I read an interesting article about the design of bullets. My interest was prompted as I read the plastic-and-cardboard wrapping of a plastic toy gun my son bought today at the National Western Stock Show. (For the pacifists among my readers, he also purchased a cute stuffed cow.)
As a matter of physics, a bullet that remains within the body it was fired at will cause the most damage. Bullets that do not penetrate cause less; bullets that travel all the way through "waste" energy. A bullet's size, shape and composition will affect its behavior. Thus, the deer hunter, elephant hunter and assassin will want different bullets.
In the case of police, they cannot necessarily predict who they will be firing at: the shirtless, the heavily bundled, or the driver behind an automobile windshield. I wonder how they choose, and I wonder if each officer is allowed to choose for himself or herself?
Monday, January 17, 2011
Book review: Last Call
This book was authored by Daniel Okrent in 2010 (ISBN 978-0-7432-7702-0). The subtitle is "The Rise and Fall of Prohibition".
This is one of those books I enjoy so much: vivid writing about an era I know a little of but come to know more. Most people I know label Prohibition a failure; in many ways it was, but the consequences of alcohol abuse before, during and after this period was and is not much better.
Okrent starts with a summary of alcohol use in the early days of the Republic. The United States started sopping wet:
* In the 1820s liquor was less expensive than tea.
* Four ounces of whiskey was the official, daily ration for U.S. Army soldiers from 1782 to 1830.
* In 1830 the yearly, per-capita adult consumption was seven gallons of pure alcohol: a little less than 6 glasses of wine per day.
The dry movement started from two quarters: women and Christians. Women who would be called feminists today agitated for suffrage and for sober men, men who would not disperse their meager earnings at a bar while their children went hungry. Christians objected to the rowdy, intemperate, and womanizing ways of these inebriated men.
For female activists alcohol was one of many issues. For the Anti-Saloon League ("ASL"), alcohol was the only issue. Started in 1893 in Ohio by Methodist and Baptist clergy, and catapulted by Wayne Wheeler's leadership starting in 1903, it was possibly the most effective political organization ever. It never controlled more than 10 percent of the vote, but that 10% was wholly committed to the prohibition cause. Its members would vote for the devil if he was dry and against God if he was wet. The 10 percent was enough to swing almost any election; as a result, "drys" outnumbered "wets" in both houses of Congress by three to one during much of the period between 1913 and 1933.
The 18th amendment to the U.S. Constitution authorized Congress to pass laws outlawing "intoxicating liquors" represented a significant blow to the national budget: taxes on alcohol represented 30% of federal revenue. The abolition of alcohol, therefore, was possible only because ASL promoted the 16th amendment, which created the national income tax.
Congress did pass such a law: the Volstead Act of 1919. It defined "intoxicating liquors" as fluids containing more than one-half of one percent alcohol. It also defined the exceptions, many-numbered and humorous. They included:
* Alcohol used for religious purposes.
* Alcohol used for medicinal purposes.
* Alcohol already owned before the effective date of the Act.
* Self-produced cider and homemade wine.
Regarding the exception for religious purposes, the population of Rabbis increased during prohibition. Some even went so far as to set up stores, with signs outside announcing the sale of "wine for sacramental purposes". Customers would approach to store, sign up for membership in the congregation, and purchase their wine. Catholics were not far behind, with Napa Valley wineries producing all they could for the diocese across the country.
Under the exception for medicinal purposes, doctors, dentists and veterinarians were permitted to issue prescriptions on government-issued forms. For the consumer, the physician's bill was generally three dollars, the pharmacist perhaps a dollar more than that.
The exception for already-owned alcohol led to stockpiling, not mention favoritism towards those wealthy enough to purchase large quantities before enforcement.
Enforcement, or the lack thereof, probably doomed Prohibition. In addition to the very large exceptions described above alcohol flowed freely from Canada and from the sea. From Canada it was floated across the Detroit River or driven across from Montreal. Men from the United States were hired to drive their cars North across the border, leave their car unlocked and parked in a garage for an hour, return to the garage and collect an honorarium, and drive back home. They did not know what was done to their cars during that hour, nor did they want to know. Alcohol was sometimes stored in the tires of automobiles, in place of air. From Britain and other points alcohol came across the sea.
On the consumer side, the further one traveled North and East the easier alcohol was to obtain. Movies glamorize the "speak-easy", and they did exist, but for the most part no subterfuge was required. While the outside of a club may not have openly advertised drinking, its offerings were well known to the public and to the police. Protection payments to the police and to criminal gangs were treated as a cost of doing business. The criminal violence occurred on city streets, on the Detroit River, and upon the oceans. The criminality arose, of course, because the alcohol trade was illegal and thus immensely profitable, much as the trade in cocaine and heroin is today. The parallel struck me in the following story from the book.
Before national prohibition many states, mostly Southern and Western, had enacted their own prohibition laws. These laws remained on the books during national prohibition and some outlasted it; some by many years (e.g., Kansas did not allow saloons open to the public selling individual drinks until 1987). During prohibition the voters of Massachusetts were asked to repeal their state's prohibition law and to stop state enforcement of the federal law (the 18th amendment provided for concurrent federal and state jurisdiction). All of Massachusetts, with the exception of Cape Cod, supported the measures. After all, more enforcement meant that criminal activity would be more lucrative and the actual perils of enforcement were small. Many in Cape Cod were making a nice living in the alcohol "business". The parallel, for me, was the recent marijuana legalization referendum in California. It failed. Given California's liberalism on social issues and the tax revenues it would have generated for that cash-strapped state, I was surprised by the outcome. How many of those "no" votes were cast by those involved in the illegal marijuana trade and were happy with the status quo?
