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Banks are getting back into the business of building mortgage bonds (wsj.com)
110 points by megacorp 28 days ago | hide | past | web | favorite | 104 comments



These bonds are fine if they're rated properly. On the other hand, if your rating system is not functioning properly (as was true in 2008) then any product that needs rating is suspect, only investments whose provenance you can directly investigate yourself are safe in that case.

Maybe we can blind the rating system? If Standard & Poor can't tell whether this instrument they're rating was created by HSBC or me in my basement, they may take a few seconds more to consider whether the scent of shit is because it is in fact just shit in a thin paper shell.

And if you blind them but they still don't give true ratings you can trivially exploit that to fill the market with highly rated shit, destroying the market but leaving the real economy largely untouched. Rinse and repeat until all the dumb money is sucked into your pocket.


The rating system has been materially modified since 2008 to reduce the risk. In 2008, the designated rating companies (NRSROs) had explicit legal immunity for the correctness of their ratings, which incentivized them to sell their ability to produce ratings that optimize for goals other than correct representation of risk. And they did.

The Dodd-Frank bill passed in 2010 removed this immunity, making them liable for bad faith ratings that did not represent the real risk. As some people may recall, this created a temporary problem in the market as many debt instruments were suddenly re-rated to eliminate this legal liability. This is also related to the downgrade of US Treasury debt from AAA status in 2011.


I'm doubtful that a liability for "bad faith ratings" is enough to get the job done.

Remember Arthur Anderson. They're gone, but the US Supreme Court concluded that they weren't guilty! They make O J Simpson look like the picture of innocence, and yet somehow the Supreme Court felt the need to grant certiorari and then decide actually people who do crimes aren't necessarily guilty of those crimes if they're rich old white men...


But by that time Arthur Andersen had gone from 24,000 employees to about 200. It was utterly wiped out.

I don't think that's enough, David Duncan in particular should have gone to jail, but it's not as if there were no consequences and to be fair to the US government they went after AA hard.



Hilarious, one of the foxes (a partner at Arthur Anderson) writes an article explaining that those chickens actually wanted to be eaten really and anyway how can it be his fault when any responsible farmer would use stronger locks to keep him out. I particularly enjoyed:

> They were indicted for shredding documents. These documents were drafts and other items that do not support the final product. All accounting firms establish policies for routinely shredding such documents.

See - all routine. Sure, your routine might not include being "reminded" to arrange for piles of documents to be urgently shredded once you hear investigators are coming but that's why you might some day be found guilty of crimes, whereas Arthur Anderson were "not guilty" after all the evidence was destroyed and their chums in the US Supreme Court reached in and overturned verdicts against them for destroying the evidence.

Now, one of the nice things in overseeing the Web PKI is that I don't care whether the auditors are incompetent or crooked, it's the same either way to me. I don't expect even their own bosses to do as much as slap them on the wrist for enabling fraud. If I'm relying on audit then I know I might as well toss a coin, I'm always going to be digging deeper than that to understand what was actually going on regardless of whether the auditors "forgot" or deliberately chose not to look.


Does removing legal immunity mean anything to these people? Is there really going to be any reckoning this next time around? C-suite people never go to prison. If the company gets dinged, they just declare bankruptcy and reform under a new name, or some such maneuver where they keep operating.


This is civil liability, and it does have real practical teeth that changes behavior.

Previously, if they rated junk debt as AAA, and you bought that debt based on that rating, you would have no recourse for their misrepresentation of risk as they were granted immunity from such things. To make matters worse, for some regulatory purposes companies were required to buy instruments rated by these organizations and take these ratings at face value.

With the change in law, if someone sells me junk debt rated as AAA by one of these NRSROs, I can now sue the NRSRO in court for damages for misrepresenting risk. For any particular rating, there are thousands of companies, often with deep pockets, who have standing to recover losses from the rating companies for misrepresentation of risk. Even if they avoid criminal liability, there is the very real prospect that the civil liability would destroy them.


Where is the responsibility of the investor? AAA ratings are not endorsements. The ratings (and rating agencies) exist to constrain the behavior of the buy side. Pension funds, insurance companies etc. are limited by laws and covenants to limit their exposure to non-investment grade securities.

