Subprime Slideshow

The subprime mess seems to be sort of a mixed example for libertarians. On the one hand, bad stuff happened in an unregulated industry because buyer weren't wary enough - this is evidence against libertarian claims that investors can take care of themselves. And the AAA rating on toxic waste is evidence against the ability of private ratings agencies to give accurate ratings for reptuational reasons. On the other hand, the bad stuff happened partly because buyers didn't think about incentives and moral hazard - some of the principles which makes us skeptical of regulatory solutions. Those who issued these loans didn't service them - of course they will tend to overstate ability to pay. The bond rating agencies get paid (as I understand it) by bond issuers, not investors, so of course they're going to tend to overstate bond quality.

But that's not what this post is about. This post is mean to direct you to a subprime slideshow, some nice gallows humor illustrating moral hazard with this real-life example.

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Private rating agencies

You do know it's a legal oligopoly, right ?

Too accurate

That "primer" is so true. I was laughing my ass off. I was at my sister in laws birthday party back before the subprime crisis talking to both an accountant and a guy who works rating bonds. Both the accountant and I were trying to explain to the other guy on why the economy is going into the shit hole. He seemed troubled by our arguments and asked our advice on how they were rating these bonds.

He went through an entire explanation on how they divide up the mortgage into good and bad pieces, hell maybe even in 7 tiers, and that there was no way the good pieces weren't going to be able to collect and thus he rated them AAA. I had a few drinks at the time but his argument was that the "good" bonds had first dibs on the "collateral", or what's known as "the home", and represented 70% of the value of the home. No way in his mind they weren't going to be able to collect on that.

I told him that some pretty smart people were thinking that housing prices could fall 50% and especially on the margin. The accountant was arguing the same thing. He left the conversation with a worried look after an hour and a half but he spent the entire time trying to justify his take and never once conceded that what he was doing was shady.

The guy hadn't factored in liquidity problems, the fact that the homes in different neighborhoods are really different goods (when the bottom falls out who's going to buy in those bad neighborhoods?), that there will be a rush for the door as things go down, that the government 'must do something' in such a crisis and that might include letting people live in homes without paying mortgages, etc.

I live in a planet full of idiots.

Too inaccurate

This things tells maybe 10% of the story, it tells it accurately but the omissions are really problematic. Curiously, every problem related to regulation is ommited.

What about the fact that most of the CDO's where sitting in SIV financed by short term commercial paper? Now that spelled disaster when the yield curve inverted but it won't be explained in two minutes with stick-figures.



The first few slides are

The first few slides are completely missing out the number one explanation for the subprime crisis: the Community Reinvestment Act.The banks handed out so many risky variable-rate credits not because they thought they could get away with it, but because they were cattle-prodded into it by the federal government.

I wouldn't call it "number

I wouldn't call it "number one"... after all it doesn't explain by itself the mispricing. It's mostly a combination of factor, cheap money pumped into a housing bubble, the SEC triopoly on S&P, Moodies and Fitch (by the way they are extending the oligopoly, times to open a rating agency and get $$), luddic fallacy by quants (government is off the hook for this one), etc.