While alcohol may have been easy to obtain, its quality varied widely. There was no truth-in-labeling act; alcoholic drinks were not even legal. A tavern might put the plainest alcohol in its high-priced bottles. That is, if you were lucky. The unlucky would be drinking industrial alcohol.
A number factors led to Prohibition's demise. Primary was its haphazard enforcement: it bred disrespect for the law and encouraged criminal violence in major cities. Secondary was the death of Wayne Wheeler and the subsequent decline in the ASL's power. Tertiary were the repeal efforts of wealthy Republicans, such as the DuPont and Rockefeller families, who resented the exercise of government power, the difficulty in obtaining liquor, and the increased income tax that resulted from the loss of alcohol taxes.
The 21st amendment, repealing the 18th, became effective in 1933.
This is one of those books I enjoy so much: vivid writing about an era I know a little of but come to know more. Most people I know label Prohibition a failure; in many ways it was, but the consequences of alcohol abuse before, during and after this period was and is not much better.
Okrent starts with a summary of alcohol use in the early days of the Republic. The United States started sopping wet:
* In the 1820s liquor was less expensive than tea.
* Four ounces of whiskey was the official, daily ration for U.S. Army soldiers from 1782 to 1830.
* In 1830 the yearly, per-capita adult consumption was seven gallons of pure alcohol: a little less than 6 glasses of wine per day.
The dry movement started from two quarters: women and Christians. Women who would be called feminists today agitated for suffrage and for sober men, men who would not disperse their meager earnings at a bar while their children went hungry. Christians objected to the rowdy, intemperate, and womanizing ways of these inebriated men.
For female activists alcohol was one of many issues. For the Anti-Saloon League ("ASL"), alcohol was the only issue. Started in 1893 in Ohio by Methodist and Baptist clergy, and catapulted by Wayne Wheeler's leadership starting in 1903, it was possibly the most effective political organization ever. It never controlled more than 10 percent of the vote, but that 10% was wholly committed to the prohibition cause. Its members would vote for the devil if he was dry and against God if he was wet. The 10 percent was enough to swing almost any election; as a result, "drys" outnumbered "wets" in both houses of Congress by three to one during much of the period between 1913 and 1933.
The 18th amendment to the U.S. Constitution authorized Congress to pass laws outlawing "intoxicating liquors" represented a significant blow to the national budget: taxes on alcohol represented 30% of federal revenue. The abolition of alcohol, therefore, was possible only because ASL promoted the 16th amendment, which created the national income tax.
Congress did pass such a law: the Volstead Act of 1919. It defined "intoxicating liquors" as fluids containing more than one-half of one percent alcohol. It also defined the exceptions, many-numbered and humorous. They included:
* Alcohol used for religious purposes.
* Alcohol used for medicinal purposes.
* Alcohol already owned before the effective date of the Act.
* Self-produced cider and homemade wine.
Regarding the exception for religious purposes, the population of Rabbis increased during prohibition. Some even went so far as to set up stores, with signs outside announcing the sale of "wine for sacramental purposes". Customers would approach to store, sign up for membership in the congregation, and purchase their wine. Catholics were not far behind, with Napa Valley wineries producing all they could for the diocese across the country.
Under the exception for medicinal purposes, doctors, dentists and veterinarians were permitted to issue prescriptions on government-issued forms. For the consumer, the physician's bill was generally three dollars, the pharmacist perhaps a dollar more than that.
The exception for already-owned alcohol led to stockpiling, not mention favoritism towards those wealthy enough to purchase large quantities before enforcement.
Enforcement, or the lack thereof, probably doomed Prohibition. In addition to the very large exceptions described above alcohol flowed freely from Canada and from the sea. From Canada it was floated across the Detroit River or driven across from Montreal. Men from the United States were hired to drive their cars North across the border, leave their car unlocked and parked in a garage for an hour, return to the garage and collect an honorarium, and drive back home. They did not know what was done to their cars during that hour, nor did they want to know. Alcohol was sometimes stored in the tires of automobiles, in place of air. From Britain and other points alcohol came across the sea.
On the consumer side, the further one traveled North and East the easier alcohol was to obtain. Movies glamorize the "speak-easy", and they did exist, but for the most part no subterfuge was required. While the outside of a club may not have openly advertised drinking, its offerings were well known to the public and to the police. Protection payments to the police and to criminal gangs were treated as a cost of doing business. The criminal violence occurred on city streets, on the Detroit River, and upon the oceans. The criminality arose, of course, because the alcohol trade was illegal and thus immensely profitable, much as the trade in cocaine and heroin is today. The parallel struck me in the following story from the book.
Before national prohibition many states, mostly Southern and Western, had enacted their own prohibition laws. These laws remained on the books during national prohibition and some outlasted it; some by many years (e.g., Kansas did not allow saloons open to the public selling individual drinks until 1987). During prohibition the voters of Massachusetts were asked to repeal their state's prohibition law and to stop state enforcement of the federal law (the 18th amendment provided for concurrent federal and state jurisdiction). All of Massachusetts, with the exception of Cape Cod, supported the measures. After all, more enforcement meant that criminal activity would be more lucrative and the actual perils of enforcement were small. Many in Cape Cod were making a nice living in the alcohol "business". The parallel, for me, was the recent marijuana legalization referendum in California. It failed. Given California's liberalism on social issues and the tax revenues it would have generated for that cash-strapped state, I was surprised by the outcome. How many of those "no" votes were cast by those involved in the illegal marijuana trade and were happy with the status quo?
