what is the case with MBSs or ABSs, CDOs are managed, with the Collateral Manager free to populate the security dynamically during its lifetime.
The reason why subprime loans played recently in CDOs the role held in earlier days by manufactured housing et al. is easy to grasp: what makes their attraction is that until the end of 2006 they were undervalued as their high yield – supposedly reflecting their embedded default risk premium – was more conservative than the risk actually incurred, providing investors with a possible arbitrage.
The reason for this opportunity for arbitrage is obvious: in the absence of any safe method for assessing the market risk component of future losses (as opposed to the credit risk component that can be estimated with the help of an individual “credit score”), risk premiums are calculated to mitigate business cycles in their entirety. The implication is that in low default times, the risk premium, i.e. the high yield, will be overvalued, constituting for the investor an attractive proposition. Conversely, in the depressed part of the business cycle, the risk premium is undervalued and fails to cover the actual financial risk appropriately, or in any case with a too thin profit spread. Collateral types like subprime mortgages, manufactured housing et al. will out of necessity only be of interest to CDO Collateral Managers during their periods of risk overvaluation and may meet their doom or at least their periodic eclipse whenever they enter the depressed part of their business cycle as demand then essentially vanishes.
In Milken’s glory days, junk bonds’ embedded risk premiums were overvalued compared to their actual default risk, making the market an attractive one. When their high yield ceased to reflect adequately their rising default rate, the market evaporated, swallowing with it its protagonists. Manufactured housing, aircraft leases, franchise business loans and 12-b1 mutual fund fees met the same fate in 2003 as far as CDOs are concerned: “We argue that the shrinkage in those sectors arose from decreased funding by the CDO markets” (p. 33), contend Mason and Rosner. They add that the exact same phenomenon is currently taking place with subprime certificates carved out from ABSs: “We therefore maintain that the shrinkage in Residential Mortgage Backed-Securities’ sector is likely to arise from decreased funding by the CDO markets as defaults accumulate. (This) could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy” (p. 33).
Their argument is too complex to be faithfully reflected in a short note like this but it is in my view flawless. The only reproach I would make is that they mix two considerations about subprime, introducing an unnecessary distraction in their demonstration. The first consideration about subprime is legitimately relevant to their argument: a borrower’s capacity at making monthly payments which is now lacking with the defaults recently observed in the subprime sector. The second consideration, crucial for the mortgage industry as a whole, but extraneous when discussing CDOs, is the borrower being “underwater,” i.e. owing debt on the house larger than the potential net proceeds of selling the house. The first consideration impacts any type of mortgage-backed security as it affects directly the capacity of recovering a loan’s principal. The second consideration is but a looming threat as long as the homeowner stays put; its effects are complex and spread out necessarily over the long term.
By contrast, the discussion by the authors of the role played by the rating agencies is at the core of their demonstration. Will these be able to do any better at rating in a time of crisis than they did in November 2001 with Enron when the public became wary at their methods? The authors’ reminder that rating agencies claim they need anywhere between three and seven weeks for “notching” i.e. for reflecting in their own rating a change of grade by another agency, casts here a giant question mark. That they promptly put their act together is no luxury but a must: as Mason and Rosner state it, here lies reputational risk for the U.S. capital markets.

(*) Joseph R. Mason and Joshua Rosner, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation market Disruptions?” presented at the Hudson Institute on February 15th, 2007

An experiment in Wikiology

I marvel at Wikipedia. There is hardly a day when I don’t go and check their site, looking up some concept, often mathematical, sometimes financial, or finding out about any other question I happen to be asking myself, about Joachim Pateniers or the bodhisattva.

In the beginning, I would only fix the typos I was coming across. Until one fateful day I got so frustrated that there was no entry for “amortizing loan” that I chose to write it up myself. The dynamics of that collective project appeal to me. I remember a science-fiction story about planet Earth being threatened by some menace from outer-space and every puny little soul that the human race counts aggregating into a single giant one. Wikipedia is a venture of that type.

What pricked my ears initially was when googling one time my own name I noticed that an entry had been created for me in the French Wikipedia. The article was skillfully written, having borrowed material from both my website and the blurb on one of my books. I looked up the author, suspecting that one of my children had been carried away by overzealous filial piety but no: not even a friend or an acquaintance, no one I knew even remotely. The person in question had authored several other entries, all about arcane technical topics like “interferential pigment” or “micro-encapsulation.” Nothing indeed I could really relate to; I felt honored though to be the only human being whom my unknown creator had cared to write about. By now there are two entries, one in English and one in French and they live their own idiosyncratic little lives: people touch them up and chat to each other about the wisdom of their touch-ups.
I was reading recently about a project of a book under a Wiki format. I checked it out and was disappointed to see it was hardly more than painting by numbers: chapter titles were already there, and sub-chapter titles had been cast in iron with blanks just waiting to be filled in. I found the whole concept disingenuous: it seemed like the publisher was trying to pinch a book out of simple-minded aspiring authors while sparing himself the trouble and costs of having to pay any writer royalties. That led me to wonder what a true experiment in Wikiology would look like. Giving it some thoughts I believe I have come up with a plausible case. Here it is.