The models the rating agencies were using were not secret. They defined to a great extent what was allowed to go into a pool, and how much support and credit enhancement would be necessary for the senior tranche to get a AAA rating. So as a pension fund manager, if I see to pieces of AAA paper of similar maturity trading at radically different yields, I have to consider am I getting a deal, or does the smart money know something about one of these deals? And honestly if I just buy in bulk, relying on the rating alone without due diligence on the deals, shouldn't I bear some responsibility?

Beyond that, it's not clear that you could prove civil liability. The ratings were based on models, and the models were based on historical experience (and some wishful thinking.) But when push comes to shove in the context of billion dollar lawsuits, you can imagine they'll tease the wishful thinking out of the models and show that their rating models, though flawed, were based on a reasonable interpretation of historical experience and that ratings are not an endorsement or a guarantee of suitability.

As someone who witnessed the crisis up close, the ultimate cause of the crisis was a bunch of ordinary people, both on Main street and on Wall Street, making good faith decisions that seemed rational at the time, but in retrospect proved to be idiotic.


What's stopping them from claiming misfeasance or just 'unknown unknowns' in the face of malfeasance? Absent smoking gun emails where they laugh at how stupid their clients are for buying the crap, how do you demonstrate this to a jury in a civil case?


Do we know if the legal immunity of the NRSROs has been restored? Trump's administration has already rolled back parts of Dodd Frank.

https://www.cnbc.com/2018/05/24/trump-signs-bank-bill-rollin...


You are correct that the ratings system is fundamental to the breakdown of these systems. I don't believe we really fixed those corruption issues. I'm looking forward to seeing some analysts of the ratings from independents vs S&P etc.

We also cannot downplay the significance of speculation systems themselves. There needs to be more burdens put on such financial mechanisms to prevent them from getting out of hand like in 2008.


The problem is that investors do not want to pay for independant research, particularly a rating where it would require the agency to do a lot of due dilligence on a transaction rather than simply rely on audited financial statements as they usually do for a regular company.


well if they paid more, it could take out any profitability from a product where real returns after fees are already very low


Agree. Which is why the issuer is currently paying for it. But with the obvious potential conflict of interest.

Plus these are securities, and all market participants should have access to the same public information. It is a problem to have half the investors in the dark about the transaction if they couldn't pay for a private rating (which in turn would negatively affect pricing).


Corruption is one issue, but as I understand it there are also technical issues. The synthesis of derivative investments like collateralized debt obligations involves modelling the probabilities of default. If the models are wrong, such as assuming probabilistic events are not correlated (e.g. that mortgage default is a microeconomic phenomenon of individual hardship, rather than macroeconomic recession), then the ratings will not be sensible. Robust ratings require economic science to be robust.


Some would say, were ratings agencies not corrupt, financial instruments that could not be accurately rated would not be rated.


Indeed. It's possible to do good faith work and simply be wrong.


It's difficult to accurately predict something that has never happened. Prime ARM delinquencies shot up to 10% in 2008 and eventually to nearly 20%. Subprime ARMs shot up to over 40% at their peak. Prior to that subprime ARMS delinquencies peaked at just over 10% at their worse.

The borrowers were different so there was really no precedent, but just a cursory review of historical data would make what we experienced highly unlikely.

[0] https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#/medi...


well, it's difficult to predict on the one hand.

on the other hand, it is easy to predict that: when the average joe holds "home ownership" up as the sterling example of "making it"; then the average politician will determine that the best way to make voters happy is to increase home ownership by lowering barriers, and exempting home ownership from risk, taxes, estates, bankruptcy, medical expenses, etc. all in the name of "obvious" fairness;

then [it's easy to predict that]: mortgages and mortgage backed institutions will become unsound.

TL;DR a crisis like this is going to happen again, and it happened before, see previous "savings and loan" crisis.

bonus lesson in finance/accounting: if the problem is framed and worded properly, it's easy to see that money paid for rent is not actually "wasted money down the drain", and that it is a fallacy that it is better to put the money toward a mortgage.

Let's say out of college you live in your old room at mom's while you save money to get your own place. Your job turns out well and you're making good money, but instead of renting your own apt, you stay at mom's to save for a down payment on a first house. You save up, and you buy a place. OK so far?