While alcohol may have been easy to obtain, its quality varied widely. There was no truth-in-labeling act; alcoholic drinks were not even legal. A tavern might put the plainest alcohol in its high-priced bottles. That is, if you were lucky. The unlucky would be drinking industrial alcohol.
A number factors led to Prohibition's demise. Primary was its haphazard enforcement: it bred disrespect for the law and encouraged criminal violence in major cities. Secondary was the death of Wayne Wheeler and the subsequent decline in the ASL's power. Tertiary were the repeal efforts of wealthy Republicans, such as the DuPont and Rockefeller families, who resented the exercise of government power, the difficulty in obtaining liquor, and the increased income tax that resulted from the loss of alcohol taxes.
The 21st amendment, repealing the 18th, became effective in 1933.
Saturday, January 15, 2011
Organizational Inertia
I know an Assistant Vice President ("AVP") at my workplace. She works in an office with a door. One day she was sitting at her desk and a work-crew visits, offering to paint one of her walls with an accent color (the other walls are beige). She accepts, removes items from her wall, temporarily vacates her office, and returns to find two walls painted.
She is not bothered by the two painted walls. She was not bothered by the unpainted walls. She has no strong opinion on the matter.
A few days later the work-crew returns. A mistake has been made, they explain: only vice-presidents and above, not AVPs, may have more than one accent wall. She temporarily vacates her office and returns to find one of the accent walls repainted in beige.
She is not bothered by the two painted walls. She was not bothered by the unpainted walls. She has no strong opinion on the matter.
A few days later the work-crew returns. A mistake has been made, they explain: only vice-presidents and above, not AVPs, may have more than one accent wall. She temporarily vacates her office and returns to find one of the accent walls repainted in beige.
Sunday, January 9, 2011
Book review: All the Devils are Here
Authored by Bethany McLean and Joe Nocera in 2010 (ISBN 978-1-59184-363-4).
Before I describe the book I need to, for my benefit and the benefit of the reader, define some terms. The book describes them, too, but not sufficiently (the book is otherwise excellent).
First, debt. A debt is a promise to pay. Think IOU. A bank account is a debt: you give your money to bank and the bank promises to pay you back, with interest. Most of us will not think for a moment that the bank will not pay us back, now that we live in the days of the FDIC. A credit card is debt, too, as you promise to pay the bank for the charges you accrue on your card.
Those debts are all unsecured, meaning there is nothing behind the promise to pay other than the good intentions of the borrower and the general legal infrastructure we have for collecting debts. If the borrower declares bankruptcy the lender's collection will range between 100% and 0%, depending on what other debts the borrower has.
Other debts are secured. The most common example is the home mortgage. The bank loans money to the purchaser and takes a security interest in the property and house. The house in this case is collateral. The security interest means, among other things:
1) The occupant (owner) of the house cannot sell it without first paying off the debt.
2) If the occupant of the house does not pay the debt the holder of the security interest can force a sale (foreclosure) and use the proceeds from that sale to collect the money owed. The remainder, if any, goes to debtor.
A car loan is another example of secured debt, with the car serving as collateral.
All other things being equal, a secured debt will carry a lower interest rate reflecting the lower risk to the lender. A lender's interest rate can be influenced by:
1) The cost of money. How much interest the lender must pay to acquire money to loan.
2) Risk. How likely is it the borrower will repay, or how likely is the borrower to default? Perversely, the poor, those least likely to repay but also in most need to borrow, pay higher interest.
3) Supply and demand. This "law" applies to most goods and services.
A debt backed by collateral usually carries lower risk than an unsecured debt and thus a lower interest rate.
A "security" is a financial instrument and is commonly bought and sold on exchanges. They come in two basic flavors, equity and debt. A share of stock in a public company, such as Google, is an example of equity. It represents fractional ownership. In the case of Google, with 320 million shares outstanding, a share of stock represents a very, very small portion of the ownership. Indeed, few people purchase shares of a public company with the goal of imposing their will; rather, they wish to share in the entity's future financial success. The success will be reflected in future, higher prices for that share of stock, which the shareholder can later sell (at a profit). Theoretically, the future price is unlimited. On the other hand, the entity could fall upon hard times, or bankruptcy, in which case the price of the share will decline, potentially to zero.
This book concerned the other flavor, debt, and I will write no more about equities. And, the authors considered mostly secured debt, so all discussion below about debts refers to secured debts.
Debt typically represents a more constrained future. The debt will pay a certain interest rate, say 5%, and if the entity performs spectacularly the lender collects 5% and if the entity performs poorly the lender collects 5%. If the entity performs especially poorly the lender may collect less than 5%, and in more spectacular cases, may lose money. This book concerned those spectacular cases, and that word describes the amounts lost, the amounts collected by the "Devils", and the amounts ponied up by U.S. taxpayers and others.
Debts can be bought and sold. Person X may borrow money from person Y. Person Y is said to "own" the debt: the right to collect the principal amount borrowed and the right to collect the interest. Person Y can sell the debt to person Z. Z is now entitled to collect the principal and interest. The sale price will reflect the interest rate and borrower ability to repay. Note that the borrower's ability to repay may be different than at the time the loan closed due to individual forces, such as job loss, and macroeconomic forces, such as a local or national drop in house prices.
An investor can purchase many debts and thus be entitled to collect the principal and interest from many debtors. The value of those debts will be based on the underlying interest rates and the underlying likelihood-of-payment from the various debtors.
Z can bundle those debts into a package and sell the package to yet another entity. As mentioned above, for purposes of this article all debts are secured by assets; a package of these debts is called an asset-backed security ("ABS"). If all of the assets backing the security are in the form of mortgages then the security is called a mortgage-backed security ("MBS"). The buying, selling, insuring and pricing of these debts featured prominently in the book. In truth, some of the debt packages included unsecured debts, such as student loans, but the vast majority of the value of these packages were home mortgages.
