

The US sub-prime crisis in graphics - vikram
http://news.bbc.co.uk/1/hi/business/7073131.stm

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indie01
Quote from the article: "The business proved extremely profitable for the
banks, which earned a fee for each mortgage they sold on. They urged mortgage
brokers to sell more and more of these mortgages."

This is a very interesting topic, one I've thought about a lot. In attempting
to understand the cause, I've forumulated some hypotheses about how and why
the sub-prime 'crisis' came to be.

But first some background. After earning my Master's ('04), I was having a
very difficult time finding employment. I thought what any lifetime academic
tends to think -- maybe more education will help?

So I enrolled in and aced just over 3/4 of this "ProSchool" course for Real
Estate Brokerage. In it, I learned all about how Realtors and their mortgage
broker cronies operate. Suffice it to say that I also came to discover that my
personal ethics possess integrity > the ethics of most people in the real
estate industry, which is why I decided to not pursue that path.

Sub-prime mortgages are to the real estate industry what lemons are to the
auto industry. And while there are laws protecting people from rapacious
salespersons in the automobile industry, there aren't really any such
protections for homebuyers. It's probably important to note that I don't
really consider "mounds of paperwork" a means of protection, especially when
buyers don't understand what they're getting into for the long-term; it
doesn't matter how many pieces of paper they're told to sign -- those pieces
of paper are usually protecting the interests of real estate and broker-
finance persons.

The root cause, the motivations of realtors, brokers and car salespersons are
the same: commissions and fees earned, amounts directly proportional to amount
exploited from customer. Think about it like. . . commissions and fees are
beneficial to people 'from the top down' in a type of order-of-operations'
that's similar to the mathematical order-of-operations. Who gets paid and
when, according to this model:

1\. Financial Institutions (banks control real estate brokers; as the article
states, banks pay themselves first); 2\. Brokers (brokers control agents;
brokers pay themselves first and then pay agents); 3\. Agents (agents or
specifically real-estate agents conspire among themselves to artificially
inflate housing and property values. There's no such thing as a real estate
agent who rents!) [P.S. I think they are evil root cause of insane rents as
well]; 4\. Property Managers or Landlords (both can be controlled by agents,
managers pay themselves first, by rules have no qualms about repossession or
eviction).

Obviously, the entities in the list all get paid their fees or commissions
immediately, or at least within a couple of months of the occurance of a sale
or the sub-prime mortgage. Or even a regular mortgage.

Fast-forward to the time of the ARM-adjustment, and the mortgagee can't pay
the significant increase. Poor dumb customers? Not always. . . isn't it job of
the fee/commission earning realtor or broker or finance person to explain
exactly to the customer what he or she is potentially getting into? Yes, but
often these people gloss over the details. This is why I think the lemon
analogy makes a lot of sense. Who in their right mind would pay full-price for
a vehicle they _know_ is going to be inoperable within a year or two?

I think what this essentially boils down to is people in the banking and real
estate industries transferring their risk to the people least able to handle
it and then not being legally accountable for their ethics.

~~~
mynameishere
_Who in their right mind would pay full-price for a vehicle they know is going
to be inoperable within a year or two?_

Someone who thinks that they can sell it to a bigger sucker in less than a
year or two?

...

Someone's holding the bag on these mortgages, and it isn't the home"owner"
usually, who probably went from zero to zero, or from bankruptcy to
bankruptcy. Investors who believed the credit agencies are the ones who had
something to lose. Bad bets happen all the time in the marketplace.

~~~
timr
If I may over-generalize, yours is the "city" opinion, and the OP is the
"rural" opinion. There were a lot more risky loans made for cynical profit in
the cities, but in rural areas, you tend to hear more sad stories about
destitute grandmothers and orphans.

I feel badly for the working people who are going to be ruined by the sub-
prime crash. Yes, they should have known better than to take such stupid
loans, but the OP's analogy to a used-car salesman is a good one: if it
weren't for consumer protection laws, there would be a lot more people who get
screwed by unethical car scams. The real-estate "industry" needs more consumer
protection laws.

That said, I'm severely annoyed that the smug, get-rich-quick mentality that
has been promoted by agents and "investors" in the cities might be rewarded
with a government bailout. For the last three years, I've watched people in
Seattle (among other places), go _insane_ with speculative greed. I've been
told that real-estate never declines in value, that renters are of a lower
caste, and that anyone who didn't buy into the bubble would be priced out of
the market forever (a statement which is transparently mathematically
ridiculous).

