Saturday, November 29, 2008

THE SUB PRIME CASE FOR BLAMING IT ALL ON SUB PRIMES

Sam Smith - There is something wrong out there. The fiscal crisis is supposedly primarily due to the collapse of sub prime mortgages. This argument places the blame squarely on the backs of stupid borrowers and predatory lenders. It also provides the Wall Street casino players with significant cover.

But let's ask one simple question: what if all the sub prime mortgages had been held by conventional banks and there had been no securitization, mortgage backed securities, structured investment vehicles or special purpose entities that, in the polite words of Wikipedia, "enabled large financial institutions to circumvent capital requirements, thereby increasing profits but augmenting risk."

The value of all residential mortgages is around $11 trillion. As of August about 9% were either delinquent or in foreclosure, or $1.1 trillion. Assuming all were sub prime and eventually foreclosed, assuming there has been a decline of 40% in the value of the homes since the mortgages were issued and assuming every one of these mortgages was for 100% of value, we would still have around $660 billion in real value and a loss of some $440 billion - considerably less than just the first bailout sum.

It is hard to get decent figures about the fiscal disaster but simple exploratory calculations - even those like the above, based on a worse case than reality - suggest that the story may not be quite as it has been presented to us.

There is no doubt that subprime mortgages played an important and even catalytic role in the fiscal disaster, but there also seems little doubt that the problem would have been far easier to cope with if it hadn't been merged with the most complex, covert and incautious gambling scheme ever devised.

Advisor Perspectives was one of the few to hit the target, and last February at that:

"The sub-prime debt that may eventually be written off represents a small corner of the financial markets. Yet its impact has been devastating. . . According to [Dan Gertner, an analyst with Grant’s Interest Rate Observer] the markets collapsed because of a loss of trust. 'One of the great innovations in structured finance was the reallocation of risk achieved by securitization,' says Gertner, adding that 'a consequence was that nobody knew where the risk was.' The markets woke up to the fact that [collateralized debt obligations] were a whole lot riskier than their AAA ratings indicated, and started to question the broader lending markets."

More recently, this - from an interview with Michael Lewis in Motley Fool:

Mac Greer: Michael Lewis, it is ugly out there. Where did it all go wrong?

Michael Lewis: The very short answer was the ability of Wall Street to repackage subprime mortgages as an investment-grade security. That is the heart of the immediate problem.

Then, having done that, [Wall Street] created alongside this market, which grew to a couple of trillion dollars, a casino in side bets where smart people could bet against the sub prime mortgages going bad -- which smart people did do -- this market in side bets, with many trillions more than the original market. So you have got -- because the subprime mortgages have all turned out to be, or mostly turned out to be kind of rotten -- you have got many trillions of dollars of supposedly investment-grade securities that are suddenly worthless. That is a traumatizing event for the global economy, but that is the very short answer. . .

Greer: How could this crisis have been prevented?

Lewis: If the financial regulatory system had controlled the leverage that investment banks were able to run, that would have dramatically reduced the amount of risk in the system. But they didn't, not properly. If the ratings agencies had done their job properly and not caved to pressure from Wall Street to . . . not allow themselves to essentially be gamed by Wall Street into putting investment-grade stickers on things that were essentially crap, then all of it would have been avoided.

In other words, what could have been a manageable crisis turned into an unmanageable disaster not because of the sub prime loans themselves but because of what happened after they were made. Wall Street turned poorly conceived loans into cards at a casino table. And sub prime mortgages weren't the only game being played. Consider the likelihood that billions of drug and other illegal profits were laundered through hedge funds. In the end, the problems created by poor sub prime loans were swamped by the effect of using them as an unprecedented form of gambling.

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Your editor has been a musician for many decades. He started the first band his Quaker school ever had and played drums with bands up until 1980 when he switched to stride piano. He had his own band until the mid-1990s and has played with the New Sunshine Jazz Band, Hill City Jazz Band, Not So Modern Jazz Band and the Phoenix Jazz Band.

NOTES ON THE MUSIC

Here are a few tracks:

SAM SMITH'S DECOLAND BAND

'SHINE' 

JELLY ROLL

PHOENIX JAZZ BAND

APEX BLUES   Sam playing with the Phoenix Jazz Band at the Central Ohio Jazz festival in 1990. Joining the band is George James on sax. James, then 84, had been a member of the Louis Armstrong and Fats Waller orchestras and hadappeared on some 60 records. More notes on James

WISER MAN  Sam piano & vocal

OH MAMA  Sam piano & vocal