Once a package of debts is bundled it can be separated, for example, by risk. These separate pieces are called tranches. Commonly a package is separated into three tranches, in order of least to most risk of default, triple-A, mezzanine and junk. The tranches are sometimes called senior, junior tranches and (confusingly) equity. In practice, the higher-risk tranches must pay more interest than the lower-risk tranches to attract investors.
Triple-A is the highest of the ratings assigned by one of the three Nationally Recognized Statistical Ratings Organizations (NRSROs). The United States government, some other governments, and some large organizations enjoy a AAA rating; in other words, the NRSROs believe that the U.S. government is highly likely to pay its debts. (Given that its debts are U.S.-dollar-denominated, and that the U.S. government can print almost as many dollars as it likes, this rating makes sense.)
One commonly accepted principal of investing is that diversity decreases risk. For example, buying the mortgage of a single homeowner can be considered risky because the buyer has put all of its "eggs in one basket"). Investing in several mortgages, by contrast, might be considered less risky because the investor is not susceptible to the risk of a single failed debtor. Investing in several mortgages, each from different areas of the country, might be considered still less risky, and so on. In fact, combining the second and third tranches of multiple asset-backed securities could be less risky than investing in a single second or third tranche of a single ABS, so less risky that a NRSRO might be willing to bestow a triple-A rating upon it. This fact resulted in the CDO: collaterized debt obligation, a collection of tranches from multiple ABSs, that the seller can tout as being triple-A rated. This may sound suspicious, and it is, being partially responsible for the financial meltdown in the late 2000s.
This slicing-and-dicing can be further extended. These CDOs themselves can be separated into tranches, and the tranches from multiple CDOs can be combined into aggregates called CDOs squared.
The purchaser of an ABS (or CDO,or CDO squared) is taking some risk: the underlying debtors may not pay their debts, and thus the actual interest rate paid by the ABS may be less than promised (or even negative). Some of these purchasers want to limit their risk, much as the owner of an automobile or house might want to obtain auto or home insurance to insure the risks to those assets. And, just as there are market players (named Nationwide, Farmers, etc.) willing to take auto or home risk in exchange for money, some market players are willing accept money in exchange for the risk that an ABS or CDO will not pay the interest it promises to pay. Insurance on an ABS is called a credit default swap ("CDS"). The insurer (seller of a credit default swap) must pay the difference between what the ABS has promised to pay and what it actually pays. In practice, when a credit event such as repudiation or a missed payment occurs, the holder of the insurance gives the ABS to the insurer and the insurer pays the holder the original, full value of the ABS.
Stock investors can go "long" or "short". Long is more typical: purchase a share now and hope the price increases. For example, the investor buys a one share of company X at the market price of $10. Two days later the market price is $11; the investor sells that share and pockets $1. The short investor, on the other hand, hopes for the price to go down. The short investor borrows a share today from Y and immediately sells it to Z, collecting the current market price of $10. Two days later the market price is $9. The investor uses $9 (of the $10 the investor has already collected) buy that a share and give it back to Y, leaving a profit of $1. In reality, most short trades do not involve an actual movement of the share; the parties wait to see the resulting price and one party pays the other depending on whether the new price is higher or lower than the old. It seems little different than gambling: money wagered on a somewhat unpredictable event, the price of a share of stock.
Insurance laws in every state prevent person X from buying life insurance on person Y without Y's consent. There is no such restriction on CDS insurance. If an investor believes an ABS is likely to experience a credit event that investor will want to purchase a CDS; such investors are called "short" because they are betting on an impairment to debt underlying the ABS much like a short stock investor is betting on the impairment to the price of a stock. Investors who are willing to sell a CDS are "long": they view the ABSs likelihood to pay as good, or improving, or at least better than the short buyer does.
A typical ABS might be worth millions of dollars because it aggregates many underlying debts. A typical CDS might involve yearly payments of several thousand dollars by the short investor. The short investor might worry about the long investor's ability to pay millions of dollars in the event of a credit event and so the credit default swap instrument may require the long investor to provide collateral. Such collateral might increase or decrease based on indicators that the value of the ABS has decreased or increased, respectively.
A synthetic CDO is to a CDS what an ABS is to a mortgage. That is, whereas an ABS is a collection of loans cut into tranches of differing risk levels, a synthetic CDO is a collection of CDSs cut into tranches of differing risk levels. A synthetic CDO is also an example of a derivative instrument: a security whose value derives from something else.
The buying a selling of CDOs squared and synthetic CDOs are examples of leverage. What is leverage? Consider the original stock investor who believes stock X is undervalued. The investor has $10 to work with. The current price of stock X is $10. The investor purchases a share for $10 and sells when the price increases to $11, yielding a $1 profit. But this investor is really, really sure the price is going up and wishes it had $20 to invest. The investor finds someone willing to loan $10, purchases two shares for $20, later sells the two shares for $22, repays the $10 loan, and now shows a $2 profit. The leverage allowed the investor to double its profits. This investor went long, but could have just as easily gone short. Essentially, if stock market investing is a form of gambling, leverage is a form of borrowing to support gambling. In the case above the share price could have fallen a dollar; the investor would have lost $2. The investor started with $10, so the lender in this case essentially had $10 of collateral to support a $2 loss: not so risky. But, if the stock price had gone from $10 to $4 the investor would have lost two times $6, or $12, more than the investor started with. In this case the lender may not have been able to collect the entire debt.