Now owning your own place, do you move into it? Well, think about it, you could stay at mom's and rent this new place you own out to somebody else and let them "waste the rent" while you collect all this fingerquotes "free money". Id est, i.e., if you move into your new place, you are essentially depriving yourself of the rent that you are entitled to earn from it; you effectively pay rent to live in your owned home. You are the one "wasting the rent money".

And the extra details actually work against you: mortgage interest expense is tax deductible, right? Well, if you rent the place out, ALL expenses are tax deductible, that's more deductions than if you live in a place.

As an additional point, is rent "such a waste of money to the tenant" that wealthy people (let's use Bill Gates as an example) buy lots and lots of houses and apartments to rent out to the rental suckers? no, they don't.

TL;DR purely financially, owning is not better than renting; rent is not wasted money, at least not more than the fingerquotes rent you spend when you live in your own place.


The one case where ownership has really shone over the past decades is that it's the only form of leveraged investment that's readily available to the public. In many places an "average" house has "earned" more in appreciation than an average salary every year.


yes, but the point of my post is that the unwarranted enthusiasm for "home ownership because rent is a waste" leads to political destabilization of sectors of the finance markets. In terms of the point you raise, the "rent is a waste" belief means that your leveraged investment in housing just keeps you on the escalator because, while your investment has appreciated, you would need to roll it over into your next house, i.e. you rarely/never get to treat it as disposible income.

and all the bankruptcies and home foreclosures in an economic downturn shows the cost of high leveraged investing. A better way to achieve leverage is high beta stocks. Beta behaves just like leverage, except it automatically rebalances debt/equity on the way up and down. And the base rate of growth of the stock market is substantially higher, so you are leveraging a higher rate, even though you can't lever as much as a home.

and don't forget, owning a home and living in it as real estate prices rise means that you are "throwing away" higher and higher virtual rents that you would be entitled to collect and which factor into the value of your home.


Thats often due to ridiculous accredited investor laws designed to make sure the rate of return on capital is greater for the rich than the poor, who are only given government approved and thus lower returning options.


Those are designed to prevent people from getting scammed, after numerous incidents. Because the absolute best "mark" is someone who thinks he's a sophisticated investor because he's watched some videos on youtube. People like to cite "higher returns" but only after conveniently ignoring all the ones that didn't pan out.

Also, leverage: if you're borrowing money to make an unsecured investment in a scheme, disaster awaits.


> People like to cite "higher returns" but only after conveniently ignoring all the ones that didn't pan out.

The United States allows 'microfinancing' via kickstarter, where poor people are allowed to give money to new ventures without any expectation of return on the given capital. Meanwhile, the rich get the opportunity to invest for actual returns on capital. Do you think an accredited investor is going to give money on kickstarter when they could offer cash as an investment?

So why is giving money allowed, but spending the same money on acquiring shares not? The answer that 'some people got scammed' does not excuse the fact that people are still allowed to spend the same money today, without consumer protections, while not receiving any benefit. In other words, we have created yet another way to privatize the benefits of new ventures (by only allowing rich people to profit off of them) while socializing the costs (the people asked to contribute to new ventures without any ownership interests via microfinancing platforms). The response that this is for consumer protection is crap, and anyone not blinded by legal confirmation bias can see that

Maximal investment limits based on income are perhaps appropriate, but wholesale banning is morally reprehensible, and a direct contributor to income inequality.


Renting has a lot of overhead. You are not only paying the landlord's profit (~100/month excluding equity is the figure I hear thrown around), you are also paying for the time your unit is vacant, and for some of the costs assosiated with bad tenents.

Put another way, as a landlord you are the best tenent you will ever have.


> purely financially, owning is not better than renting; rent is not wasted money, at least not more than the fingerquotes rent you spend when you live in your own place.

Only if you're having no kids which you plan to leave some wealth to inherit. Owning a home is the way for the lower/ middle class to build up trans-generational wealth. Let's just take the following example:

1. I buy a home today and pay it off in 30 years (standard schedule).

2. I get a kid in three years.

3. The kid is ~30 when I become a pensioner and move off to Croatia to smoke pot all day and night... meaning the kid can either move with his family into my fully paid off home, rent it out or sell it off at 4-5x the "original" value. Either way, my kid can keep a vast proportion of his paycheck and either save it up or investing it, thus creating wealth.

