Sorting out the current crisis plaguing the financial world is going to be harder than dubbing a Nicholas Cage movie into Cantonese (the guy never opens his mouth!), so I've tried to split it into three separate questions: how did it happen, how do we fix it, and how can Amstelboy profit off of it? (That's not just me being jealous and cynical, he actually called me to specifically ask my advice on squeezing the last bit of cash out of the people and institutions falling into ruin.) I will address each issue in a separate section, which will get shorter as I get bored and use up all my asset valuation humor. By the way, I know basically nothing about this topic, I just like to rant and find excuses to mention Nick Leeson, because I think it's funny he still acts like it's a tiresome imposition that people still think of him as The Boy Who Broke the Bank of England when he's moved on with his life, other than the odd movie deal where Ewan MacGregor can rehabilitate his image and leave out certain sordid details. (Was I the only one who wondered why his ex-wife was a flight attendant at the end of the movie? But I digress.)
As to how it happened, the short version is new tools for new fools playing a very old game. What's amazing is five years after Enron it still took so long for the mainstream financial media to start whispering the F word (psst, it's fraud). Please give the Street and the City credit, they knew a cash loan to a guy who lives under a bridge was a loser, they just didn't care. At the heights reached by the real estate market in the last few years, there really isn't enough oxygen for people to be making sensible decisions, and asset valuations could be based entirely on stupidity, as in "Is there somebody stupid enough to pay $1m for this? If not, is there somebody stupid enough to pay $950K?" Repeat ad nauseam, or ad venditio. The proof of this by the way is now that the cat's out of the bag about making boat loans to homeless people, nobody can figure out how to value those loans (except me, because I don't get fired if the answer is $0). Like a communion wafer is just bread until blessed by a priest, the value of those loans is drawn out of the ether by the presence of a stupid buyer. (Actually that example only works if you're Catholic, in Protestant churches the wafer is still bread.) That's why it's fraud, even for the people who were aware of it, they figured there would always be another rung of the pyramid to pass these things off to.
As to how anybody can possibly be that dumb in this day and age while still possessing the capital to sink into sub-prime lending, it's because every time we get a new tool, we magically figure it's all different now. Remember when P/E ratios didn't matter on the internet? This time there are collateralized debt obligations and many other tools I don't understand but feel qualified to speak about (if P/E ratios don't matter, neither does my lack of financial education), which make new things possible and old things easier. These are great tools that make it easier to diversify risk, increase liquidity, and raise capital, all of which are good things for the financial system... and annoyingly, all things that reduce returns. If you loan money to one person you have to limit your stake to what you can lose if they don't pay you back, and charge them enough to make it worth the risk of walking away with nothing. If you can 1000 people 0.1% of your capital and have 999 other investors pony up the other 99.9% of each loan, everything reverts to the mean and you can budget for the expected payback rate, with very little risk of walking away with nothing, so it's safer to put more money in. It's more liquid, since it's easier to sell a diverse package of loans than singing the praises of your particular debtors... while you're trying to dump their debts off on somebody else. The liquidity makes it easier to find institutions that want in, since it's easier for them to understand the fundamentals behind a slice of a big market than a small volatile pool of individual assets. More money was competing for suddenly safer assets, and this meant suddenly loaning money to people who pay their credit cards every month wasn't very lucrative.
Getting some higher return assets back into the portfolio required finding some new places to park money, and this could have meant opening new frontiers, but that was unlikely since there's a reason London, Ingulland is once again the world financial capital... London is throwing money into new markets while in the US companies only grow by mergers & acquisitions and the NYSE costs the US economy 10 billion annually by making it harder to raise capital and value assets through their archaic system of hysterically screaming men in ugly jackets who sweat too much throwing paper airplanes at each other to transfer billions of dollars. So instead they did what they did best, just more of it, in sillier and sillier ways. A little bit was logical, as new tools made it possible to make loans that would have been marginal before, moving the rates into reasonable territory, and this should have been another positive, for one thing expanding the class of low-income homeowners, with significant benefit to society.
