FINANCIALESE SIMPLIFIED

 

Financialese Simplified

BLOGGER:  ARIN GOLDMAN

I’ve noticed that many people are having a hard time keeping up with a lot of what’s going on these days in the financial world.  Even the language seems foreign. Credit Derivatives, mark-to-market accounting, securitization, up-tick rules, what does all this stuff mean?  Why don’t those banks just hold on to mortgages the way they used to?  What’s a muni bond anyway?  I’ve spent most of my adult life immersed in banking and finance, though I am not sure it is safe to admit that anymore, and I frequently find myself baffled by what I hear on CNBC, Fox and Bloomberg. Sometimes that’s because the commentators are even more confused than I am but other times its because the concepts they are reporting are just so arcane.  So here’s my first attempt at simplifying some of the terms and concepts being bandied about these days.  I’ll address more in future blogs.  I am only skimming the surface here and am more of a generalist than an expert so I caution all that my explanations are basic, still I hope they help and at the very least I will try hard to avoid using financialese as much as I can.  If there’s anything else that you’d like me to take a stab at translating please post your question to the comment section and if I have a clue I’ll try to respond.     

Why don’t banks hold onto mortgages anymore?

Banks haven’t held mortgages to maturity for a long time.  In fact, previous banking crises have been caused by financial institutions going long low yielding mortgages in the face of rising interest rates. Since low yielding debt decreases in value when interest rates rise, mortgage lenders who held onto their portfolios sustained some huge losses.   Securitization initially came about to help  banks sell their mortgage portfolios, freeing up funds for additional mortgage loans.  A good deal of the problem in the current crisis is related to credit quality rather than interest rate volatility.  Many mortgages were made to borrowers with weak credit histories or previously solid borrowers who were stretching themselves too far.  Many of these borrowers either couldn’t or never intended to repay their loans.  At the same time the value of the property securing some of these mortgages was either overstated on day one and/or assumptions that increasing property values would bail out weak credits proved ridiculously optimistic. Further complicating all this, there was opportunity for unscrupulous behavior all the way along the line in the mortgage origination process as even legitimate borrowers, mortgage brokers, appraisers, securities firms and rating agencies all pressed the edges  of their collective envelopes. When the real estate bubble burst everything came crashing down at once. 

Just what is this securitization thing anyway?

In the old days, when a bank or other financial institution wanted to sell a mortgage loan they bundled it with other loans and sold thousands of them together as a package.  Overtime, the banks got more sophisticated and realized that they could deposit these bundles of mortgage loans into some type of trust instrument, hire one firm to service the borrowers and sell the collective cashflows.  Although the action of an individual homebuyer is hard to predict the collective behavior of thousands of borrowers is fairly predictable.  Bankers were able to allocate these predictable payment streams  to debt instruments with different maturities and/or different credit ratings.  They then sold these new securities to institutional buyers (insurance companies, pension funds, money managers, etc) with distinct credit and maturity preferences.  Since these securitized transactions maximized the value of the pool of loans, securitization became the favored way for banks to sell their mortgage loans.  After a few years this securitization technique was applied to other types of loans including car loans, corporate loans and just about any loan out there.  Anything that had a reasonably predictable income stream became a possible securitization candidate.  Securitization remains a useful tool. The problem comes about when the underlying loans don’t behave as predicted because of unexpected delinquencies and defaults or in the worst case, because the loans shouldn’t have been made in the first place.     

What’s the story with the uptick rule?

When you sell stock you don’t own you are “shorting” the stock.  Although shorting can be risky it is a legitimate financial tool.  For a long time rules governing the shorting of stocks required that a short sale could only be completed following a trade that had been completed at a price higher than the  the one that had preceded it – in other words  you couldn’t sell stock short unless the price of the stock was moving up or was reasonably stable. I am leaving out some details about the actual rule, but hopefully have gotten the concept across.  The uptick rule had been put into effect after the market crash of the twenties in an effort to stabilize the market and prevent bear runs on specific stocks.  Whether or not it worked is debatable but it stood until a few years ago when it was eliminated.  The SEC is now considering reinstating the uptick rule because many people believe that the absence of the rule accelerated the demise of companies such as Bear Stearns and Lehman Brothers last year.  Others argue that the uptick rule won’t do much given current technology and volumes.        

Mark-to-Market, not to be confused with a shopping spree with your friend Mark.