If I will spend the rest of my time renting, however, I will leave nothing for my kid to inherit and use as leverage to build their own wealth.


I mean if you rent you could leave your kid actual cash or investments which are higher returning than houses. Then they can buy three houses


Which cash should I leave them when all I make is going to rent?! For people who are not in the US tech/finance bubble, there is no way to accumulate any money other than paying a mortgage on a home. Hell even the US tech bros have difficulties finding an affordable price to live, if one goes by common Reddit/HN sentiments.


But you had to have saved up money in the first place in order to make a downpayment on the mortgage. If your rent is so expensive that you can’t save any money then you aren’t going to be able to get a mortgage anyway. And if you can save money for a downpayment then you have to compare the opportunity cost of investing those savings versus using them to buy a house.


> But you had to have saved up money in the first place in order to make a downpayment on the mortgage

Now you understand why my generation is so truly fucked.

>And if you can save money for a downpayment then you have to compare the opportunity cost of investing those savings versus using them to buy a house.

The house will always win if you are in any metropolitan area. In 20 years property prices in Munich, for example, have tripled or quadrupled, if not more. If you're not in a metro area you don't have the rent problem anyway.


> Now you understand why my generation is so truly fucked.

No. I find it incredibly difficult to understand why my generation seems to be so truly 'fucked'. Especially, the type of people who are on HN should be able to save money and make a down payment.


you are exactly right, but when people have bad ideas lodged in their heads, it's difficult to dislodge them.


How does it work out when your mom lives 5 hours driving distance from that place where your good job is?

How does it work out when your mom is renting herself and when you went to university she started renting a smaller place without extra room, to save some money?

rent vs own comparison may look a little different when you actually need a place to live


The yield on the bond is a pretty good indicator that something is amiss. If you're making 100bps over other AAA paper, it's unlikely that you got a really good deal. It's more likely what you're holding isn't really AAA.


Weren't there also chains of derivatives based off the same mortgages too with each of them being insured? I wasn't paying much attention back then but it seemed like that was one of the biggest issues because when mortgage started failing in large numbers it affected whole chains of derivative products and all of them triggered insurance at the same time.


The problem with rating systems is they are third-party. If you want to knowingly package assets with a poor grade bad at a better rating, you will shop around until you find a rater who will give you the grade you want. It becomes the cost of doing business. It takes one bad seed to mis-grade. What's worse is, the rating agency that grades fraudulently will get paid more, since the one's trying to maintain integrity won't want to mis-grade.

Broader point here: grading systems aren't all that resilient. It only takes one bad actor to threaten the whole system, if we assume ratings (in aggregate) are always believable. Dodd-Frank may have been re-worked but I wouldn't, for a second, assume there isn't a loophole in there that will allow the bad guys to resume.


It's not just about the ratings. If a person is too risky you simply don't lend them money.


But where "too risky" lies is very-much a personal decision.

It's the rating on the debt which makes it clear exactly how risky it is, and allows people to make a decision about it.


> But where "too risky" lies is very-much a personal decision.

What? No. Its a statistical decision. Its a question of how good your data on your risk profile and the risk the creditee represents is.


Another approach would be making raters pay the first percent or two of any default.


Have any two financial crises happened for the same reasons ?

I’m in my early 30s and can recall the following in the US. All for different reasons which would lead me to believe that government regulation post crisis can be effective at avoiding the same crisis from repeating (while arguably could cause a new one):

- mortgage crisis 07 - dot com 00 - savings and loans late 80s - oil crisis late 70s


The answer is yes and I always point to the Financial Crisis of 33 AD in Rome which was mainly caused by a mass issuance of unsecured loans by the Roman banking house.[1]

Some of the major reasons why financial recessions happen are: abnormal leveraging, liquidity mismatches, wars, taxes, subsidies, governance.

[1] https://www.businessinsider.com/qe-in-the-financial-crisis-o...


>Have any two financial crises happened for the same reasons?

