More on the CRA

[johnpalmer]

Though the source won't convince any of the Republican Faithful, the facts are in line.

CRA only applies to banks and thrifts, when most of the troublesome loans didn't originate with those types of institutions. Only one in four did. (And, again, typically, those loans weren't the problems; they had a good chance of being paid back.)

I've also done a bit more research, and I understand the bit about credit default swaps, now.

A credit default swap is just a form of insurance. You give me X amount each year, and I promise, in return, to make sure you don't lose the face value of the investment. So, you invest in a 7% bond, but pay me 1.5% to make sure you don't lose the face value. You get 5.5% return on your investment, and you're happy. I get 1.5% of your investment, and if your bond seller doesn't default, I'm *really* happy.

But it only works if I have the assets to back your potential loss. You don't know if I do, because my assets might include multiple CDSes. And no one can value them, because no one can tell what the risk of default on the bonds are, because so many of the bonds are made up of stuff like "mortgages where we don't know the risk of default because we didn't bother verifying enough financial information, and plus, who knows if the people can handle one or more "resets" on their ARM?"

It's stuff like this that makes me understand the reasoning behind the bailout. See, no one is saying "give money away." The idea is "buy up CDSes and mortgage bonds and stuff like that; people now have more money than they had before, freeing up money for loans and letting some of them recover. Later, maybe we can find out if any of these are worth something or not."

Because one of the biggest problems that seems to be going around is *no one is buying anything*. No one will buy the mortgage bonds. No one will buy the CDSes. No one knows how to value them, so they won't offer a cash price for them.

And then, this is the part that gets interesting. When financial institutions value assets, they have to set the value to the "fair market value", what they can sell the asset for. But no one is buying anything. There isn't a reasonable fair market value!

There's a proposal to remove that requirement, which is absolutely frickin' *insane*. I mean, what, value an asset at something *other* than what someone will pay for it? How do you do that? Why not just assume your pile of super-expensive mortgages whose monthly payments are due to skyrocket are all as good as T-bonds? It's a great way to cheat people, by pretending you have more capital than you do! On the other hand, that collection of mortgage bonds you're holding might end up paying off at face value, plus interest... it's just no one is willing to buy them because you can't prove they'll pay off like that. Good assets are being valued the same as bad ones.

When I step back and look at all of this from a distance, I have to admit, as a kind of black humor, this could be almost funny, if real people weren't facing real problems as a result.

Comments

[fourgates.livejournal.com]

There's a proposal to remove that requirement, which is absolutely frickin' *insane*. I mean, what, value an asset at something *other* than what someone will pay for it? How do you do that? Why not just assume your pile of super-expensive mortgages whose monthly payments are due to skyrocket are all as good as T-bonds? It's a great way to cheat people, by pretending you have more capital than you do! On the other hand, that collection of mortgage bonds you're holding might end up paying off at face value, plus interest... it's just no one is willing to buy them because you can't prove they'll pay off like that. Good assets are being valued the same as bad ones.

Let's say subprime loans, in the reasonable days, were assumed to have a 5% default rate. That 5% default ends up costing you 1% of return, because you get back most of your money when you resell the house after foreclosure. If you take a blend of 80% prime loans and mix in 20% subprime loans, you get a very weakly diluted prime portfolio, with the same credit rating. That's the magic. It's also the source of the catastrophe.

Now let's say the subprime default rate is 20% in today's market. That'll cost you 5% on a pure subprime portfolio, or some unknown amount in a blend with prime loans. The increased default rate might be very regional (look at Las Vegas vs. Seattle). The default rate is also very much tied to the fact that housing prices dropped by unexpected amounts --- very directly interacting with the proliferation of fancy you-can-just-refi-later-when-values-go-up-20% mortgages. Now the amount that the prime portfolio is diluted is directly dependent on 1) the prime/subprime blend ratio (which is variable), and 2) what's happening in the housing market. The unquantifiable expectations of a further spike in defaults is one side of the uncertainty (it also makes prime loans suspect, as many people are "reasonable" in walking away from a deeply underwater house).

In this situation, the vast majority of prime loans are still good, and the large majority of subprime loans are still good. But both are in the same the boat, and it is leaking, and we don't know how much the leak is going to grow. The uncertainty kill the marketability of these securities, not the default rate.

Reasonable estimates put current values of many of these securities at 80%+ of their original expected values (it's hard to make generalizations because the sellers were creative in offering different blends at different credit ratings). But with the uncertainty there is no market, so the perceived value is zero. Some of the big investment banks, in desperation, unloaded some of these for 22% of face value recently. Someone got a sweet deal.

These moldy subprime loans are included (in small amounts) in a huge slice of the mortgage portfolios out there, so the "infection" is very widespread. The fear is detached from the market reality (which is pointing south in any case).

So you ask why the government might suspect the mark-to-market rule. The reason is that forcing the holders to rate their securities at panic levels means that they can't count the true (long-term) value of those securities as collateral. All banks have more debt than collateral, and they're required to maintain it at certain levels, in order to be able to borrow money and stay in business. If their collateral is marked down 80% because there is no market for most of what they're holding, then their credit rating falls and the interest rate they have to pay triples, and that means they can't compete for consumer credit, and they go out of business. Enforcing mark-to-market means pushing the panic to its logical extreme -- waves of bank failures. It's that simple.

[droops.livejournal.com]

Very nicely put. It's the capital requirements and the credit ratings that suffer because of the current situation because valuing the underlying assets either isn't possible or it results in such a low figure that it makes them worthless, which leads to the problem you mentioned.

[fourgates.livejournal.com]

A side thought: If the government can get these toxic mortgage bundles at 50% of long-term value, then this is a fire sale, and it could be hugely profitable for the government. The cost/profitability question is completely dependent on what price the government is willing to pay. So far they've been leaning toward paying a guess at long-term fair value, instead of taking advantage of the market vulnerability of the holders. This is pure Republican give-the-money-to-the-rich-because-they-deserve-it-and-will-do-more-with-it-than-Washington bullshit, and just about no one is taking note of it. Instead of "bailing out the fat cats on Wall Street", we could be looting their companies. That the executives will still carry away millions is true (and unavoidable). But that is distracting people from the fact that we could be carrying away billions -- billions we deserve more than they do, billions we could spend on healthcare, or to pay for the entire Iraq war. That use of fat cats as a distraction away from the cash-making machines they operate is the real tragedy, IMO. I'm all for imposing a "tax" on companies that were recently making multi-billion-dollar profits every quarter. So I'm against the bailout as it is written, because the assurances that were added about balancing the books in the long term are toothless, with the goal being "try to make this revenue-neutral in 10 years" rather than "go shopping and pay the lowest rates you can for everything that is on sale." The difference is subtle -- only about $700 billion.

[droops.livejournal.com]

Very good, you've been able to swim through this. Not always easy to do, but once understood it becomes more clear what's happening and what's at stake.