Collateralized Debt Obligations
Mort and I exchanged news about grandkids and home projects over breakfast a few Thursdays ago. Gina refilled our mugs, left the pot on the table, and cleared the dishes.
“Say, Mort, we’ve talked about the economy and some of the causes of the meltdown. But I still haven’t figured out about CDO’s. Got any thoughts about that?”
“I’ve been thinking about that, too, ‘cuz I have a way to illustrate it that would make some sense. It’s such a big and abstract subject it doesn’t lend itself to easy dissection.”
I sipped my hot black coffee and sat back in my chair. “Go for it, man. I’m all ears.”
“Okay. I’m gonna ask you to remember some of things we talked about the last several weeks, ‘cuz some of it ties together.” He scowled, cleared his throat, drank some water, and began:
“Remember, we talked about the bank managers our dads worked with fifty or sixty years ago in our small hometowns. The guys who knew everyone in town and their finances?”
“Sure, I remember that.” I really did remember, slightly surprising myself.
“Now, suppose that bank manager had a brainstorm that he could virtually eliminate risk in his loans and improve his cash flow at the same time.”
“Okay, I got it. Bank manager’s a smart cookie.”
“Right. Now bear in mind he couldn’t have done what I’m about to propose—this is hypothetical. The regulators woulda been all over’im like white on rice if he tried this in ‘55.”
Okay,” I agreed, “Hypothetically speaking.”
“Yeah, I gotta make it small to have it make sense. Here’s how it works: Bank manager wants to show a bigger revenue stream to the owners of the bank—he has in mind a raise, maybe a promotion to VP. He picks thirty of the bank’s loans to bundle together into a group, which he will then sell to various investors around the county—moneyed folks who are looking for investments. So he takes ten excellent loans—the collateral on them is farms, businesses, crops, machinery—and the loans’ total value is, say $200,000. The value of their collateral is $300,000 plus. They get a AAA rating.”
“I’m with you so far, Mort. Those are loans that are almost guaranteed to be paid back.”
“Right. Now he takes ten more loans that are a mix of pretty good loans and sorta good loans. The value of these loans is also $200,000. Half are to really good farmers and businessmen who’ve proven over time they will underestimate their income for the life of the loan. The other five of this group is to borrowers who have over-extended themselves, but’ll probably be able to pay off the loans. Those loans are not quite as good as the first half. If everything goes well, the collateral value on these will be $250,000. If everything goes bad, the value will be $150,000. This group gets a AA-BB rating.”
“So let me guess. That means on five of those loans, some of the loan officers didn’t do their homework, or the families are in trouble a little—they’re marginal, right?”
“That’s right, Hank.” Mort paused and poured and sipped some coffee. “Our bank manager bundles the last ten loans up and puts them into the third ‘bucket.’ He hopes nobody notices them. Today, we call ‘em subprime loans. By the way, the last ten loans have a collateral value of $200,000 if every single tiny thing goes exactly right. That means the crops have to come in and be sold at the right price, the businessman or farmer has to budget very carefully, he can’t go buying a new car or a new tractor this year, etcetera, etcetera. And if the weather’s too wet or too dry, if there’s a hailstorm, if there’s a disease among the pigs or cattle or chickens, the loans will go into default. Those loans are unrated. We’ll call ‘em XXX so we can identify them later.”
“Right. So now we have a bucket of AAA loans, a bucket of AA-BB loans and a bucket of XXX, unrated loans?” I was doing my best to keep up.
“Yep. The buckets are called ‘tranches.’ The financial guys call ‘em that to try and keep everyone in the dark. It means portions. Oh, by the way, the Wall Street guys labeled those buckets ‘Senior,’ Mezzanine,’ and ‘Equity.’ That way nobody could figure out what the hell they were talking about. What it really meant was Senior CDO’s were good, Mezzanine were so-so, and Equity meant ‘You own ‘em now, so Good luck!’ The total asset value of those loans is $600,000 if our math is right. And there is collateral on all of ‘em also worth $600,000 plus if everything goes right. If enough things go wrong, it’s worth what? $400,000? Our bank manager is the loan originator for which his bank collected origination fees. Now, anybody can sell assets, as a general rule. I can sell my La-Z-Boy, my car, and if I own a note or a race track ticket or an IOU, I can sell all or part of it, can’t I? If I own a hundred acres, I can sell ten of ‘em or all of ‘em.”
“I guess so, depending on the zoning and EPA restrictions and stuff like that.”
“I’m gonna ignore those gratuitous comments, Hank. Remember, this is a hypothetical case, and we hafta keep it pretty simple so you’ll understand it. Quit trying to confuse the issue. In any case, the bank manager has a nominal $600,000 worth of assets to sell. He can find buyers for them, divide ‘em up into parcels, some AAA, some AA-BB, and some XXX, and sell them or parts of them. Let’s assume he does that. To entice buyers, he’s going to discount the loans a little, plus pay the investors the interest every quarter, highest interest on the highest risk loans—XXX, lowest interest on the AAA loans. The AA-BB loans are somewhere in the middle. That’ll be the buyers’ Returns On Investment. Also known as ROI. So Mr. Bank Manager goes around to about a hundred or so potential investors, folks around the county he knows have ready cash—some retired farmers, some widows, some enterprising implement dealers and so on. He ‘lets each of them in on the deal,’ which he has made up into 600 shares at a thousand dollars a share. Their organization is responsible for collecting the annual interest on all those notes he’s bundled up and the mortgagees will pay them off when the notes come due, or so hope the investors.”