Dolls

I own that painting. I had a hunch about who had painted it. A year ago or so, I approached the gallery representing that artist. They said they would present her with the slide. Some time later they e-mailed me back; she had seen it and, no: it wasn’t hers. I was back to square one. The experiment in Wikiology is the following: I start an entry for the painting that will be updated with your comments to this blog as they come in. Major and minor progress will be versioned as, for instance, “Dolls 2.3.” There will be a prize for the winner, i.e. the person making a convincing case for authorship and date. A final hint: the back of the canvas as well as a piece of attached newspaper suggest the work was painted within the 1955 to 1965 time frame. Good luck to all!

Dolls 0.0
[Dolls] (32” x 37”) was painted by [X] in [19XX]. Born in [19XX] in [XXX], [X] studied fine arts at [XXX] under the masterful direction of [Y]….

Beijing’s Food Palace

The girl who was taking us to the opera asked where we intended to have dinner and we told her we would be going for the third time in a row to the Golden Tripod Attic. There was some sneer in her voice when she said “But that’s a normal place!” And she was right: the Golden Tripod Attic is a “normal” Beijing place, nothing like the fancy schmantzy Qianmen Quanjude Roast Duck Restaurant where we had some fun eating the all-duck set menu – despite the European couple at the neighboring table keeping a permanently lit cigarette close at hand to puff from between every other mouthful.

Yes, the Golden Tripod Attic is a perfectly normal place where normal Beijing people come for a mildly-priced excellent meal (we paid $25 to $30 for a feast of a meal for the two of us).

We had had our count of the lemon chicken, sweet and sour pork and hot and sour soup that our travel agency imagined was as much as we could take – we were even offered (decent, I need to add) French fries at the Friendship Restaurant on our way to the Great Wall, but it was an utmost relief to find something different, like beef tripe, goose intestine or kidney, that we’ve learned to get so much starved of in the US.
Tripe or “maw”
We ate there last night, today for lunch and tonight for dinner again. When yesterday night we first glimpsed at the restaurant’s gloriously neon-lit façade, we baptized it the “Food Palace” and that’s the way it will remain in our minds, despite the intriguing poetry of its actual name: the “Golden Tripod Attic.”

The attic on the 3d floor is where we had our first meal: no open space for tables, but private alcoves separated by screen-like wooden walls reminding – for all I know – of the opium eateries of yore.
The glossy menu at the Golden Tripode Attic
None of the hyper-active young crew knows as much as broken English but don’t worry, the menu is of the glitzy glossy magazine type with full illustrations and comments in English – don’t go too far in trusting those: the “leek” of the “kidney and leek” look uncannily like cilantro and it is the latter that you’ll get in your plate. The wine list however has not been translated from the Chinese and so we stuck unadventurously with beer and tea that we could pinpoint on neighboring tables.

Don’t expect that asking for a non-smoking table will get you anything more than a smoke-free six-feet radius from the place you sit: this remains China after all. Requests for doggie-bags or even doggie-cups are welcome: Adriana had to ask for one to take back to the hotel some of the delicious ‘shark fin and abalone soup’ she had ordered as soups come in the size fit to serve an entire platoon.

The Golden Tripod Attic is open around the clock. It is located across from another four star attraction: the Lama temple.

Where did the housing bubble come from?

In today’s Wall Street Journal, Andy Laperrière, a managing director of the Washington office of the ISI Group, wrote a piece on the crisis in the mortgage industry, I wrote to the Journal’s editor, the following letter:

In his “Mortgage Meltdown” (Wall Street Journal, March 21, 2007), Andy Laperrière assigns the residential real estate bubble to the boost to home prices that the subprime market has provided “at the margin.” By that he ignores that housing is segmented and although easier access to the lower part of the market has no doubt contributed at raising prices at that particular end of the range, it is unlikely to have had any impact on housing higher up on the ladder where Alt-A and prime borrowers do shop for a home.