This is a concept that’s gotten a lot of press lately.  Rules governing how banks value their financial positions were rewritten a few years ago by the accounting standards guys.  Basically, rule changes required banks to adjust their financial statements to reflect the market value of all their securities positions, even the ones that weren’t in trading accounts.  This sounds pretty straightforward.  If you buy some US Treasury securities for $100,000 and interest rates move so that you portfolio is now worth $95,000 why not show them on your books at the lower, more accurate value?  Well, when it comes to US Treasuries and other highly liquid securities, this is pretty easy because the securities trade all day and everyone knows what they are worth. But it gets harder and harder to value securities that are further down the liquidity and credit scale.  Corporate bonds are harder to precisely value than Treasuries. Mortgage securities are significantly more challenging with their mix of credit issues and funky payment characteristics and subordinate subprime mortgage backed securities are among the toughest to value and sell.  Not surprisingly, it gets even harder when everyone needs to dump their positions of those unusual securities at the same time.  Even though many of the illiquid securities are still generating significant cashflows, their market values have gotten so low that these cashflows may not be fairly valued.  The banks argue that given time and the return of some market stability many of these securities will regain a significant portion of their value.  The mark- to-market guys argue the value is the value dictated by the market, period.  Since a number of very smart hedge fund managers are anxious to have the opportunity to buy the so called toxic subprime paper at current “market” prices its fair to assume that the banks probably have a point.  These securities are probably undervalued at the current time; just how undervalued remains hard to assess.  Recent changes in mark-to-market accounting seem to be geared to finding a bit of a middle round.    

To find out about Arin, click here to read her bio. 

 

 

 

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Incentive Systems: The Mortgage Industry

Incentive Systems: The Mortgage Industry

BLOGGER: BEN PIERSON

 

“People respond to incentives in predictable ways.”

 

This is the first rule I was ever taught during my high school economics class and remains one of the most powerful I’ve ever learned.  I’m reminded of this rule often, in all contexts.  And, this applies to the mortgage industry.

In some sense, a cornerstone of our society is that we are all role players.  In the industrial revolution we discovered the value of specialization.  Instead of one person making each whole shoe by themselves, one person would cut the leather, another would hit the same nail in each time, and yet another would sew the same spot each time…  We rely on predictability; we rely on people fulfilling their role.  It’s up to us to understand what each person’s role is and how each person is predictable.   

So what does this have to do with mortgages, you ask?

Mortgages provide a good example of how the incentive system got screwy. People acted rationally, oversight was negligible and consequences became severe.  Mortgage brokers were paid based off how many mortgages they originated (‘sold’).  It made zero difference to their payout if any – or all – of the mortgages end up defaulting in two or three years.  The future risk would be the bank’s problem since the mortgage broker has already gotten paid and the mortgage now belonged to the bank.  Banks didn’t want this risk either (they were conscious to some extent of the risk in the mortgages they were selling), so would take all of these mortgages and resell them to, say, an Investment Bank (eg Lehman, Merrill, etc), who would then package the mortgages up and resell them again (eg. Mortgage Backed Securities and CDOs).  The individuals working at the mortgage broker, bank, and investment bank all get paid off revenue.  They all get paid at the point of sale, with little exposure to the future risks.

So to sum this up, you have a system where the people working at almost every layer are exposed to vast reward with finite risk.  And we now have terms such as the NINJA Loan (No Income, No Job, No Assets… no problem!) with the corresponding mortgage malpractice that has now come to light. 

To give an example to better explain this, like many others, if I am driving at 4am, the only car on the road, I will likely drive fast.  What keeps me from going very fast was the risk of getting caught.  The mortgage system and those working in the field aren’t any different.

The calls for tighter restrictions and regulations on banks and hedge funds are, for the most part, erroneous as fairly comprehensive restrictions and regulations already exist.  The problem is there’s little to no enforcement and the enforcement which exists is painfully inadequate.  I’ve only been on Wall Street for 8 years, but since the beginning I remember people making fun of how woefully inadequate the S.E.C. is.  In addition to the S.E.C., the Ratings Agencies (Standard & Poor’s, Moody’s, Fitch, etc…) were supposed to help regulate companies as well.  So, you’d think there was an adequate system in place to keep problems like we are in right now from happening.  Right?  Wrong.

Most people who played a part in all this mess – Mortgage Brokers, Banks, Investment Banks, and Ratings Agencies – were really acting as we should anticipate the would given the incentive structure involved with them.  Failings must be placed in a large part on then regulatory bodies like the SEC and Ratings Agencies who were set up explicitly to be outside of the ‘incentive system’.  One must also then throw blame on the government – and rely on them to fix this – for it would seem the problem grew from the innate nature of the structure.

Should you want to read more on the rating agencies’ role, here are two comprehensive (very detailed) articles:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajs7BqG4_X8I

http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=ah839IWTLP9s

Certainly this is a very complicated issue which has touched us all in some way.

What do you think?

 Leave a comment…

To find out about Ben, click here to read his bio.

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