Hank went on, “What’s interesting is that our Bank Manager has transferred all the risk to those shareholders who bought pieces of his bundled Collateralized Debt Obligations. He calls them that ‘cuz it sounds better than “a grab bag of mixed loans.” Furthermore, the shareholders are now the owners of those assets and hafta set up methods for collection of the interest and the monthly or quarterly or annual payments on the notes. So the bank is out of the picture. Bank Manager sends a letter to the mortgagees telling them that the new owners of the notes are the Gump County Association of Rich Folks Who Want to Get Richer, Inc. Bank Manager gets a raise and a promotion and a bonus and laughs all the way to the bank. Gets a job on Wall Street. At two million dollars a year plus perks and stock options. Just kidding about the last part!”
“That sounds pretty good, Mort. Why wouldn’t it work?”
“Remember the caveat I put in there about everything having to go perfectly right for those XXX rated loans? Well, everything goes wrong! A year or two after Mr. Bank Manager put together the deal, there was a hard frost in April. Everybody had to go out and replant his corn. Then in June, there was hardly any rain. A lot of the corn got too dry and didn’t mature. Oats crop failed. Then in September a tornado hit the county and wiped out about thirty percent of the debtors’ farms. Then in October, the Congress voted to do away with some of the subsidies farmers had been getting for four generations. I tell you, it was a catastrophe! Those retired farmers and widows lost their pensions and everything. And just like that, property values went down, too. So those investors could foreclose, but what good would it do? They couldn’t get their value out of the property.”
“Well, that sure sounds familiar, Mort. Except for the details, it’s a lot like what we’ve been seeing the last six months.”
“Yeah, multiplied by about ten million.” Mort grinned, swallowed the last of his coffee, put on his cap on and headed for the cashier. “Gimme a call when you wanna go for coffee, Hank.” I said I sure would. I walked to my car shaking my head.
Wednesday, May 27, 2009
Mort & Hank Talk Economics #4
Understanding Contracts, Derivatives, Hedges, and Options
Mort sat outside at a table in the fall sunshine when I walked up with my Americano, no room no cream no sugar.
“Hey, Hank,” he said. “I was just lookin’ at the sports section of the paper. You like the horses, doncha?”
I sipped my coffee tentatively to see how bad it would burn my tongue. “Oh, I get down to the track once in a while if I’ve got $20.00 to waste.”
“Well, Hank, that’s sure the proper attitude to take when you gamble.” Mort sipped at his coffee and went, “Mmmm.” He studied the newspaper for a moment. “Here’s what I was thinkin’ as I looked at this paper: there’s not a whole lot of difference between horse racing and modern day financial investment.”
“Whaddya mean, Mort?”
“It’s like this—when you go down to the track and place a bet on a horse, you are making an investment in that horse for that race, aren’t you? And you get a piece of paper that proves it—you get a ticket that has value, ‘specially if your horse wins.”
“Sure. If I bet $2 I’m buying a share in that horse for that race. And a $50 bet buys me 25 shares in that horse. The more I buy, the more I can win or lose. That the idea?”
“Yep, think about it Hank. You place a 2-dollar bet on a 25 to 1 horse, then you’re holding a ticket, a document, aren’t you? It has a potential 50-dollar value, depending on how many other people bet on the horse and then how the horse performs. But here’s the thing—you could also sell that document, or part of it. It’s conceivable for you to sell it any time up to when the race is almost over. All you have to do is find a buyer, right?”
“Why would I wanna do that, Mort?” I was puzzled. What was he getting at? I took a big swallow of coffee and dripped some on my jeans.
“Just stay with me on this, okay, Hank? Let’s say a guy at the track comes up to you in a hurry and says, ‘Who’s your ticket on, pal?’ and you say, ‘Fast Eddie, number 3 horse in the sixth race—just now parading to the post.’ The guy says, ‘The betting windows are closed, but I want a piece of that horse. I will give you 5 dollars right now for a half interest in your winnings. If the horse loses, you keep the fiver.”
“That sounds good to me, as long as the fiver isn’t counterfeit,” I said. “Where ya going with this, Mort?”
“Here, now, pay attention, Hank. This gets complicated because I’m gonna explain how contracts, hedges, derivatives and options are all the same as placing a bet at the race track. With some subsequent transactions, of course.”
“I’m all ears, Mort. Let’s start with contracts, then.”
“The contract is simple. As soon as you placed your $2 bet at the window, you and the track entered into a contract. Okay so far?”
“Oh, yeah. And I got a document as proof of the contract, right?”
“Yep. Now, as soon as you took the $5 bill from the fella that offered it to you, the two of you created a derivative. That is, the new contract between you and him was derived from your first contract, with the track. Make sense?”
