This morning I listened to Dan Carlin's latest podcast. In the first part, he didn't have much to say and repeated himself a number of times, dragging out the point. Fortunately it was a good point. In the second part, he lost his mind, but I won't go into the second part, rather elaborate on the first. A lot of people have been mouthing off that GREED is the reason why Wall Street is having a hard slog of it these days. A lot of people are wrong.
To use Carlin's apt analogy - saying that people who run business want to make money is like saying that people in sports like to play games. Duh. That's the point. Pitchers pitch, batters bat. Salesmen sell, investors invest. The point is not that pitchers want to pitch faster or batters want to bat further, nor is it the point that sellers want to sell even more at higher prices and buyers in the marketplace want to buy even more at lower prices. The problem is when people change the rules of the game and have no real idea where it will get them. What we are seeing in the financial securities market is not the exposure of greed, nor something fundamentally wrong with capitalism or the 'absence of pure capitalism'. We are seeing what happens when the players exceed the limits of the old rules.
I don't know how many times, in pro football, the rules for pass interference have been changed, but I would think that it has been at least four times in my lifetime. At one time you couldn't touch the reciever when he's catching the ball. Now you can have one hand on him. At one time you couldn't block the reciever off the line of scrimmage. Now you can hit him once. The rules have changed because of what we have seen with extraordinary recievers and defenders. If following these rules one day results in a touchdown the might have won the SuperBowl getting called back and destroys the credibility of the referees, it would be stupid to say that the reason the game is losing confidence of the fans is because football is just too violent, that would be ridiculous. Violence is part of the game, and it is an agreed-upon level of violence with rules and supervision that makes everybody happy and professional about it. The same thing is the case with markets.
Not long ago, Wall Street changed a rule on the ability for traders to engage in a transaction called 'naked shorts'. It was something that the heads on CNBC talked about for a couple days and then it went away. The market makers and regulators are always changing rules to adjust to reality. It makes a real difference to people who play the game, and there are never any shortage of opinions. Mark Cuban, for example had this to say:
This is not a loan that has no value to you, the shareholder. You are PAID for loaning the stock. In fact, for some stocks, you are paid quite a bit. So if you own a share a stock and you take money for it being loaned out, then you have to deal with the consequence that the person who borrowed your share may vote the share. In fact, your shares may not only be loaned to someone trying to short the stock, it may be loaned out to someone who only wants toVOTE THE STOCK.
You get paid for loaning the stock. Its your job to know what rights you have to the share of stock that has been loaned out. It is your job to discuss with your broker whether or not you want your shares loaned out. If you get paid to loan the share, and its voted in a way that goes against your interests, you can scream all you want, but you prostituted your rights. You is a corporate ho.
Now what's all this business of stock loans? I have no idea. Never done it, but somewhere there are rules governing the short sale of stocks and what market makers can do loaning and trading short options and all that complexity. The point is that there are incentives to do just about any and everything with every kind of money: stock, debit, credit, loan, asset, bond, option, strip, coupon, reit, trust, fund, debenture, commodity, adr you can imagine. You can buy them, sell them, trade them, insure them, gift them, hide them, bundle them, unbundle them, hedge against their rise, their fall, their liquidity. You can place time limits on them, or remove them. And people are probably inventing new things to do with new kinds of financial instruments every damned day, like sports coaches and players are always thinking of new ways to improve their game. All within complex sets of rules that the pros and dedicated fans know something about. How do you or I know if it's cricket? Sometimes you just have to be a player to know or even have a clue.
Now I agree with Carlin, that somebody was incented to DO MORE. Well duh. Obviously there were incentives to make more people homeowners. There were obviously incentives to keep intrest rates low. Seems like an obvious combination for financial organizations to make more home loans. Was it right to emphasize this segment of the market? Of all the things that are interesting to do in the financial world, why issue more risky loans and then try to secure it with credit swaps? Why bundle loans sideways instead of longitudinally? Because that's what the people want!
Let's talk a moment about bundling sideways. I heard this on the radio yesterday and it's something I never even thought about, I'm not even sure what the technical term is called or how often its done, but it's a very cool idea.
Lets say that you are a bank, Bank of Cobbler, and you own 100 million dollars of 30 year home loans whose total value at maturity is about 105 million. Roughly 5% is the value of that bundle 30 years out. That's a mere 300 loans with an average value of 350,000 at maturity. Roughly speaking, you get 289k of debt service every month. You with me so far? Simple math, divide 105M/360. Now let's say that looking at the actual history of cashflows over the past 36 months, you are getting an average of 285k allowing for late payments, a small default rate, overhead and being conservative. Suddenly, you need to get a million bucks, like now. So you can take your loan portfolio of that 100M and then sell the next four months of loan payments to a third party. But you make a deal based on a less conservative figure. You need a million and you should be getting 289K so you bump up your loan amount to 1.1M. Your actual collections should be anywhere between 1.140 and 1.56M for those four months, so you figure you can handle the interbank loan rate of 3%. So now you have securitized off some portion of your loan portfolio - the next four months, for 1.1 million in cash. All you have to do is collect on those 300 mortgage payments and pay $33,000 in interest.
Obviously things are a little more complicated than this because you have to make determinations on which parts of these payments are interest and which are principal and rejigger your asset base vs your cash base and treat those monies with the appropriate wisdom. But you can see how easy it is to turn this tiny fragment of you loan portfolio into cash. It seems like a relatively safe bet. The problem now becomes, what exactly are your liabilities if Joe Mortgagepayer doesn't pay two of those three months, and how do you hedge that in your language on the interbank loan? There are probably some interesting rules for that, and obviously investment bankers like Morgan Stanley and Goldman Sachs had more legal leeway than your average mortgage banker or commercial bank. I mean your average Wall Street trader does 100 million dollar deals in their sleep. What's interest on 1.1M for one quarter? Hell, they could pay that out of their pockets. Now you can imagine all the kinds of side bets that could be made with that 1.1M in cash.
The deal was that Fannie and Freddie were quasi-government guaranteed, so that a third party - say Bank of Bowen would have no problem loaning that 1.1M at 3%. Why? Because there was essentially a guarantee that the loans behind this is good money. Now I don't care what Bank of Cobbler does with that 1.1M, so long as I get my 1.133.
Anyway, I haven't come up with a way to show how that 1.1M loan leverages a way bigger amount, but it may have something to do with the way the original bundle was classified at the Bank of Cobbler. That is to say if Joe Mortgagepayer and two more of the 300 in that pile miss one payment, then Cobbler has to declare it somehow to Bowen. Let's say that during those months, that pile had to be re-graded as AA instead of AAA. Then I wouldn't have given Cobbler a 3% rate but probably 4.5%. And then I would have used the difference to buy an insurance premium. Now my insurer is on the hook for this chopped up pile of mortgage pieces in which I have an interest, and Cobbler has an interest and Fannie Mae has an interest and Joe Mortgagepayer has an interest. If I don't get my 1.133, then my insurer has to pay me, Cobbler may call Joe on his loan so he can repackage a new pile at AAA, but now I don't trust Cobbler's porfolios, and my insurer is really in the tank for the little policy premium I took against 1.133...
In all of this failure, all the players are playing by rules we may not understand because we don't get into these transactions, but they are the rules that are necessary to keep all the players interested in the game. I use the term market makers clearly here because the market is not a natural phenomenon, any more than football is a natural phenonmenon, but playing the game becomes a natural part of our culture because it is based upon innate human traits - you can call them Greed and Violence, but it's much more than that.