This book by two economists seeks to answer that question:

This Time It’s Different: Eight Centuries of Financial Folly

http://www.reinhartandrogoff.com/

Hint: yes.



>Have any two financial crises happened for the same reasons?

Yes, they all do. Fundamentally, they are the result of leverage (usually with a significant amount of maturity and liquidity mismatch) being used to bid up the price of capital assets. HIGHLY recommend reading Irving Fisher's "Booms and Depressions" and "The Debt Deflation Theory of Great Depressions" as well as pretty much everything Hyman Minsky wrote as a starting point. This is a subject that has fascinated me for decades.


I believe the question implied "reason" being something more specific like mortgage-backed securities or a tech bubble, not something generic.

Also, the submission was previously titled something like, "Banks are cozying up to the same types of mortgage bonds as the ones from 2008."


Yes, the specific capital asset - be it tulips, tech stocks, real estate, or something else - will definitely vary.


Ray Dalio of Bridgewater and author of the famous Principles book recently wrote a nice article detailing the history of the US - https://www.linkedin.com/pulse/paradigm-shifts-ray-dalio/

You can also find it on a podcast or two where someone reads it.


There is a consistent trend of crash, liberal leadership elected, passing liberal economic recovery and regulation legislation, time for Americans to forget why the crash happened, then the election of conservative leadership, cannibalization of successful regulation, tax cuts, then another crash. This happened under W into 2007 and under Trump today (with the addition of tariffs). It also happened under Reagan in the 80's (trickle down...).

generally speaking, regulation slows but also stabilizes economic growth. Until the removal of the gold standard and stronger fiscal and economic policy in the 30's, we had a boom bust cycle almost yearly with inflation/deflation cycles often within 16 months and massive spikes and drops in the stock market. Since the New Deal era, the stock market has seen typically steady growth without constant swings in inflation and a longer trend or cycle to economic crashes usually dictated by the process in my first paragraph.

Inflation rates since 1914 (see the negative or deflation period in the early 20's): https://www.usinflationcalculator.com/inflation/historical-i...

Dow Jones average over the last 100 years (see the ups/downs leading into WWII and the not uniform but consistent growth since the New Deal era): https://www.macrotrends.net/1319/dow-jones-100-year-historic...

History of US recessions (very brief but note that regulation/government entities created to prevent the same issue from coming up again like the 1907 recession): https://www.macrotrends.net/1319/dow-jones-100-year-historic...


> Have any two financial crises happened for the same reasons ?

Yes, all of them for the same reason: FIAT currency instead of real money.


Fiat currency is one of the reasons society has had a lot more stability in the value of money in comparison to any other time in the past. Currencies tied to commodities such as gold, silver, etc have always been more volatile due to supply oscillation, business cycles and periodic bursts of 'pocket' recessions.


The problem with fiat currencies is that there is just a little too much temptation to print a truckload when there are "emergencies". This often causes hyperinflation or massive inequality leading to the rise of populism and democratic backsliding.


Printing a truckload of currency is often a byproduct of populism. Even without fiat currencies, governments would simply use other methods to debase the value of their coins [1]

[1] https://en.wikipedia.org/wiki/Methods_of_coin_debasement


The constant inflation due to fiat currency is worse than the effects you describe, because it has destroyed more wealth.


Yes, that’s were no banking panics before the end of Bretton Woods in 1971


What caused the many many financial panics of the 19th century and the Great Depression?


What’s “real” money? We going back to trading livestock?

You realize even hard specie only has value because of government fiat declaring that it’s appropriate to use for public debts right?


Real money would be any instrument that's based on work already performed instead of work promised to be performed in the future, i.e. not debt based.


But that's not actually what you want for preserving value: you want to know that a unit now buys you a loaf of bread today or next week or in ten or a hundred years time. Currency is useful because you can use it to buy future work.


> What’s “real” money?

Money based on value of some kind, as opposed to debt.


Who decides what "value" is or what things should be values at? The whole point of money is to make unspecified commitments for future production. If you want direct exchange of value then you're bartering.

The only reason we ever decided on gold or silver as the store of value was because kings made it so.


> Who decides what "value" is or what things should be values at?

The buyer. By paying the price.