“Sure does.” I thought for a couple minutes. “So where’s the hedge come in?”
“All right. Let’s say the other guy wanted to buy a part of your bet because he bet $20 on an eighty to one horse. Now if his horse wins, he wins $1600. But he wants to cover himself, ‘cuz his horse will probably lose. But he waited too long to make another bet at the window, so he ran around trying to find somebody at the rail with your horse, and there you were. So he gives you a fiver for an option on half your winnings. It’s an option because if your horse doesn’t win, you don’t hafta to pay him back the $5.” Mort stopped and sipped his coffee for a minute.
“Now the guy spent $20 on his original bet and gave $5 to you—so he’s out $25. But if your horse comes in first, you pay him $25, half your winnings, and he‘s even! He hedged his original bet so if his horse loses and yours wins, he breaks even, right? And he made you a $3 winner minimum—no matter what happens in the race. Your $2 bet already earned you $5. You’re like one a those mortgage middlemen who came out a winner regardless of what happened at the end.”
“I like that. What if the favorite wins—the horse that’s going off at four to one—and my horse loses, Mort?”
“Well, Hank, as the saying goes, that’s horse racing, isn’t it? But just like in financial circles, there’s always a number of people willing to bet the long odds—and they lose mosta the time.” Mort swallowed up the last of his coffee and got up to leave. “I gotta go over to the hardware store and get me a box of nails. Gimme a call Tuesday—I’ll be ready to get outta the house before Aggie gives me another honey dew list for the week.”
As I walked home I thought about how hard it is to actually win at the races or the financial markets, and how much luck plays a part in both of ‘em. But I wondered if Mort could explain collateralized debt obligations to me some time. It felt like time for a nap.
Mort sat outside at a table in the fall sunshine when I walked up with my Americano, no room no cream no sugar.
“Hey, Hank,” he said. “I was just lookin’ at the sports section of the paper. You like the horses, doncha?”
I sipped my coffee tentatively to see how bad it would burn my tongue. “Oh, I get down to the track once in a while if I’ve got $20.00 to waste.”
“Well, Hank, that’s sure the proper attitude to take when you gamble.” Mort sipped at his coffee and went, “Mmmm.” He studied the newspaper for a moment. “Here’s what I was thinkin’ as I looked at this paper: there’s not a whole lot of difference between horse racing and modern day financial investment.”
“Whaddya mean, Mort?”
“It’s like this—when you go down to the track and place a bet on a horse, you are making an investment in that horse for that race, aren’t you? And you get a piece of paper that proves it—you get a ticket that has value, ‘specially if your horse wins.”
“Sure. If I bet $2 I’m buying a share in that horse for that race. And a $50 bet buys me 25 shares in that horse. The more I buy, the more I can win or lose. That the idea?”
“Yep, think about it Hank. You place a 2-dollar bet on a 25 to 1 horse, then you’re holding a ticket, a document, aren’t you? It has a potential 50-dollar value, depending on how many other people bet on the horse and then how the horse performs. But here’s the thing—you could also sell that document, or part of it. It’s conceivable for you to sell it any time up to when the race is almost over. All you have to do is find a buyer, right?”
“Why would I wanna do that, Mort?” I was puzzled. What was he getting at? I took a big swallow of coffee and dripped some on my jeans.
“Just stay with me on this, okay, Hank? Let’s say a guy at the track comes up to you in a hurry and says, ‘Who’s your ticket on, pal?’ and you say, ‘Fast Eddie, number 3 horse in the sixth race—just now parading to the post.’ The guy says, ‘The betting windows are closed, but I want a piece of that horse. I will give you 5 dollars right now for a half interest in your winnings. If the horse loses, you keep the fiver.”
“That sounds good to me, as long as the fiver isn’t counterfeit,” I said. “Where ya going with this, Mort?”
“Here, now, pay attention, Hank. This gets complicated because I’m gonna explain how contracts, hedges, derivatives and options are all the same as placing a bet at the race track. With some subsequent transactions, of course.”
“I’m all ears, Mort. Let’s start with contracts, then.”
“The contract is simple. As soon as you placed your $2 bet at the window, you and the track entered into a contract. Okay so far?”
“Oh, yeah. And I got a document as proof of the contract, right?”
“Yep. Now, as soon as you took the $5 bill from the fella that offered it to you, the two of you created a derivative. That is, the new contract between you and him was derived from your first contract, with the track. Make sense?”
“Sure does.” I thought for a couple minutes. “So where’s the hedge come in?”
“All right. Let’s say the other guy wanted to buy a part of your bet because he bet $20 on an eighty to one horse. Now if his horse wins, he wins $1600. But he wants to cover himself, ‘cuz his horse will probably lose. But he waited too long to make another bet at the window, so he ran around trying to find somebody at the rail with your horse, and there you were. So he gives you a fiver for an option on half your winnings. It’s an option because if your horse doesn’t win, you don’t hafta to pay him back the $5.” Mort stopped and sipped his coffee for a minute.
