Archive for October 2008
Mortgage finance in pictures
This graphic is from TheDeal.com (via Paul Kedrosky). Note they give the notional to net ratio for CDS as $62 to $2 trillion, or 30 to 1. That ratio is a good proxy for the complexity of the network of contracts and how difficult it will be to disentangle.
Don’t blame the quants: Fannie edition
This article in the Times gives some details about the collapse of Fannie Mae. It’s pretty clear that the quants at Fannie knew they were undercharging for risky loans, and that senior management knowingly pushed the firm into dangerous territory.
Fannie’s business: repackaging mortgages into collateralized securities. But it operated under political pressure to help low-income buyers achieve home ownership and under financial pressure to compete with investment banks getting aggressively into the mortgage securitization business.
NYTimes: …When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.
…So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.
Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.
With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.
All this helped supercharge Fannie’s stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.
Take aggressive risks, or “get out of the company”:
…But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.
Even so, Fannie began buying huge numbers of riskier loans.
In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.”
In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.
Employees, however, say they got a different message.
“Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little,” said a former senior Fannie executive. “But our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”
I complained about Frankin Raines, who embroiled Fannie in a derivatives accounting scandal, back in 2004-5.
Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.
Dinner with the Econ
Late this afternoon (Friday), the picture below appeared on my Google Reader screen with the caption Six kinds of recycling at the University of Oregon,
compliments of the feed from Brad DeLong’s blog. I immediately thought, is Brad DeLong (with iPhone camera) on campus? and checked the seminar page in the economics department. Yes, he was scheduled for a 3:30 pm seminar, with Economist’s View blogger Mark Thoma as host!
Given current events, I thought this would have to be an especially interesting talk, so I walked across campus for the chance to be a fly on the wall during a meeting of the Econ tribe. I was treated to a wonderful 90 minute talk which started from the general question of whether central banks should fight asset bubbles, but soon dove into the intricate details of the credit crisis. Mark recognized me and was kind enough to invite me to dinner, along with the speaker and professors Tim Duy and Nick Magud. It was quite an interesting discussion as we had among us a former member of Treasury (Brad), of the Fed (Tim) and an expert on Latin American financial crises (Nick). At one point Brad asked me about spontaneous symmetry breaking and the Higgs. I noted that physics is much easier than figuring out how Treasury is going to handle the bailout!
Quant trivia: at one point in the talk Brad mentions all the physicists modeling mortgage backed securities. The economists laugh, but Brad protests that his Harvard roommate Paul Mende (who did a string theory PhD under David Gross at Princeton) is now working for a hedge fund modeling volatility!
Buffet on the credit crisis
Skeptics will claim he is talking his own book, with the recent GS and GE investments. But I agree with most of it. Buffet says that if he could take a 1 percent stake in the bailout (investing $7 billion), he would. He thinks the bailout will make money investing in distressed mortgage securities at current market prices.
“I love to buy distressed assets… I just don’t have $700B to do it with.” (At about 13-14 minutes into the hour long interview.)
Bubble logic: “Innovators, Imitators and then the Idiots” (20 minutes)
“Confidence in markets and institutions is like oxygen… when you have it you don’t think about it… but you can’t go 5 minutes without it.” (24 minutes)
“Beware of geeks bearing formulas!” (takes a shot at quants at 27 minutes)
Upper income people should pay more taxes (basically endorses Obama’s tax plan) (42 minutes)
“It is terrible that income from investments (capital gains) should be taxed less than income from labor.” (against regressive taxes) (44 minutes)
“If AIG had to unwind their derivatives book, it would have hit every institution in the world.” (50 minutes)
“The Fed structured the AIG deal very well. They are very likely to get their money back or more.” (51 minutes)
Are you a Biller or a Player?
Excellent article by Arnold Kling and Nick Schulz. “Winner take most” markets, the upper-upper and upper-lower income gaps, and more.