But it wasn't enough, and all that extra cash had to go farther and farther out on a limb to find somebody to loan money to, into riskier and riskier loans. But they were safer than they would have been previously, right? Well, here's the thing about diversification as a risk management strategy: the Law of Large Numbers (the second most obvious thing I learned in economics**) brings returns closer to the mean, and sometimes that's not so good for high risks... ever been to a casino? Their entire return revolves around the diversification strategy, while the gamblers depend on volatility: the casino makes %2, and the more bets you make, the more likely you lose exactly 2%... actually given the finite resources of gamblers, the return on large numbers of bets is even less than -2%. If you loan money to a heroin addict, there's a 1 in a 1000 chance he might pay you back with interest, but if you loan money to 1,000 heroin addicts, you're statistically guaranteed to lose so much of your money it's probably not even worth bothering to track down the one who might pay you (I'm assuming collections from heroin addicts incur high transaction costs like getting stuck with an HIV infected needle). There are people who pursue only high risks and are protected by diversifying their high risks, such as venture capitalists, but here's a critical difference: there's no upper limit to what a VC project can return, so with enough fingers in enough pies, they find a single project that pays for all the failures. Somebody could pay you %30 interest on their mortgage forever and never pay off their loan or ever default, but I seriously $%#&'ing doubt it.
Nobody could be so starry-eyed as to not realize that, but that's the liquidity aspect of CDO's comes in. It's a lot easier to hide the quality of your underlying assets when every problem is only a tiny fraction of the whole. "Sure, one of these guys who applied for a home equity loan lived in a cardboard box, but your exposure to his default is low. Oh, um, yeah, the guy who scrawled I WILL KILL YOU when we asked for a signature is also a high risk, but that's only two guys, and Mr. I WILL KILL YOU also qualified for a boat loan and a car loan, so that's better. It just is. Quit asking so many questions." This gets even sillier in the case of unique securitized operating assets that can't be valued until they're sold... how much is the name Dunkin' Donuts worth, or the royalties on the Kinks song HP is using for printer commercials? How much are FedEx's assets at the Memphis airport worth, when owned by somebody else? With the expectation of flipping these assets to somebody else, volume became the primary measure of performance, as the banks with the ability to directly make loans flipped the loans of the people trying to flip the real estate, all dipping their beaks in the endless stream of flipping revenue. The underlying mechanism shouldn't be that shocking, since this is what the S&L barons did in the 80's: buy worthless stuff (like your wife's paintings), tell everybody it's valuable, and then when something happens, the company needs money and you can't sell your wife's paintings, run for the border with the money your wife earned as an artist, while your accountant is hospitalized for shitting out his pancreas.
I mentioned Nick Leeson earlier, because one day he sent a fax in to his bosses to tell them they illegally held positions on the Nikkei leaving them with obligations of nearly 300 million pounds as he beat a path out of town. Supposedly it ballooned to 700 million because the directors didn't know what the hell he was talking about and the market figured it out before they did, until ING stepped in and bought the whole bank for a pound and hopefully gave them all a one way ticket to Cornwall. It's hard to believe that grown men could sit in a room with Nick Leeson and believe he had a secret client who in the wake of an earthquake was still so exuberant about the Nikkei he bet over a billion US taking long positions against the rest of the world. And it's hard to believe that bankers across the world all collectively forgot that broke-ass people with no income and not a cent to their name probably got that way for a reason, and are also conveniently judgment proof... nobody forgot, they just ran out of suckers. What do you do if a homeless guy doesn't pay back his boat loan, take his cardboard box away and securitize that?
*-Larry Wilmore's sub-prime lending analysis on The Daily Show was hilarious, and I'll shamelessly steal lines from it if necessary
**-The single most obvious thing an economics professor ever told me with a straight face was the First Law of Financial Economics: more money is better than less money. That and the French PhD candidate who humored me by adding more and more extraneous data to problems at my request figuring once I actually solved the problem I'd realize how pointless all the extra information I'd asked for really was. "'Ere is zee extra rhope, avez vous 'ung yourself weeth it yet?"
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