With CDOs squared and synthetic CDOs the short and long investors need have no relationship with the underlying lenders and debtors. And, the same loan can be referenced in a single synthetic CDO (or CDO squared) multiple times, meaning that the loss or gain of $1 in the value of that loan could be reflected in a loss or gain of $2 or $10 or $50 in the derivative instrument. The long synthetic CDO investors, the ones who are collecting the premiums, could end up owing many times the original obligation of a CDS, which itself is typically in the millions of dollars.
Now, the book. The financial crisis of 2007/2008 was caused by:
1) Greed.
1a) Wall Street players were greedy, though they are always greedy.
1b) Sub-prime mortgage companies.
1c) Ratings agencies.
1d) Consumers.
2) Insufficient regulation.
Before I read the book I remembered only September 2008. Indeed, that is the time most Americans started suffering. But there were failures in 2007 and early 2008 as well: the bankruptcy of two Bear Stearns hedge funds, American Home Mortgage Investment Corporation's bankruptcy, J.P. Morgan's fire-sale purchase of Bear Stearns, and Bank of America's fire-sale purchase of Countrywide. All stemmed from the same lack of liquidity in the market for ABSs and their derivatives that so impacted the market in September 2008. In the years before this Wall Street and the U.S. government calmly explained that the market troubles were temporary and corrective in nature. According to the book's authors these statements may not have been lies in the sense that the speakers were fooling themselves as much as they were fooling the listeners. I remember the CEO of my employer (a mutual fund company) writing to the employees via email the day after the Dow Jones average climbed 1000 points (the previous session had been a loss of roughly the same amount). He claimed that those bailing out were mistaken, because the long-term trend for stock markets has always been up. Several colleagues repeated his analysis. The Dow dropped another 20% after his email before starting to rise again. Again, the CEO may have been earnest, yet he was wrong. The lesson I take is this: I pay no attention to economists, government officials, journalists or business leaders predicting the direction of the economy or stock market.
Cause one: Wall Street greed. The descriptions of the ABS, CDO, CDS and synthetic CDO stated above confused me. I would expect most Americans to be similarly confused and even less interested. I can definitely see the value of a mortgage, because it accelerates economic activity. I can also see the value in selling a mortgage, because banks will be more willing to lend if they can buy risk protection. Beyond that I see a slippery slope into silliness. Does a synthetic CDO accelerate economic activity? Maybe, but try to prove it. And, if it does, by how much? Is that marginal improvement really worth the inevitable calamity that results when so many investors taking so much risk?
Cause two: sub-prime mortgage companies. The two names I remembered were Ameriquest and Countrywide, the former because of its television advertisements and the latter because it bought my mortgage from my local bank. Ameriquest and its founder, Ronald Arnall, fared poorly in this book. Ameriquest's business practices were reprehensible and likely illegal: think of the "stated-income" loan or, as it was called in the industry, the "liar's loan". The verdict on Countrywide was mixed. Its co-founder, Italian-American Angelo Mozilo, had two goals: 1) make the dream of home ownership a reality for those, like himself, who were not part of the economic mainstream, and 2) grow market share. He did not set out to loan money to people would not pay it back. But, his competitors like Ameriquest did, and growing market share while maintaining underwriting standards were incompatible under those competitive circumstances. Mozilo chose to enter the sub-prime field, too, but fooled himself and others until the forced sale to Bank of America.
Cause three: the ratings agencies. Moody's, Standard and Poor's and Fitch formerly earned revenue by selling their ratings to the bond-buying public. It was in their interest, therefore, that the ratings be accurate. In the 1970s Moody's changed its model by charging the bond seller itself for the rating. Despite the obvious potential conflict-of-interest, ratings remained by-and-large fair, if not accurate. The employees making the ratings did not change and still carried their duties faithfully. But in 2000 Moody's spun off its ratings business, granted stock options, and promoted a hard-charging Brian Clarkson to CEO. By 2007 a Moody's rating on a financial derivative bore little relation with reality.
Cause four: consumers. All mortgage applications have an applicant. Even though the book chronicled cases where unwitting potential homeowners were duped into signing applications that were untruthful, many consumers remained ignorant, perhaps intentionally so, about what they were promising to pay in exchange for a home loan (or, more frequently, cash-out refinance).
That being said, I am very much in favor of relief for homeowner's who are upside-down in their home and unable to pay their mortgage. For one, it is not in the national interest to have large numbers of people lose their homes. Two, the mortgage bankers and Wall Street have already taken their turn at the public trough; I cannot see any good reason to exclude the homeowners.
Cause five: insufficient regulation. The Federal Reserve, Securities and Exchange Commission ("SEC"), Treasury Department and Commodity Futures Trading Commission all had opportunities to regulate, to enforce laws already on the books or assume policy positions that would have subjected the mortgage companies and Wall Street to greater scrutiny. Congress, being lobbied heavily by Wall Street, by mortgage companies, and Fannie Mae and Freddie Mac, did not push the agencies. Alan Greenspan felt the market could do no wrong and saw government regulation as evil. Derivatives were bought and sold like securities. Perhaps the SEC would have lost in a bid to regulate them, but it did not even try. One irony is that some Wall Street executives requested regulation. They recognized that the lack of regulation fueled a race to the bottom with excessive risk-taking because to that point risk-taking meant bigger profits and bonuses. Regulation may have yielded a collective, if silent, sigh of relief.
It was popular in 2008 and 2009 to criticize Fannie Mae in the aftermath of the meltdown for pushing home ownership even in cases where the homeowner was not credit-worthy. In truth, Fannie Mae was late to the party; it behaved much like Countrywide, vaguely uneasy with deteriorating standards but, as a for-profit corporation, unwilling to cede market share. Fannie Mae was no more or less at fault than the Wall Street banks who were willing to fund these toxic mortgages and lie to themselves and the public about them.