“Now the guy spent $20 on his original bet and gave $5 to you—so he’s out $25. But if your horse comes in first, you pay him $25, half your winnings, and he‘s even! He hedged his original bet so if his horse loses and yours wins, he breaks even, right? And he made you a $3 winner minimum—no matter what happens in the race. Your $2 bet already earned you $5. You’re like one a those mortgage middlemen who came out a winner regardless of what happened at the end.”
“I like that. What if the favorite wins—the horse that’s going off at four to one—and my horse loses, Mort?”
“Well, Hank, as the saying goes, that’s horse racing, isn’t it? But just like in financial circles, there’s always a number of people willing to bet the long odds—and they lose mosta the time.” Mort swallowed up the last of his coffee and got up to leave. “I gotta go over to the hardware store and get me a box of nails. Gimme a call Tuesday—I’ll be ready to get outta the house before Aggie gives me another honey dew list for the week.”
As I walked home I thought about how hard it is to actually win at the races or the financial markets, and how much luck plays a part in both of ‘em. But I wondered if Mort could explain collateralized debt obligations to me some time. It felt like time for a nap.
Mort & Hank Talk Economics #3
Mort and I took our coffee to an iron table in the sunshine outside the café. I offered Mort a small cigar. “No thanks,” Mort said. “I gave that up almost fifty years ago when I married Aggie. Yep, and in those forty-nine years I’ve never seen anything like the state of the economy today. I’m a little young to remember the Great Depression.”
I said, “I only know what my folks’ generation told about it. My mom was in the Dust Bowl—Western Kansas. She went to California to work in ’34.”
“My dad worked in a tractor factory,” Mort said “He kept his job. But some of my uncles went without work for a few years—one of them got on with the WPA and another one rode the rails, working’ whenever he could for 25¢ a day.”
“It got more complicated in our lifetimes, Mort.”
Mort was in a lecturing mood. “It sure did, Hank. I was reading on the Net about those various investment instruments that’re out there now! The only thing is, what makes some of those things complicated is this: in the old days our parents didn’t hafta know about futures and derivatives and and swaps and hedges ‘cuz they never expected to strike it rich. Nowadays everybody expects to strike it rich.”
“Whaddya mean?”
“It’s like this. Our dads went to the local bank and talked to the manager about a loan, say for a car. The manager lived there in town. He knew your dad—and the neighbors—how much you made, how you paid your bills. So he’d make your dad a loan and your dad made the payments every month.”
I said, “Oh, I know what you mean. My folks used to save up to buy stuff like a new washing machine. I bought my first fishing rod on lay-away. A dollar a week, then I got my rod and reel in 15 weeks. Did your folks have charge accounts at the grocery store and gas station? Paid ‘em off every month, right? Mine did.”
“Yep. Well, trouble started when every day working folks got to believing the American Dream means they can have every damn thing they want right now.”
“I’d say so. Advertising made people think they couldn’t live without air freshener or deodorant or greeting cards or a new car every three years. So what’s your point, Mort?”
“Well, I guess it’s this: People forget ‘the devil in the details.’ Like sliding interest rates, fine print, adjustable rate mortgages, spreading themselves too thin to cover their monthly payments. They scurried around like squirrels in the fall leaves, trying to find new ways to debt-finance their living style. Using debt to finance a lifestyle is a real perilous idea. It’s like trying to finance a lifestyle at the casino unless you’re a good professional gambler.”
”So you’re saying people are living beyond their means. That’s what they called it in the old days—living beyond their means.”
“That’s part of it, Hank—but it goes deeper than that. Some of the eggheads call it ‘instant gratification.’ That’s what I meant by ‘right now.’”
“But there’s more to it than that, huh, Mort?”
“I think so. There’s this attitude of getting rich quick, too. It’s sorta like people are thinking all the time ‘If I can just win the Lotto . .’ or ‘I’ll just take a hundred dollars out to the casino—I know I’ll hit a jackpot this time—I’m due . . .’ But they never realize how much the odds are against them time after time.”
“Do you think that’s what people had in mind when they were buying houses and flipping them and then going together with others and buying more houses to flip?”
“A-course it is! Here were these weasels out there telling everyone how they made ten million dollars in real estate with no risk and making out like everyone could do it. Well, if you think about it, it’s stupid to think everyone can do it. If everyone could do it, it wouldn’t mean anything.”
I said, “What do you think happened to people’s thinking? How come so many folks think the world owes ‘em a living?”
Mort sipped of his coffee. “I think advertising and the popular culture—the media—make it look like the highlife is within reach of every working’ stiff out there. Spend, spend, spend—the result is everybody is trying to keep up with the Joneses, but the Joneses aren’t even real people, like your neighbors. They’re the families on the sitcoms. There’s real confusion between fantasy and reality. Folks don’t even really know their neighbors and talk to them—to know how hard it is for them, too.”
We walked toward our cars. “Imagine a world without yard sales and E-Bay,” I said.
“Yeah,” Mort said. “I have a friend who says whenever he’s in a mall, he thinks to himself, ‘Wow! Look at this huge place just packed with stuff that nobody needs!’”