So we're back to barter again, because you're going to need to negotiate value independently for each and every traded good if you don't have an agreed upon unit of accounting (i.e. defined currency).


And why wouldn't they? they lost some money but mostly got bailed out at the taxpayer's expense, and nobody went to jail.

If we haven't made the disincentives stronger (we haven't) and if they were inadequate the first time (they were), why are we expecting bankers to make different choices?

This is the expected outcome.


> And why wouldn't they? they lost some money but mostly got bailed out at the taxpayer's expense, and nobody went to jail.

Let's just clarify - American citizens lost $12.8Bn. [0] That money didn't evaporate, it got funneled back into many of the banks and auto manufacturers as a hand out. Some banks that took risk had little to no downside and we know that there were a continuation of bonus payouts to executives by banks that took bailout trailing the debacle. The US had a chance to wipe out some of the hogs of the market but instead chose to feed them.

[0] https://finance.yahoo.com/blogs/daily-ticker/2008-financial-...


According to your source you are off by three orders of magnitude on the losses.

$12.8 Trillion is the actual loss.


You are correct, my typo.


While in principle I don’t ever believe in bailouts of any kind, not bailing out the banks would have led to an apocalyptic situation probably worse than the Great Depression. Sometimes those in power have a responsibility to the people instead of some idealistic morality.


And now the banks have learned they can hold the economy for ransom.


We could have bailed the companies out while tossing the executives who facilitated this crisis into the gulags.


Not that I dislike the idea of putting bankers into gulags, but I believe taking away all their wealth and seizing eveything they earn above poverty level for life would be more of an effective punishment.

Also, the shareholders of such banks should be held accountable - the banks in question should be dissolved and the assets distributed to the public/the state. If shareholders do not have to fear total loss as a consequence of managerial misconduct they will not have any incentive to put actual controllers instead of yes-men to the boards.


There's the alternative of nationalizing them before bailing them out if they are too big to fail. When they are stable again, you can put them back on the market.

With the 2008 setup, there is little incentive not to repeat it.


yes, that's exactly what the bankers told us (via their special interest politicians who were given the talking points)

do you believe them?

and even if you do, why are they allowed to remain that big? this is exactly what "too big to fail" means, and why it's a problem.


It seems like you're presenting a false dichotomy, where the options are the bailouts we gave, or nothing. We could have bailed out the banks without rewarding all the bad actors involved at the same time, i.e. harsher terms for the bailouts. What we actually did is broadly excuse impropriety in the financial sector.


There’s nothing wrong inferently wrong with MBSs. They are a little complicated, but then again, so are lots of things. The problem that occured in 07-08 were two-fold: corrupt/lazy rating agencies and a lack of understanding about the long-tail correlation between mortgages. The copulas banks were using to join the probability density functions of the mortgages were incorrect and spit out much lower levels of correlation than was accurate.

In reality, MBSs are a truly beautiful idea that have a lot of potential to help a lot of people. The banks just needed to have better risk management and I think a lot of lessons have been learned. Despite what the public thinks, banks, especially Goldman, (one of the only institutions to not get hit very much by the collapse) take risk management very seriously. And the guys that didn’t have gone out of business (i.e Lehman).

And you’re right, this is the expected (good) outcome. Learn some lessons and start selling a useful product again gaining some wisdom. Nothing wrong with that.


Lehman had a C-level risk officer, which surely means they took risk seriously at the time they established it. In 2007 they didn't (they fired the risk officer!), but that just makes me worry whether it's possible for banks in general to durably learn risk-related lessons. Some banks are responsible and will manage risk properly on their own - to protect the others, maybe some risky but useful asset classes need to be restricted.


There is nothing inherently wrong with mortgage bonds.

The principle is simple and fine, chop up a bunch of mortgages from all over, with the same risk profile and pool them together.

That way local environmental factors don't cause the whole investment to go south. Basically raid for investment

What is a problem, and one that still hasn't fully been tackled is the industrial scale fraud that sold delinquent, or knowingly under par mortgages as high quality instruments.

Through all the use of fancy words, every seems to have got the impression that commoditized mortgages investments are complex, using words like "tranche", "proprietary instruments" and blended risk.

its really not, get a bunch of mortgages, shove them in a blender and make mortgage sausage.