And what, technically, happened? As 2006 rolled into 2007 and 2008 Goldman Sachs and others started questioning the value of these MBSs and the other instruments and derivatives based on them. Homeowner defaults were rising. Collateral was demanded; because of leverage, a lot of collateral was demanded, amounts in the billions of dollars. Some large Wall Street firms did not have the necessary cash at hand. In some cases the Treasury Department, led by former Goldman Sachs head Henry "Hank" Paulson, cajoled a buyer to take control of the failing firm (Bank of America bought Merrill Lynch). In some cases the Treasury Department could not or would not find a buyer (Lehman Brothers declared bankruptcy). And in some cases the Treasury Department, backed by $700 billion in TARP funds, was the buyer (AIG, Freddie Mac and Fannie Mae).
Before I describe the book I need to, for my benefit and the benefit of the reader, define some terms. The book describes them, too, but not sufficiently (the book is otherwise excellent).
First, debt. A debt is a promise to pay. Think IOU. A bank account is a debt: you give your money to bank and the bank promises to pay you back, with interest. Most of us will not think for a moment that the bank will not pay us back, now that we live in the days of the FDIC. A credit card is debt, too, as you promise to pay the bank for the charges you accrue on your card.
Those debts are all unsecured, meaning there is nothing behind the promise to pay other than the good intentions of the borrower and the general legal infrastructure we have for collecting debts. If the borrower declares bankruptcy the lender's collection will range between 100% and 0%, depending on what other debts the borrower has.
Other debts are secured. The most common example is the home mortgage. The bank loans money to the purchaser and takes a security interest in the property and house. The house in this case is collateral. The security interest means, among other things:
1) The occupant (owner) of the house cannot sell it without first paying off the debt.
2) If the occupant of the house does not pay the debt the holder of the security interest can force a sale (foreclosure) and use the proceeds from that sale to collect the money owed. The remainder, if any, goes to debtor.
A car loan is another example of secured debt, with the car serving as collateral.
All other things being equal, a secured debt will carry a lower interest rate reflecting the lower risk to the lender. A lender's interest rate can be influenced by:
1) The cost of money. How much interest the lender must pay to acquire money to loan.
2) Risk. How likely is it the borrower will repay, or how likely is the borrower to default? Perversely, the poor, those least likely to repay but also in most need to borrow, pay higher interest.
3) Supply and demand. This "law" applies to most goods and services.
A debt backed by collateral usually carries lower risk than an unsecured debt and thus a lower interest rate.
A "security" is a financial instrument and is commonly bought and sold on exchanges. They come in two basic flavors, equity and debt. A share of stock in a public company, such as Google, is an example of equity. It represents fractional ownership. In the case of Google, with 320 million shares outstanding, a share of stock represents a very, very small portion of the ownership. Indeed, few people purchase shares of a public company with the goal of imposing their will; rather, they wish to share in the entity's future financial success. The success will be reflected in future, higher prices for that share of stock, which the shareholder can later sell (at a profit). Theoretically, the future price is unlimited. On the other hand, the entity could fall upon hard times, or bankruptcy, in which case the price of the share will decline, potentially to zero.
This book concerned the other flavor, debt, and I will write no more about equities. And, the authors considered mostly secured debt, so all discussion below about debts refers to secured debts.
Debt typically represents a more constrained future. The debt will pay a certain interest rate, say 5%, and if the entity performs spectacularly the lender collects 5% and if the entity performs poorly the lender collects 5%. If the entity performs especially poorly the lender may collect less than 5%, and in more spectacular cases, may lose money. This book concerned those spectacular cases, and that word describes the amounts lost, the amounts collected by the "Devils", and the amounts ponied up by U.S. taxpayers and others.
Debts can be bought and sold. Person X may borrow money from person Y. Person Y is said to "own" the debt: the right to collect the principal amount borrowed and the right to collect the interest. Person Y can sell the debt to person Z. Z is now entitled to collect the principal and interest. The sale price will reflect the interest rate and borrower ability to repay. Note that the borrower's ability to repay may be different than at the time the loan closed due to individual forces, such as job loss, and macroeconomic forces, such as a local or national drop in house prices.
An investor can purchase many debts and thus be entitled to collect the principal and interest from many debtors. The value of those debts will be based on the underlying interest rates and the underlying likelihood-of-payment from the various debtors.
Z can bundle those debts into a package and sell the package to yet another entity. As mentioned above, for purposes of this article all debts are secured by assets; a package of these debts is called an asset-backed security ("ABS"). If all of the assets backing the security are in the form of mortgages then the security is called a mortgage-backed security ("MBS"). The buying, selling, insuring and pricing of these debts featured prominently in the book. In truth, some of the debt packages included unsecured debts, such as student loans, but the vast majority of the value of these packages were home mortgages.
Once a package of debts is bundled it can be separated, for example, by risk. These separate pieces are called tranches. Commonly a package is separated into three tranches, in order of least to most risk of default, triple-A, mezzanine and junk. The tranches are sometimes called senior, junior tranches and (confusingly) equity. In practice, the higher-risk tranches must pay more interest than the lower-risk tranches to attract investors.
Triple-A is the highest of the ratings assigned by one of the three Nationally Recognized Statistical Ratings Organizations (NRSROs). The United States government, some other governments, and some large organizations enjoy a AAA rating; in other words, the NRSROs believe that the U.S. government is highly likely to pay its debts. (Given that its debts are U.S.-dollar-denominated, and that the U.S. government can print almost as many dollars as it likes, this rating makes sense.)