I laughed. “See you next week, Mort.” He waved as he eased himself into his car and started it up.
I said, “I only know what my folks’ generation told about it. My mom was in the Dust Bowl—Western Kansas. She went to California to work in ’34.”
“My dad worked in a tractor factory,” Mort said “He kept his job. But some of my uncles went without work for a few years—one of them got on with the WPA and another one rode the rails, working’ whenever he could for 25¢ a day.”
“It got more complicated in our lifetimes, Mort.”
Mort was in a lecturing mood. “It sure did, Hank. I was reading on the Net about those various investment instruments that’re out there now! The only thing is, what makes some of those things complicated is this: in the old days our parents didn’t hafta know about futures and derivatives and and swaps and hedges ‘cuz they never expected to strike it rich. Nowadays everybody expects to strike it rich.”
“Whaddya mean?”
“It’s like this. Our dads went to the local bank and talked to the manager about a loan, say for a car. The manager lived there in town. He knew your dad—and the neighbors—how much you made, how you paid your bills. So he’d make your dad a loan and your dad made the payments every month.”
I said, “Oh, I know what you mean. My folks used to save up to buy stuff like a new washing machine. I bought my first fishing rod on lay-away. A dollar a week, then I got my rod and reel in 15 weeks. Did your folks have charge accounts at the grocery store and gas station? Paid ‘em off every month, right? Mine did.”
“Yep. Well, trouble started when every day working folks got to believing the American Dream means they can have every damn thing they want right now.”
“I’d say so. Advertising made people think they couldn’t live without air freshener or deodorant or greeting cards or a new car every three years. So what’s your point, Mort?”
“Well, I guess it’s this: People forget ‘the devil in the details.’ Like sliding interest rates, fine print, adjustable rate mortgages, spreading themselves too thin to cover their monthly payments. They scurried around like squirrels in the fall leaves, trying to find new ways to debt-finance their living style. Using debt to finance a lifestyle is a real perilous idea. It’s like trying to finance a lifestyle at the casino unless you’re a good professional gambler.”
”So you’re saying people are living beyond their means. That’s what they called it in the old days—living beyond their means.”
“That’s part of it, Hank—but it goes deeper than that. Some of the eggheads call it ‘instant gratification.’ That’s what I meant by ‘right now.’”
“But there’s more to it than that, huh, Mort?”
“I think so. There’s this attitude of getting rich quick, too. It’s sorta like people are thinking all the time ‘If I can just win the Lotto . .’ or ‘I’ll just take a hundred dollars out to the casino—I know I’ll hit a jackpot this time—I’m due . . .’ But they never realize how much the odds are against them time after time.”
“Do you think that’s what people had in mind when they were buying houses and flipping them and then going together with others and buying more houses to flip?”
“A-course it is! Here were these weasels out there telling everyone how they made ten million dollars in real estate with no risk and making out like everyone could do it. Well, if you think about it, it’s stupid to think everyone can do it. If everyone could do it, it wouldn’t mean anything.”
I said, “What do you think happened to people’s thinking? How come so many folks think the world owes ‘em a living?”
Mort sipped of his coffee. “I think advertising and the popular culture—the media—make it look like the highlife is within reach of every working’ stiff out there. Spend, spend, spend—the result is everybody is trying to keep up with the Joneses, but the Joneses aren’t even real people, like your neighbors. They’re the families on the sitcoms. There’s real confusion between fantasy and reality. Folks don’t even really know their neighbors and talk to them—to know how hard it is for them, too.”
We walked toward our cars. “Imagine a world without yard sales and E-Bay,” I said.
“Yeah,” Mort said. “I have a friend who says whenever he’s in a mall, he thinks to himself, ‘Wow! Look at this huge place just packed with stuff that nobody needs!’”
I laughed. “See you next week, Mort.” He waved as he eased himself into his car and started it up.
Mort & Hank Talk Economics #2
How Competition and the Bottom Line Can Affect Honest Reporting
I met Mort again at the coffee shop Saturday afternoon. I got there first then Mort slunk in looking so morose I wondered why he came out of his house for coffee and a Danish.
“What’s the trouble, Mort?” I said.
“Ah, Hank, times are bad, really bad. I think times are even worse than I thought before. Did you ever hear the saying, ‘the first guy lies, then the second guy swears to it?’”
“Yeah, I can remember hearing that before—it was part of the vernacular when I was growing up in the Midwest. Especially useful when guys were telling tall tales. One guy would tell a ‘huge fish that got away story’, and another feller would say, ‘Yeah, ‘at’s right—I was there too and seen it with my own eyes.’ ‘Course, they were both lying!”
“Well, I was reading a piece in the Times today, and it just about sunk me down to the scuppers. It had to do with this current financial crisis. And it made me think of that old saying.” The waitress brought us our coffee and pastries.
“How so, Mort?” We both lifted our cups and took scalding swallows. Mort blinked and shook his head and I had to squinch my eyes.