The number of "talking haircuts" driving around in leased Mercedes and BMWs
has skyrocketed; the _perception_ of wealth is at an all-time high. Meanwhile,
landlords are evicting low-income tenants from apartments (to capitalize on
the bubble with sketchy condo conversions), raising rents, and using market
forces to otherwise screw people who can't stomach the idea of paying 3-4
times as much to "own" a property as to rent one. As far as I'm concerned, our
society will be better off if this latter class of people go bankrupt -- if
not to jail.

But I still feel for the grandmothers and orphans.

~~~
nkohari
There are laws against predatory lending which are intended to protect
consumers from lenders trying to take advantage of them. Obviously, they
aren't good enough. In my opinion, the real problem is that lenders should
never be able to profit if the consumer defaults on the loan. Without the
mortgage brokers and hedge funds on the back-end buying the debt from the
banks, the banks would be much less likely to issue bad loans, because they
would end up getting royally shafted if the purchaser defaulted and they still
"owned" the debt.

~~~
timr
On my personal wish-list of reforms is an incredibly high (say, 90%) tax on
short-term capital gains for real estate investments.

The whole justification for the mortgage interest write-off (which is
otherwise just a gigantic government handout to property owners), is that it
promotes home ownership, the family unit, etc. The problem is, there's no
equivalent dis-incentive for short-term speculation on property, and what was
_intended_ to be an incentive for family home ownership actually helped to
fuel the ponzi scheme that is effectively driving families out of their homes
today.

If short-term gains on home sales were taxed at very high rates, it would
basically be impossible for "investors" to flip homes for short-term profits.
A huge incentive for speculative price increases in the housing market would
be eliminated.

(Plus, no more stupid TV shows about house flipping. It's win-win!)

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DaniFong
This post is derived from a similar post I made on TopCoder.

There's a simple model of stock pricing that's even cleaner than price
earnings ratios. Adjusted for risk and inflation, stocks are priced, in an
efficient market, based on the estimation of all future profits.

This is actually a terrific mental model for long term trading, and holding
companies such as Berkshire-Hathaway use similar models.

However if all you are trading are shares of real companies proving regular
goods or services, then trading in the short term implies that you're making a
bet regarding the first derivative of its market price.

In recent years there is a lot of trading in what are called derivatives. The
prices of the derivatives themselves estimate value at some future date, and
short term funding of _these_ is then dependent on the second derivatives of
equities.

The system blows up and becomes non-linear very quickly: in particular many of
the nice properties that are derived from the efficient market hypothesis
become less and less valid, and short term gains become quite accessible.

Additionally, the managers of big money funds (venture capital, private
equity, hedge funds) have asymmetric incentives: that is, given a choice
between an investing making 30% on average with a 1% SD, or an investment
making 28% with a 10% SD, they'll take the latter. Why? Performance fees are
structured so that fund managers receive some percentage of the profits each
year (around 20% - 50%, in some cases), while they do not have to pay any of
their own money on a downswing (indeed, they would still incur a management
fee on the original principal!).

As a result, short-term traders, as represented by say, hedge funds, do not
trade towards new future income, and do not, in many cases, such as in
financial bubbles and credit crunches, move the market any closer towards the
efficient model commonly described and referenced to, in both finance and
academia. The following article here documents a slice of these phenomena in
time:
[http://www.princeton.edu/~markus/research/papers/hedgefunds_...](http://www.princeton.edu/~markus/research/papers/hedgefunds_bubble.htm)

In particular, the housing bubble and subsequent credit crunch was largely
aided by the new lending model the banks had devised. In previous years, the
banks would lend their own money to home owners, and as a result were less
likely to take risks funding mortgages that might not be paid-off, for
property at unusual values.

In the new model (as described in the topic post), banks would appraise the
property and, in a sense, broker a deal through a mortgage bond market. Like
brokers there are incentives to 'churn' deals - to move more volume to grab
fees. Now the mortgage bond market itself was open to public investment to the
stock market, and quickly swelled due to short term investments.

Hedge funds, largely computerized, would notice a high-growth, high-beta
(volatility uncorrelated with the existing portfolio) stock and feed into the
bond market, yielding billions in performance fees for the industry (the first
movers were particularly satisfied).

