Friday, December 07, 2007

Zero sum game

The Washington Post has a good writup of the housing market meltdown.

Basically the problem occurred because high risk bonds were being traded as AAA grade investments.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

The problem with these models is that as any outside observer could tell there is a conservation of risk. No matter how the risk is sliced and diced the number of borrowers who default on their mortgage from a given pool will be exactly the same. If the tranching process was honest it should have identified equal amounts of high and low grade paper, or at least equal amounts of risk. But an honest process would not be half as profitable as selling the high grade paper as AAA and the remainder at its original mezzanine rating.

In other word the scheme is like buying up packets of baseball cards in bulk, picking out the small number of valuable, highly collectable cards and then selling on the remainder at the original purchase price.

Baseball card collectors know this which is why opened packets of cards change hands at a lower price than sealed packs. The chance of finding a Mickey Mantle rookie card in an open pack is approximately zero. But this law does not apply to sophisticated mortgage traders since the high grade paper identified by one analysts model differs from the next. The mezzanine paper is by definition paper that is compromised in some way but not to the extent that a full default is likely.

So after one analyst sifts the packet of sub prime mortgages and selects their favorites it is passed to the next who extracts their favorites and so on. The only time a mortgage is ever removed from the mezzanine pool is when it is close to or actually in default. Each analyst is rewarded according to the amount of money they make which in turn depends on the amount of mezzanine risk that they can rebrand as AAA. Suddenly almost everything appears to be a favorite. Mortgages churn round the mezzanine pool until they emerge as either AAA or go into default.

Lender's don't need to care about the quality of the risks they acquire. In fact a high risk loan is more profitable since it will eventually sell as low risk and a bank somewhere will profit the difference.

The net result of this behavior is that for the past ten years or so the cost of sub-prime borrowing has been artificially low which has in turn allowed property prices to inflate. Now that the bubble has burst the ratings of the mezzanine trances has plummeted from AAA to junk overnight.

The property market is bust but liquidation will take quite a while yet. Most people will try as hard as they can to avoid default and the loss of their home. But there are plenty of people out there who are way over-leveraged that are going to go under. Its not just the people who took on a mortgage they could not possibly afford, its the property speculators and the over-leveraged landlords who are going to be in trouble.

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