“Okay, one of the liars in this story is Standard & Poors’ credit rating organization and the other is Moody’s credit rating branch. Here’s the deal. A few years ago, Moody’s got spun off from D&B—Dun and Bradstreet. Now Dun and Bradstreet has been reporting on businesses credit ratings for oh, I dunno, a couple hundred years. Still are, I reckon. But they wanted out of the securities and bond credit rating business. So they spun Moody’s off on their own. You with me so far?” He chewed a bite of Danish.
“Yep. Now Moody’s is out there on their own, trying to make a profit, right?”
“You got it, Hank. Well, Standard and Poors practically had a monopoly on bond rating forever. So Moody’s said, “We gotta get some of that business away from S&P. How can we do it?” What they decided to do, was relax their criteria that would make what you might call marginal stuff into triple A rated stuff. Then the clients what wanted to have a triple or double A rating on securities issues, or packages of various kinds of issues had an up-to-then reliable outfit stamping out triple A ratings—those clients came on over to Moody’s. Now here’s what—for a century or two, those outfits had almost a quasi-regulatory status among investors. If one a them said something was an AAA risk, it was like the Agriculture Department putting a ‘Choice’ stamp on a piece a beef. Or calling it Kosher. It was by God practically guaranteed to be a secure risk, barring a catastrophe.” He took a swallow of coffee.
“Okay, so then Moody’s started eating into Standard and Poors’ share of the market, huh?” I said and finished off the last bite of my Danish.
“Yep, that’s it. So do you wanna guess what S&P did then?”
“Let me try. They followed suit and relaxed their criteria, too—right?”
“On the nailhead, Hank. So now you’ve got these two old companies that’ve built a reputation over a century or two, each trying to keep a-hold of their share of the market. And what do you think came along as these two were competing head-to-head in the earlier part of this decade?”
“I dunno, Mort. Something to do with the housing bubble and subprime loans, I bet.”
“Right again.” Mort swallowed down the last sip of his coffee and signaled the waitress for a refill. “The mortgage guys and the Wall Street guys came up with this instrument called a CDO—collateralized debt obligations. What those were was bundled-up bunches of mortgages—some of ‘em good and some of ‘em those damn’ subprimes.”
“Uh-oh, trouble,” I said.
“Big trouble. What they were doing was rating those CDO’s based on the good loans in the package and ignoring the bad ones when they rated ‘em.” Mort frowned. “Credit analysts from both companies, some of ‘em with forty years experience, were jumpin’ like rats off a sinking ship. And some of the managers and executives, too. They’re out there saying, ‘Top management wants us to rate this garbage way too high. I ain’t gonna stand by and see this happen.’ So a bunch of ‘em quit or took early retirement if they didn’t wanta play along. So Moody’s was rating some junk too high, and then S&P was backin’ ‘em up—or vice-versa. Either way, one was lying and the other was swearing to it. It was like they broke a sacred trust.” Mort swallowed up the rest of his coffee.
“Holy smoke,” I said. “Those companies gotta have analysts, don’t they?”
“Well, sort of, Hank. There’s a new breed o’ cat out there called ‘quantitative analysts’ that build an analysis on computer models. Only they seemed to leave historical per-formance data out of their models. At least that’s what some old-timers said. Their models sorta made it look like nobody would get hurt too bad.”
The waitress looked at us like she was gonna start charging us rent for our table.
We left a dollar apiece on the table for a tip and walked to the cashier desk to pay our checks.
As we walked toward our cars, I said, “Well, thanks, Mort. Talking to you doesn’t make me feel any better, but it usually makes me feel smarter.”
Mort gave me a weak wave before he got into his car and drove off.
I met Mort again at the coffee shop Saturday afternoon. I got there first then Mort slunk in looking so morose I wondered why he came out of his house for coffee and a Danish.
“What’s the trouble, Mort?” I said.
“Ah, Hank, times are bad, really bad. I think times are even worse than I thought before. Did you ever hear the saying, ‘the first guy lies, then the second guy swears to it?’”
“Yeah, I can remember hearing that before—it was part of the vernacular when I was growing up in the Midwest. Especially useful when guys were telling tall tales. One guy would tell a ‘huge fish that got away story’, and another feller would say, ‘Yeah, ‘at’s right—I was there too and seen it with my own eyes.’ ‘Course, they were both lying!”
“Well, I was reading a piece in the Times today, and it just about sunk me down to the scuppers. It had to do with this current financial crisis. And it made me think of that old saying.” The waitress brought us our coffee and pastries.
“How so, Mort?” We both lifted our cups and took scalding swallows. Mort blinked and shook his head and I had to squinch my eyes.
“Okay, one of the liars in this story is Standard & Poors’ credit rating organization and the other is Moody’s credit rating branch. Here’s the deal. A few years ago, Moody’s got spun off from D&B—Dun and Bradstreet. Now Dun and Bradstreet has been reporting on businesses credit ratings for oh, I dunno, a couple hundred years. Still are, I reckon. But they wanted out of the securities and bond credit rating business. So they spun Moody’s off on their own. You with me so far?” He chewed a bite of Danish.
“Yep. Now Moody’s is out there on their own, trying to make a profit, right?”