Inequality and the Sergey Brin effect
…A final trend that promotes income inequality is that more Americans may be engaging in a kind of gambling behavior in their choice of occupation. They are increasingly choosing to play in winners-take-most tournaments, such as the contest to build the leading Internet search engine. For every Sergey Brin, there were thousands of software engineers who played in the search-engine contest and lost.
As best-selling writer and investor Nassim Nicholas Taleb points out in The Black Swan, safe occupations are those where the worker is paid a fixed amount per unit of time. An accountant or a nurse is not going to become extremely rich or extremely poor; they could be called “billers,” because they bill for their time. On the other hand, a professional singer or a software entrepreneur is playing in a winners-take-most tournament. The difference in talent between an international pop star and an unknown lounge singer may actually be quite small. However, the nature of these fields is that the difference in rewards can be enormous. People who choose these sorts of occupations could be called “players.”
Sign problem in QCD
The revised version of our paper 0808.2987 is up on arXiv now. Special thanks to Kim Splittorff, Mark Alford, Bob Sugar, Phillippe de Forcrand and many others for comments. See earlier discussion.
On the sign problem in dense QCD
http://arXiv.org/abs/0808.2987
S. Hsu and D. Reeb
We investigate the Euclidean path integral formulation of QCD at finite baryon density. We show that the partition function Z can be written as the difference between two sums Z+ and Z-, each of which defines a partition function with positive weights. If the ratio Z-/Z+ is nonzero in the infinite volume limit the sign problem is said to be severe. This occurs only if, and generically always if, the associated free energy densities F+ and F- are equal in this limit. In an earlier version of this paper we conjectured that F- is bigger than F+ in some regions of the QCD phase diagram, leading to domination by Z+. However, we present evidence here that the sign problem may be severe at almost all points in the phase diagram, except in special cases like exactly zero chemical potential (ordinary QCD), which requires a particular order of limits, or at exactly zero temperature and small chemical potential. Finally, we describe a Monte Carlo technique to simulate finite-density QCD in regions where Z-/Z+ is small.
Simple question, complex answer
A former physicist (but non-financier) writes:
I have a question, and who better to ask than you. …something isn’t adding up.
I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn’t this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.
Is this reasoning correct? If so, I don’t understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.
Your calculations are reasonably correct (see comments for more detail). So why the crisis?
1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It’s like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor…
2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed — no muni bond issuance, no short term loans to businesses, no car loans, etc.
The efficient functioning of our economy is built on trust — I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.
We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.
Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing — our most valuable asset.)
Meltdown links
1) Leonard Lopate interview with Economist editor Greg Ip, formerly of the WSJ. (Scroll down the page to Financial Crisis: What Happens Next?). This is the best 12 minute summary of the current situation I have yet heard. Ip is consistently good at explaining this complicated subject in an accessible manner. If you have a friend who is confused about the credit crisis, have them listen to this interview. (Avoid Terri Gross and pals on this one… 😉
I have been listening to Leonard Lopate’s show for some time and I can tell his grasp of finance has increased dramatically in the last year or so (his strength is interviewing artists, writers, etc.). It’s yet another example of high-g at work. He knew almost nothing a year ago but now asks occasional perceptive questions. (But of course it doesn’t matter how smart our next President is!)
2) Mark Thoma discusses the pros and cons of mark to market accounting. To me it’s rather obvious that M2M accounting is exacerbating this crisis. It has introduced a very significant nonlinearity, both on the upside (bubble), and now in the collapse. If the market for mortgage assets has failed it is crazy to use it as a barometer for value. More discussion at WSJ.
3) This NYTimes Op-Ed written by a former theoretical physicist discusses agent-based simulation, behavioral economics and phase transitions — yes, in an Op-Ed! (Thanks again to reader STS for the pointer.)
Trends in social science
More interesting graphs from GNXP, based on searches of JSTOR in the following journal categories: anthropology, economics, education, political science, psychology and sociology. Progress!
Information Processing 