So long as there isn't widespread and systematic fraud, then everything will be fine.

However considering that there haven't been large scale arrests, I don't hold out much hope.


> There is nothing inherently wrong with mortgage bonds.

If Bank X is sloppy about qualifying customers for mortgages but keeps the mortgages on their own books, the sloppy behaviour will bite them in the ass. Thus, they are incentivised to be careful with no external oversight needed.

The moment it's possible to sell the mortgages on, that incentive is removed.


> The moment it's possible to sell the mortgages on, that incentive is removed.

It's not. Investors in the secondary market don't want to buy shitty subprime loans. The only reason lenders originate these awful loans is because the government incentivizes them to do so by guaranteeing to buy them via Fannie and Freddie. Fannie and Freddie buy half of all US mortgages, and in doing so dramatically distort interest rates and the amount of liquidity in the housing market. They also guarantee these loans, something a lender would never do, which is why mortgage-backed securities were considered "safe" leading up to the crash in 2008.

If Fannie and Freddie didn't exist, subprime loans would either not exist or would have dramatically higher interest rates in order to properly protect against the risk of default.


Fannie and Freddie do not buy subprime loans, subprime stays in the private market. If Fannie and Freddie didn't exist, prime rates would be closer to subprime rates since it's effectively those prime rates that are being subsidized.


> Fannie and Freddie do not buy subprime loans, subprime stays in the private market.

I'm not sure where you got that idea. Fannie and Freddie exist for the explicit purpose of making mortgages more accessible to people who would otherwise be considered too risky to lend to (low down payments, low income, no assets, etc.). They do this by purchasing mortgages that are underwritten to lower standards and at lower interest rates than would be acceptable to private lenders, effectively shifting the risk from private lenders to the taxpayers.

Fannie and Freddie bought a tremendous amount of subprime loans. From page 454 of the Financial Crisis Inquiry Commission report[1]:

> "...on June 30, 2008, immediately prior to the onset of the financial crisis, [Fannie and Freddie] held or had guaranteed 12 million subprime and Alt-A loans. This was 37 percent of their total mortgage exposure of 32 million loans, which in turn was approximately 58 percent of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie, accordingly, were by far the dominant players in the U.S. mortgage market before the financial crisis and their underwriting standards largely set the standards for the rest of the mortgage financing industry."

[1] https://fcic-static.law.stanford.edu/cdn_media/fcic-reports/...


What I meant to say is, Fannie and Freddie no longer purchase subprime mortgages (not since the crisis). You’re citing numbers from 11 years ago, and the structure of the market has changed considerably since then. Subprime specifically refers to low credit scores (below 620), which is purely in the private market now since Fannie and Freddie no longer buy those.

Whether or not you agree with the risk assessment of lending to low income borrowers, it is strictly not the same thing as subprime lending.


nobody wants to buy subprime debt.

the reason why people did was because the instruments they were buying had a fraudulent A rating slapped on them.

As soon as word got out that these thing were dodgy, they were junked. Or sold on to some sucker and then junked.

the regulated market only work if illegality is minimised.


The skepticism with respect to ratings is likely forever damaged, since everyone knows bankers aren't held liable for their actions. On paper, Dodd Frank may have changed, but if bankers hand out rosy, inaccurate ratings -- we know there will be no liability. There is no reason to trust ratings. But accurate ratings are an essential part of the financial system.


Right, this time around people will be careful to keep these bonds off their book but still get a commission for selling them


> Banks today are buying both mortgages that are eligible to be sold to Fannie and Freddie as well as ones that aren’t because they are too large or they are considered riskier—often because they use alternative documentation to approve the borrower.

I'm really curious what this "alternative documentation" is. This was part of the problem leading up to 2008: banks did not verify people's information. Some people received mortgages after putting their pet's name on the paperwork.

We might not be there yet, but it's a slippery slope.


Alternative documentation tends to be for borrowers that don't have good verification of income (like tax returns or paystubs). Often self-employed borrowers, or borrowers with large amounts of assets but little income.


Of course they would. Lots of people made loads of money the last time, and no one went to prison. Seems like an obvious thing to try if you're a smart and low-empathy person.