“You got it, Hank. Well, Standard and Poors practically had a monopoly on bond rating forever. So Moody’s said, “We gotta get some of that business away from S&P. How can we do it?” What they decided to do, was relax their criteria that would make what you might call marginal stuff into triple A rated stuff. Then the clients what wanted to have a triple or double A rating on securities issues, or packages of various kinds of issues had an up-to-then reliable outfit stamping out triple A ratings—those clients came on over to Moody’s. Now here’s what—for a century or two, those outfits had almost a quasi-regulatory status among investors. If one a them said something was an AAA risk, it was like the Agriculture Department putting a ‘Choice’ stamp on a piece a beef. Or calling it Kosher. It was by God practically guaranteed to be a secure risk, barring a catastrophe.” He took a swallow of coffee.
“Okay, so then Moody’s started eating into Standard and Poors’ share of the market, huh?” I said and finished off the last bite of my Danish.
“Yep, that’s it. So do you wanna guess what S&P did then?”
“Let me try. They followed suit and relaxed their criteria, too—right?”
“On the nailhead, Hank. So now you’ve got these two old companies that’ve built a reputation over a century or two, each trying to keep a-hold of their share of the market. And what do you think came along as these two were competing head-to-head in the earlier part of this decade?”
“I dunno, Mort. Something to do with the housing bubble and subprime loans, I bet.”
“Right again.” Mort swallowed down the last sip of his coffee and signaled the waitress for a refill. “The mortgage guys and the Wall Street guys came up with this instrument called a CDO—collateralized debt obligations. What those were was bundled-up bunches of mortgages—some of ‘em good and some of ‘em those damn’ subprimes.”
“Uh-oh, trouble,” I said.
“Big trouble. What they were doing was rating those CDO’s based on the good loans in the package and ignoring the bad ones when they rated ‘em.” Mort frowned. “Credit analysts from both companies, some of ‘em with forty years experience, were jumpin’ like rats off a sinking ship. And some of the managers and executives, too. They’re out there saying, ‘Top management wants us to rate this garbage way too high. I ain’t gonna stand by and see this happen.’ So a bunch of ‘em quit or took early retirement if they didn’t wanta play along. So Moody’s was rating some junk too high, and then S&P was backin’ ‘em up—or vice-versa. Either way, one was lying and the other was swearing to it. It was like they broke a sacred trust.” Mort swallowed up the rest of his coffee.
“Holy smoke,” I said. “Those companies gotta have analysts, don’t they?”
“Well, sort of, Hank. There’s a new breed o’ cat out there called ‘quantitative analysts’ that build an analysis on computer models. Only they seemed to leave historical per-formance data out of their models. At least that’s what some old-timers said. Their models sorta made it look like nobody would get hurt too bad.”
The waitress looked at us like she was gonna start charging us rent for our table.
We left a dollar apiece on the table for a tip and walked to the cashier desk to pay our checks.
As we walked toward our cars, I said, “Well, thanks, Mort. Talking to you doesn’t make me feel any better, but it usually makes me feel smarter.”
Mort gave me a weak wave before he got into his car and drove off.
Wednesday, March 4, 2009
Mort & Hank Talk Economics #1
My friend Mort and I had coffee together Wednesday morning.
Mort said, "Hank, you know, about current events, here’s what I think it all comes down to—if somebody offers you a deal that’s too good to be true, then it probably isn’t true."
"What d’ya mean?"
"Okay, take a Ponzi scheme—you know what a Ponzi scheme is, right?"
"Refresh me, Mort."
"Well, I was watching the History Channel the other night and they did a piece on a guy name of Charles Ponzi. About a hundred years ago he had this idea where he got a bunch of people to invest with him by promising to pay a real high dividend, say 20% on a 30-day contract. Then he got more people to pay in, and he used their investments to pay off the earlier investors. Then he starts making deals like 50% return—but the period is a year, see? So when the earlier investors get back their original investment in 30-days along with the 20% interest, they naturally think it’s great deal. They go around telling the guys down at the billiard parlor and over at the coffee shop. They tell their slacker brother-in-law and the neighbors, and pretty soon, Charlie has more investors than he can keep track of. The money just comes a-rolling in."
"Wait a second, Mort. Are you telling me I coulda given old Charlie say, a thousand dollars and he’d pay me back twelve hundred in thirty days?"
"Egg-zackly, Hank. So these investors start spreading the word around, right? They tell all their friends, show’em the check, say, ‘Looky here—I found a way to make easy money.’ So the friend naturally says, ‘Wow, how can I get in on this deal?’ and he sells his pinkie ring and his wife’s fur and the kid’s sled and takes the cash to Charlie and says, ‘Hey Charlie, I got a cool grand here—can I get twelve hundred back in thirty days if I invest it with you?’ Charlie says, ‘Sure. Here’s your receipt."
"Don’t the people want to know what they’re investing in?"
"Sure, sometimes. So Charlie tells ‘em some fol-de-rol about ‘arbitraging international reply coupons for postage stamps’ or something, then takes their dough and uses it to pay off some earlier investors, and keeps a nice little chunk to fatten up his own position, too."