One commonly accepted principal of investing is that diversity decreases risk. For example, buying the mortgage of a single homeowner can be considered risky because the buyer has put all of its "eggs in one basket"). Investing in several mortgages, by contrast, might be considered less risky because the investor is not susceptible to the risk of a single failed debtor. Investing in several mortgages, each from different areas of the country, might be considered still less risky, and so on. In fact, combining the second and third tranches of multiple asset-backed securities could be less risky than investing in a single second or third tranche of a single ABS, so less risky that a NRSRO might be willing to bestow a triple-A rating upon it. This fact resulted in the CDO: collaterized debt obligation, a collection of tranches from multiple ABSs, that the seller can tout as being triple-A rated. This may sound suspicious, and it is, being partially responsible for the financial meltdown in the late 2000s.
This slicing-and-dicing can be further extended. These CDOs themselves can be separated into tranches, and the tranches from multiple CDOs can be combined into aggregates called CDOs squared.
The purchaser of an ABS (or CDO,or CDO squared) is taking some risk: the underlying debtors may not pay their debts, and thus the actual interest rate paid by the ABS may be less than promised (or even negative). Some of these purchasers want to limit their risk, much as the owner of an automobile or house might want to obtain auto or home insurance to insure the risks to those assets. And, just as there are market players (named Nationwide, Farmers, etc.) willing to take auto or home risk in exchange for money, some market players are willing accept money in exchange for the risk that an ABS or CDO will not pay the interest it promises to pay. Insurance on an ABS is called a credit default swap ("CDS"). The insurer (seller of a credit default swap) must pay the difference between what the ABS has promised to pay and what it actually pays. In practice, when a credit event such as repudiation or a missed payment occurs, the holder of the insurance gives the ABS to the insurer and the insurer pays the holder the original, full value of the ABS.
Stock investors can go "long" or "short". Long is more typical: purchase a share now and hope the price increases. For example, the investor buys a one share of company X at the market price of $10. Two days later the market price is $11; the investor sells that share and pockets $1. The short investor, on the other hand, hopes for the price to go down. The short investor borrows a share today from Y and immediately sells it to Z, collecting the current market price of $10. Two days later the market price is $9. The investor uses $9 (of the $10 the investor has already collected) buy that a share and give it back to Y, leaving a profit of $1. In reality, most short trades do not involve an actual movement of the share; the parties wait to see the resulting price and one party pays the other depending on whether the new price is higher or lower than the old. It seems little different than gambling: money wagered on a somewhat unpredictable event, the price of a share of stock.
Insurance laws in every state prevent person X from buying life insurance on person Y without Y's consent. There is no such restriction on CDS insurance. If an investor believes an ABS is likely to experience a credit event that investor will want to purchase a CDS; such investors are called "short" because they are betting on an impairment to debt underlying the ABS much like a short stock investor is betting on the impairment to the price of a stock. Investors who are willing to sell a CDS are "long": they view the ABSs likelihood to pay as good, or improving, or at least better than the short buyer does.
A typical ABS might be worth millions of dollars because it aggregates many underlying debts. A typical CDS might involve yearly payments of several thousand dollars by the short investor. The short investor might worry about the long investor's ability to pay millions of dollars in the event of a credit event and so the credit default swap instrument may require the long investor to provide collateral. Such collateral might increase or decrease based on indicators that the value of the ABS has decreased or increased, respectively.
A synthetic CDO is to a CDS what an ABS is to a mortgage. That is, whereas an ABS is a collection of loans cut into tranches of differing risk levels, a synthetic CDO is a collection of CDSs cut into tranches of differing risk levels. A synthetic CDO is also an example of a derivative instrument: a security whose value derives from something else.
The buying a selling of CDOs squared and synthetic CDOs are examples of leverage. What is leverage? Consider the original stock investor who believes stock X is undervalued. The investor has $10 to work with. The current price of stock X is $10. The investor purchases a share for $10 and sells when the price increases to $11, yielding a $1 profit. But this investor is really, really sure the price is going up and wishes it had $20 to invest. The investor finds someone willing to loan $10, purchases two shares for $20, later sells the two shares for $22, repays the $10 loan, and now shows a $2 profit. The leverage allowed the investor to double its profits. This investor went long, but could have just as easily gone short. Essentially, if stock market investing is a form of gambling, leverage is a form of borrowing to support gambling. In the case above the share price could have fallen a dollar; the investor would have lost $2. The investor started with $10, so the lender in this case essentially had $10 of collateral to support a $2 loss: not so risky. But, if the stock price had gone from $10 to $4 the investor would have lost two times $6, or $12, more than the investor started with. In this case the lender may not have been able to collect the entire debt.
With CDOs squared and synthetic CDOs the short and long investors need have no relationship with the underlying lenders and debtors. And, the same loan can be referenced in a single synthetic CDO (or CDO squared) multiple times, meaning that the loss or gain of $1 in the value of that loan could be reflected in a loss or gain of $2 or $10 or $50 in the derivative instrument. The long synthetic CDO investors, the ones who are collecting the premiums, could end up owing many times the original obligation of a CDS, which itself is typically in the millions of dollars.
Now, the book. The financial crisis of 2007/2008 was caused by:
1) Greed.
1a) Wall Street players were greedy, though they are always greedy.
1b) Sub-prime mortgage companies.
1c) Ratings agencies.
1d) Consumers.
2) Insufficient regulation.