Chasing yields wherever they can find any. I read this in a tweet recently:

"Buying stocks for yield, bonds for capital gains".


So what's the difference this time around?

I can't imagine they're going "remember that investment product that crashed? Please buy it again. "


They're probably going "remember that investment product that made you a fuck-ton of money right up until the crash? Please buy version 2.0"


and get in early, and cash out while the goings' good, and let the late suckers fall.

Even pyramid schemes are profitable at the beginning!


All securities have exposure to something that can result in them crashing. Despite this, people are still buying them. It would be pretty ridiculeous to say “remember the Great Depression? Don’t buy any stocks! It’s a scam!” So what’s the difference with MBSs? Also, what exactly about MBSs do you think makes them fundamentally unsound investments?


The fall will be even larger.


People think that greed and an infinite backstop (the fed backing Fannie Mae and Freddie Mac guaranteeing ~50% of the US mortgages that these MBSes are made up of) is going to end any differently? I doubt it. It will just be bigger because the government mandated that they have larger reserves, they didn't mandate they change they way they think about capitalism or greed, etc.

If you had a VC behind you with trillions that would fund your every idea even after you burned many untold billions you wouldn't change your thought process either, it's no different here in my opinion. And that opinion might be jaded or unrealistic but I don't think I am that far off. I don't have much faith in the measures that have been taken to prevent another 2008 style crash.


Would banks be responsible if the Fed wasn't a lender of last resort?

I wonder if thousands of years from now people will look back on our economics like we did to the Romans- "how could they not understand inflation?"


These banks have been at it awhile. They've spun off 'rating' companies to check these mortgage packages, private not their internal departments. They've used those companies to run their custom models against fannie mae packages (gs against fannie mae i'm 100% of was witness to), with out that other knowing, and other banks. Whatever is going on, they've been prepping to make sure it happens with high velocity.


This time is different.


Banks gotta make money somehow in a low interest world.


For the people who thing that there is nothing inherently wrong about MBS. Unfortunately, that´s not the case.

When banks sell off their loans, which is what an MBS is, it fundamentally changes the ratio of money:debt originating from the banking system. In a non-MBS banking system, there is roughly the same amount of deposit money flowing around as there are loans. In an MBS using banking system, there are significantly more loans being created - unlike the initial creation of a loan by a bank, the sale of the MBS does not create any additional money.

So the underlying economy may or may not need the extra debt, but creating it this way is anything but side effect free. Granted neither is creating normal bank debt given the money supply side effects.

The evidence of history suggests that an economy can get away with small amounts of this, but at some point there is too big an imbalance of debt to money, and this causes solvency issues in paying back the debt. And that´s when everything all goes terribly wrong.

But it´s a $1 trillion a year industry in the USA, so perish the thought that minor issues like systemic stability should be allowed to interfere with that. On the plus side, China introduced them a few years ago as well, so it will be very interesting to see what happens there as things play out.

For a deeply depressing paper, considering when(2000) and where (US Federal Reserve) it was written, see:

https://www.sciencedirect.com/science/article/pii/S037842669...


> In a non-MBS banking system, there is roughly the same amount of deposit money flowing around as there are loans.

Because when you take out a mortgage it gets deposited immediately in someone elses account. The mechanics are effectively the same as for non-intermediated (MBS) debt.


The double entry book keeping operation when a bank issues a new loan, is [debit loan, credit deposit account] creating deposit money.

When a loan is securitzed (sold) by the bank, the DBE operations are:

[credit loan, debit deposit account of purchaser]

and the purchaser now owns loan. At this point strictly money has been removed from the banking system, but in practice the bank then recreates that money with a new loan (as above) because they are now within their regulatory lending requirements, and can issue a new loan. They can continue this indefinitely until the market for securitized loans dries up, which is effectively what happened in 2008.


Maybe not literally, but don't regulations stipulate how many liquid assets a lender must have on hand? Even if the ratio isn't 1:1, it's bounded, unlike an unbounded MBS market.

IANA finance expert, but I suppose you could bound the MBS market with some kind of maximum-degrees-removed-from-real-assets metric, and regulate based off of that. But that, to me, would seem unwise since that metric would likely be fairly abstract and therefore dis-preferred as a basis of regulation.




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