"That sounds . . uh . . dishonest, Mort."
"Well, a-course, it is. The thing is, if you’re one of the first hundred investors or so, you can get back some good money at first. But just like when you let your winnings ride at the crap table, maybe you decide to let that twelve hundred ride, and take it back to Charlie instead of thinking ‘I should be getttin’ out of the game,’ that’s gambling, right there."
"Ah! and then, you might lose the whole stake, huh?"
"Yep. That’s how it worked. ‘Course, the end result is that the originator of the plan has to skip town when he’s uncovered, or he ends up in the hoosegow."
"That’s a pretty nifty scheme, alright. Do folks still do that? Run a scheme like that?"
"Sure they do. Now they’ve got it down to a science, though. And nobody goes to jail, either—in fact they can even clear millions before the skullduggery gets found out and the scheme collapses."
"What? Who’s doin’ that?"
"Just look around, Hank. Those mortgage bankers, an’ Wall Street hot-shots that pack-aged up the ‘too good to be true’ subprime loans, the investors that bought ‘em—the whole lot of ‘em was just running a big Ponzi Scheme. But this time, the government was right there to bail ‘em out—and a lot of ‘em took millions with ‘em. Not many of ‘em gonna go to jail, either, I guaran-damn-tee you."
"Well, Mort—who’s gonna pay? Who’s gonna be the ones that lose in the end?"
"Hank—it’s you an’me an’ our grandkids—you an’ me an’ our kids’ grandkids."
I walked to the cashier and paid for our coffee. With his mouth turned down at the corners, Mort stared into his empty cup and slowly shook his head.
Mort said, "Hank, you know, about current events, here’s what I think it all comes down to—if somebody offers you a deal that’s too good to be true, then it probably isn’t true."
"What d’ya mean?"
"Okay, take a Ponzi scheme—you know what a Ponzi scheme is, right?"
"Refresh me, Mort."
"Well, I was watching the History Channel the other night and they did a piece on a guy name of Charles Ponzi. About a hundred years ago he had this idea where he got a bunch of people to invest with him by promising to pay a real high dividend, say 20% on a 30-day contract. Then he got more people to pay in, and he used their investments to pay off the earlier investors. Then he starts making deals like 50% return—but the period is a year, see? So when the earlier investors get back their original investment in 30-days along with the 20% interest, they naturally think it’s great deal. They go around telling the guys down at the billiard parlor and over at the coffee shop. They tell their slacker brother-in-law and the neighbors, and pretty soon, Charlie has more investors than he can keep track of. The money just comes a-rolling in."
"Wait a second, Mort. Are you telling me I coulda given old Charlie say, a thousand dollars and he’d pay me back twelve hundred in thirty days?"
"Egg-zackly, Hank. So these investors start spreading the word around, right? They tell all their friends, show’em the check, say, ‘Looky here—I found a way to make easy money.’ So the friend naturally says, ‘Wow, how can I get in on this deal?’ and he sells his pinkie ring and his wife’s fur and the kid’s sled and takes the cash to Charlie and says, ‘Hey Charlie, I got a cool grand here—can I get twelve hundred back in thirty days if I invest it with you?’ Charlie says, ‘Sure. Here’s your receipt."
"Don’t the people want to know what they’re investing in?"
"Sure, sometimes. So Charlie tells ‘em some fol-de-rol about ‘arbitraging international reply coupons for postage stamps’ or something, then takes their dough and uses it to pay off some earlier investors, and keeps a nice little chunk to fatten up his own position, too."
"That sounds . . uh . . dishonest, Mort."
"Well, a-course, it is. The thing is, if you’re one of the first hundred investors or so, you can get back some good money at first. But just like when you let your winnings ride at the crap table, maybe you decide to let that twelve hundred ride, and take it back to Charlie instead of thinking ‘I should be getttin’ out of the game,’ that’s gambling, right there."
"Ah! and then, you might lose the whole stake, huh?"
"Yep. That’s how it worked. ‘Course, the end result is that the originator of the plan has to skip town when he’s uncovered, or he ends up in the hoosegow."
"That’s a pretty nifty scheme, alright. Do folks still do that? Run a scheme like that?"
"Sure they do. Now they’ve got it down to a science, though. And nobody goes to jail, either—in fact they can even clear millions before the skullduggery gets found out and the scheme collapses."
"What? Who’s doin’ that?"
"Just look around, Hank. Those mortgage bankers, an’ Wall Street hot-shots that pack-aged up the ‘too good to be true’ subprime loans, the investors that bought ‘em—the whole lot of ‘em was just running a big Ponzi Scheme. But this time, the government was right there to bail ‘em out—and a lot of ‘em took millions with ‘em. Not many of ‘em gonna go to jail, either, I guaran-damn-tee you."
"Well, Mort—who’s gonna pay? Who’s gonna be the ones that lose in the end?"
"Hank—it’s you an’me an’ our grandkids—you an’ me an’ our kids’ grandkids."
I walked to the cashier and paid for our coffee. With his mouth turned down at the corners, Mort stared into his empty cup and slowly shook his head.
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