If this is so, what are then the factors that contributed to lifting the price of housing? The Agencies, Fannie Mae and Freddie Mac, have claimed part of the responsibility, saying that their active securitization of individual loans into Mortgage-Backed Securities has resulted in lowering the interest rates charged to borrowers. Wayne Passmore, a researcher at the Federal Reserve, has shown convincingly that this was not the case and that the Agencies’ favorable impact for the borrower amounts to a negligible 7 basis points (0.07 %) (1). Fannie and Freddie come out thus clean in that respect.

Governor Alan Greenspan had a different culprit in mind when he was assigning the blame to new construction: the lower progress in productivity in that sector compared to the rest of the economy, he explained, meant that the price of new construction would necessarily rise, forcing that of existing homes to align on them (2). But the 1% yearly increment credited to that cause was a far cry from the 28% rise in home prices observed over the period 1997 to 2002.

Tax deductibility of interest payments is another likely candidate as the government subsidy may erase up to a third of the amount of a mortgage’s monthly payment. It is reckoned that in 2004 borrowers saved 61.5 billion dollars through tax-deductibility of interest. In the first years of an amortizing mortgage, the best part of a monthly payment is interest, with only a small part of principal being repaid. On a typical 30 year fixed rate mortgage, it takes nearly twenty years before the monthly payment contains a larger portion of principal than of interest due. Laperrière reminds us also that in 2006, Interest Only loans represented about one third of all mortgages, with here of course, tax deductibility applying to the entire payment.

The “causes of the current housing bust” may not be that mysterious after all.

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(1) Passmore, Wayne, The GSE Implicit Subsidy and the Value of Government Ambiguity, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., 2003 et 2005.

(2) Alan Greenspan, Home Mortgage Market, Remarks by Chairman Alan Greenspan At the annual convention of the Independent Community Bankers of America, Orlando, Florida, , 4 mars 2003.

Malaise in the subprime sector

In today’s Wall Street Journal, Alex J. Pollock a former President and Chief Executive Officer of the Federal Home Loan Bank of Chicago wrote a piece on the subprime industry, I wrote to the Journal’s editor, the following letter:

“In his “Credit Crack-Up” (March 12, 2007), Alex J. Pollock offers a perceptive summary of the current malaise in the subprime mortgage industry. Some of his comments however call for qualification.

1. The risk of “punishing of the innocent along with the guilty”

Some segment of the subprime industry falls unfortunately under the category of “predatory lending” where the lender seeks his profit not, as in normal circumstances, in the interest being charged but in the equity locked in the property and attempts in fact to force repossession. In a speech he made in 2004, Edward M. Gramlich, a Governor of the Federal Reserve, complained that “despite […] actions by the Fed and other bank regulators, we still have no obvious way to monitor the lending behavior of independent mortgage companies” (*), which at the time represented 12% of originations in that sector.

2. “How could all these problems arise […] given our massive computer power manipulating mortgage data with sophisticated models built by mathematical experts?”

No amount of computer power and mathematical expertise will ever allow to bridge safely from observations of the past to prediction of the future. A majority of the mortgage products currently offered to the consumer are of recent invention and have only a short track-record from which to extrapolate. The FICO score has shown a remarkable efficacy at predicting borrower default. Its power derives from assuming that consumers’ past credit behavior along with the current servicing of their debt predicts accurately their future credit behavior. This simple assumption neglects however that the wider economic context, such as the current level of interest rates or of unemployment, has an influence on consumer creditworthiness and the fact remains that the FICO score has never been tested over a full business-cycle including a recession. The “traditional” threshold of 620 FICO points that the industry had adopted as marking the border between subprime and prime has in the past few weeks been raised by lenders to 660; the move is no doubt prudent but it is not based on any objective measurement: new developments only will eventually reveal if the new value was too conservative or still too low.

3. “The belief that the economy has changed in some fundamental way, and that a ‘new era’ is beginning”

The single true danger lies here precisely. Because it has no choice but to extrapolate from historical data, the mortgage industry is bound to develop new scenarios whenever new circumstances dictate. If we keep in mind that what we see now may only reflect the favorable part of the business cycle, we will envisage consumer behavior within that context and remember that a downside remains possible in the future. If on the contrary we assume that a “new era” has opened where business cycles are a thing of the past or, which amounts to the same, that the favorable part will last forever, then we haven’t seen the end of our troubles.
But are we justified to blame mortgage bankers for having trumpeted the arrival of a “new era” in consumer credit? In its most recent guise, the “new era” theme was once again reborn from its ashes as the “optimal allocation of financial risk,” where risk migrates automatically to those parties ideally suited to take it. Its advocate was of course no less an authority on these matters than the former Chairman of the Federal Reserve, Alan Greenspan.”