Before I read the book I remembered only September 2008. Indeed, that is the time most Americans started suffering. But there were failures in 2007 and early 2008 as well: the bankruptcy of two Bear Stearns hedge funds, American Home Mortgage Investment Corporation's bankruptcy, J.P. Morgan's fire-sale purchase of Bear Stearns, and Bank of America's fire-sale purchase of Countrywide. All stemmed from the same lack of liquidity in the market for ABSs and their derivatives that so impacted the market in September 2008. In the years before this Wall Street and the U.S. government calmly explained that the market troubles were temporary and corrective in nature. According to the book's authors these statements may not have been lies in the sense that the speakers were fooling themselves as much as they were fooling the listeners. I remember the CEO of my employer (a mutual fund company) writing to the employees via email the day after the Dow Jones average climbed 1000 points (the previous session had been a loss of roughly the same amount). He claimed that those bailing out were mistaken, because the long-term trend for stock markets has always been up. Several colleagues repeated his analysis. The Dow dropped another 20% after his email before starting to rise again. Again, the CEO may have been earnest, yet he was wrong. The lesson I take is this: I pay no attention to economists, government officials, journalists or business leaders predicting the direction of the economy or stock market.
Cause one: Wall Street greed. The descriptions of the ABS, CDO, CDS and synthetic CDO stated above confused me. I would expect most Americans to be similarly confused and even less interested. I can definitely see the value of a mortgage, because it accelerates economic activity. I can also see the value in selling a mortgage, because banks will be more willing to lend if they can buy risk protection. Beyond that I see a slippery slope into silliness. Does a synthetic CDO accelerate economic activity? Maybe, but try to prove it. And, if it does, by how much? Is that marginal improvement really worth the inevitable calamity that results when so many investors taking so much risk?
Cause two: sub-prime mortgage companies. The two names I remembered were Ameriquest and Countrywide, the former because of its television advertisements and the latter because it bought my mortgage from my local bank. Ameriquest and its founder, Ronald Arnall, fared poorly in this book. Ameriquest's business practices were reprehensible and likely illegal: think of the "stated-income" loan or, as it was called in the industry, the "liar's loan". The verdict on Countrywide was mixed. Its co-founder, Italian-American Angelo Mozilo, had two goals: 1) make the dream of home ownership a reality for those, like himself, who were not part of the economic mainstream, and 2) grow market share. He did not set out to loan money to people would not pay it back. But, his competitors like Ameriquest did, and growing market share while maintaining underwriting standards were incompatible under those competitive circumstances. Mozilo chose to enter the sub-prime field, too, but fooled himself and others until the forced sale to Bank of America.
Cause three: the ratings agencies. Moody's, Standard and Poor's and Fitch formerly earned revenue by selling their ratings to the bond-buying public. It was in their interest, therefore, that the ratings be accurate. In the 1970s Moody's changed its model by charging the bond seller itself for the rating. Despite the obvious potential conflict-of-interest, ratings remained by-and-large fair, if not accurate. The employees making the ratings did not change and still carried their duties faithfully. But in 2000 Moody's spun off its ratings business, granted stock options, and promoted a hard-charging Brian Clarkson to CEO. By 2007 a Moody's rating on a financial derivative bore little relation with reality.
Cause four: consumers. All mortgage applications have an applicant. Even though the book chronicled cases where unwitting potential homeowners were duped into signing applications that were untruthful, many consumers remained ignorant, perhaps intentionally so, about what they were promising to pay in exchange for a home loan (or, more frequently, cash-out refinance).
That being said, I am very much in favor of relief for homeowner's who are upside-down in their home and unable to pay their mortgage. For one, it is not in the national interest to have large numbers of people lose their homes. Two, the mortgage bankers and Wall Street have already taken their turn at the public trough; I cannot see any good reason to exclude the homeowners.
Cause five: insufficient regulation. The Federal Reserve, Securities and Exchange Commission ("SEC"), Treasury Department and Commodity Futures Trading Commission all had opportunities to regulate, to enforce laws already on the books or assume policy positions that would have subjected the mortgage companies and Wall Street to greater scrutiny. Congress, being lobbied heavily by Wall Street, by mortgage companies, and Fannie Mae and Freddie Mac, did not push the agencies. Alan Greenspan felt the market could do no wrong and saw government regulation as evil. Derivatives were bought and sold like securities. Perhaps the SEC would have lost in a bid to regulate them, but it did not even try. One irony is that some Wall Street executives requested regulation. They recognized that the lack of regulation fueled a race to the bottom with excessive risk-taking because to that point risk-taking meant bigger profits and bonuses. Regulation may have yielded a collective, if silent, sigh of relief.
It was popular in 2008 and 2009 to criticize Fannie Mae in the aftermath of the meltdown for pushing home ownership even in cases where the homeowner was not credit-worthy. In truth, Fannie Mae was late to the party; it behaved much like Countrywide, vaguely uneasy with deteriorating standards but, as a for-profit corporation, unwilling to cede market share. Fannie Mae was no more or less at fault than the Wall Street banks who were willing to fund these toxic mortgages and lie to themselves and the public about them.
And what, technically, happened? As 2006 rolled into 2007 and 2008 Goldman Sachs and others started questioning the value of these MBSs and the other instruments and derivatives based on them. Homeowner defaults were rising. Collateral was demanded; because of leverage, a lot of collateral was demanded, amounts in the billions of dollars. Some large Wall Street firms did not have the necessary cash at hand. In some cases the Treasury Department, led by former Goldman Sachs head Henry "Hank" Paulson, cajoled a buyer to take control of the failing firm (Bank of America bought Merrill Lynch). In some cases the Treasury Department could not or would not find a buyer (Lehman Brothers declared bankruptcy). And in some cases the Treasury Department, backed by $700 billion in TARP funds, was the buyer (AIG, Freddie Mac and Fannie Mae).
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