Unfortunately, mortgage bond markets are very unlike normal public companies,
where at least there's quarterly financial reporting, and many other windows
into operations as well. The risk depends, in aggregate, on the risk of
funding all these individual home owners. It turns out that the banks had done
a poor job vetting home owners, because many started, well, not paying.
Additionally, since the housing prices, exposed inadvertently to the public
market's fickle derivative pricing schemes, had hit a peak and started to turn
downwards, many people were left with _negative_ equity on their homes. Human
nature being what it is, many refused to pay mortgage on negative equity,
which rapidly accelerated the spiral.

The hedge funds, rather quickly, pulled out of the mortgage bond market, and
then most of the mortgage bonds went bankrupt.

Some might blame human nature, or say it was just a strange market
inefficiency, but it was bound to happen really. The consequences of
investment were not aligned to the risks, and short term investors could make
a fortune without improving the economy as a whole.

I think this summarizes my picture of corporations as well. When they
represent small groups, risks are quite commensurate with effort and rewards.
As they get larger, many corporations more resemble the structure of fascist
governments, rather than free markets, internally, and the decisions are often
not made to maximize the welfare of the corporation, nor the economy as a
whole, but rather the comfort of the individuals within the system's
constraints. At the turn of the century, that meant Enron's and WorldCom's
shenanigans, this summer, it meant hedge fund managers selling short on the
mortgage bond market after pumping them up, and sometime later, it's going to
mean people being individually greedy on the circus that is the financial
markets.

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davidw
This is somewhat relevant, although this article/discussion borders on things
perhaps best left to other sites:

[http://www.marginalrevolution.com/marginalrevolution/2007/12...](http://www.marginalrevolution.com/marginalrevolution/2007/12/the-
scope-of-mo.html)

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vikram
I'm wondering if the problems happened because of some sort of economic
downturn, or lack of available credit. I thought most of the time people just
re mortgaged after the 2-3 year fixed deal.

------
jonathon
Any chance this was caused by the Fed raising rates too quickly and killing
the housing market? That's a theory I've heard, but personally disagree with.

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mrtron
How do you see this impacting technologies, and what opportunities does this
present?

Very interesting way of demonstrating the issue.

~~~
cellis
Well, if you are Goldman Sachs, you find a way to short CDOs, profiting
~4Billion or so.

~~~
mrtron
I am Mr. Sachs...so I get a real kick out of this reply...

I meant more from a hacker standpoint. A downfall in the economy is apparently
a good time to startup as a previous article showed.

Any way to effectively short against this housing trend with some technology?
The upcoming increase in housing supply could mean some sort of algorithmic
housing search could be very useful. Any other ideas?

~~~
Xichekolas
Crisis or no, a decent housing search would be a goldmine. The problem is
doing it with Realtors stranglehold on the MLS database.

MLS is like Google... if a house isn't listed on MLS, it might as well not
exist.

~~~
indie01
Indeed.

[http://www.usdoj.gov/atr/public/press_releases/2005/211008.h...](http://www.usdoj.gov/atr/public/press_releases/2005/211008.htm)

From the first page of the DOJ complaint:

"The Department of Justice's Antitrust Division today filed a lawsuit against
the National Association of Realtors (NAR), challenging a policy that
obstructs real estate brokers who use innovative Internet-based tools to offer
better services and lower costs to consumers. The Department said that NAR's
policy prevents consumers from receiving the full benefits of competition and
threatens to lock in outmoded business models and discourage discounting."

Isn't it interesting to note that in this instance, it does not specify
whether the 'consumers' of the broker are considered agents or the actual
homebuyers themselves? Most brokers don't deal with the little people (the
little people being the homebuyers themselves) . . . they run shops which
employ agents who compete with each other (e.g. artificially inflating
property valuations).

In this wikipedia article on the MLS
(<http://en.wikipedia.org/wiki/Multiple_Listing_Service>):

''A person selling his/her own property - acting as a For Sale By Owner (or
FSBO) - cannot put a listing for the home directly into the MLS. ''

So. . . a decent housing search tool aimed at people who want to sell FSBO to
people who are not agents themselves and who don't have buyers' agents would
probably go over quite well.

The main challenge here would still be that evil Realtor stranglehold . . .
keeping the agents away from the FSBOs.

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edw519
Why is it that no matter whose "fault" it was, the taxpayer is the one who
ends up penalized?

~~~
eru
Hard working lobbies?

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downer
I thought this was going to be about Intel on-board graphics chipsets
displacing expensive enthusiast add-in cards from Nvidia.