(*) Edward M. Gramlich, “Subprime Mortgage Lending: Benefits, Costs, and Challenges”, May 21, 2004

Optimistic and pessimistic views on immortality

Religions are most often associated with a representation of the after-life where immortality, which is clearly unattainable in the nether-world, is ultimately achieved.
Other widely held belief systems don’t share that view, in particular Taoism, the “atheistic religion” or “philosophy” of the Chinese people over the ages. Indeed, some disparagingly called “superstitious” versions of Taoism put the stress on attaining immortality in our everyday world, recounting numerous tales of princes going to great length to secure lifesavers of various kinds. In the West, alchemy shared that same concern, being not only focused on the transmutation of antimony into gold but also on the achievement of immortality, either under the highly idealized form of a perfect identification with the person of Jesus-Christ or under the more prosaic form of the incorruptibility of the material body. Cagliostro and the count of Saint-Germain, among others, allegedly realized this aim. The British anthropological school of hyper-diffusionism, widely popular in the 1910s and 1920s (Sir Grafton Elliot Smith, William J. Perry et al.) held that culture had spread at the surface of the Earth as a consequence of the more advanced civilizations’ quest for lifesavers, the ancient Egyptians most prominently.
World representations entailing that immortality is only achievable in an after-life clearly constitute the pessimistic version of the more upbeat assumption that immortality is attainable in the material world that we’re familiar with. Now that medicine and biology are on the eve of making immortality a reality, the final push will no doubt come from these cultures which consistently envisaged immortality as an achievable pursuit: they are unencumbered by the pessimistic view that the only desirable form of immortality is the one requiring us to first die.

The safest financial world of all

A recurrent theme in Alan Greenspan’s speeches, either when he was head of the board of governors of the Fed or now in his capacity as an invited speaker, has been that the financial world has become in recent years a much more sturdy, much more robust and let’s say it, a safer place, because risk has been redistributed and has essentially found its way to the hands of the investors optimally fit to manage it.

There are two notions in Greenspan’s statement, neither of which in my mind is true. The first is that risk has been redistributed and the second is that it has found its way to the investors best fit to manage it.

The part that is certainly true is that securitization of debt has allowed debt to be repackaged, time-scheduled and customized in an infinite number of ways. To that extent, the tools required to redistribute financial risk have no doubt been created over the past twenty years. The additional condition that needs to be met is that risk has been therefore effectively redistributed. The fact is however that none of this repackaging and customization has prevented the glitzy debt instruments to end up in the portfolios of a somewhat restricted number of actors: life insurance companies, pension funds, hedge funds and foreign central banks. This means that – for all practical purposes – that immense potential for redistribution ends up in concentration in the same few hands.
Similarly for the notion that the current investors in these debt instruments are the optimal managers of their underlying risk. Let’s imagine for one second that these investors are all using securitization as the way for them to hedge some market position they need to hold otherwise and that they’ve found that way the ideal method for offsetting two types of risk while, hopefully, at the same time locking a small but risk-free profit.

But as we know very well, this is not the way things actually work: every one of the traders working for these investors holds a call option, getting a share of whatever profit she or he is making while being shielded from the losses … until she or he gets fired, that is.

Risk has been splintered no doubt, whether it has found its way to its safest havens is where Alan Greenspan and I may differ.

Artificial reason and the heart

So, Marvin Minsky has just published a new book called The Emotional Machine (Simon & Schuster 2007) where he states that Artificial Intelligence should rest on the observed feature that intelligence is emotional by nature. This of course rings a bell, as some twenty years ago an audacious AI engineer, traveling between Martlesham Heath (Suffolk) and Paris (France), wrote ANELLA (Associative Network with Emergent Logical and Learning Abilities), a piece of software mimicking logical reasoning on a body of knowledge it had constituted through asking questions only. I say “mimicking” as there were no rules of logic in ANELLA; whatever logic could be seen was generated by ANELLA’s affect dynamics and driven by the feedback it was receiving from its users.
The author of ANELLA was your humble servant indeed, having been granted at the time an Academic Fellowship by British Telecom.
In those days, the single psychological school having paid attention to emotion as the driver of human intelligence and of human behavior altogether was of course psychoanalysis. In 1987 I was both writing AI source code and training to become a psychoanalyst: ANELLA allowed me to combine both. In that same year I published in L’Âne, the literary magazine led by Judith Lacan-Miller, “Ce que l’Intelligence Artificielle devra à Freud”: “What Artificial Intelligence will owe Freud”. Three years later my book Principes des systèmes intelligents came out where I described ANELLA’s philosophy and concept. The book has become, to its author’s delight, a minor classic. No doubt that Minsky’s call to arms will mean that flocks of English-speaking publishers will now vie to publish this pioneering work in their native idiom!

Human Complex Systems – Economy – Anthropology – Arts – Fun