Yet another alert reader just sent me a link to this extremely
humorous blog. It’s not recent, but it’s silly enough that it’s worth pointing
out even now. I’m not one hundred percent sure that this isn’t a parody. Looking at
the blog as a whole, I think it’s serious. Pathetic, but serious.

According to scientists, The French / Eurotrash “metric” system is in a state of crisis today, as scientists discovered that the weight of the “kilogram” is flip-flopping faster than John McCain at an episcopalian rally.

The Kilo – a unit with an identity crisis: This is one of the approximately 30 standard kilograms stored in a French castle. The polished metallic pellet a the center of this contraption is made of an alloy of precious metals, provided at government expense. Only in Europe would government subsidize such folly!

Since Europe converted to the metric system a few years back, this could have a grave impact on that continent’s faltering economy. Imagine a situation where customers wishing to buy some meat, or fill their car with gas literally have no idea how much their goods will cost, simply because nobody knows the exact definition of a weight.

Jesus, the humble carpenter no doubt used a ruler to measure his wood every day, however the Bible clearly states that he had no need of the metric system.

How much simpler life would be if we only adopted the standard units of weights and measures mentioned in the King James Bible? Biblical measures are authorized by God, and like God are not tied down to fickle matter. This is yet another example of how Science only really makes sense when it is rooted in the Bible.

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Look folks, I don’t want to become an economics blogger! Stop sending me economics questions. I hate to disappoint my readers and not answer their questions, but this economics stuff is almost terminally dull to me.

The mortgage posts have gotten an insane amount of traffic, which has in turn brought in a huge number of questions. Most of them are about details of the whole mortgage situation – and honestly, I can’t answer those. I don’t know the details, only the basics, and I can’t explain what I don’t know.

On the other hand, a lot of people have used my down-to-earth explanation of the mortgages as
a springboard to ask for a similar explanation of another issue that’s been getting a lot of attention in America – insurance. Why is health insurance such a big problem?

I’m going to focus specifically on the insurance part. There are plenty of things wrong with the
American medical care system. But I’m going to focus specifically on how insurance works, and
how simple min/max calculations led to the current situation.

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I’ve received an amazing number of requests in the short period of time since my last post to
explain “Tranching”. I mentioned it off-handedly, but a lot of people have heard about its role in the
whole sub-prime mess, and wanted to know just what it means. I don’t particularly like writing
about economics; it’s just not my bag. But enough people are asking that I feel like I need to answer the question. But this is it folks – no more of this nonsense after today! There are plenty of other people writing about this, who know more about it, and who are more interested in it, than I am.

It’s also a relatively simple idea. You’ve got a bundle made up of, say, 100 loans. You want
to sell at least part of that bundle as a super-safe rated investment. But because it’s formed from
risky loans, you know that at least some of them are likely to default.

So what you do is divide it into tiers called tranches. Suppose you’ve got 5 tiers – levels 1
through 5, where 5 is the top tier, and five is the lowest. Each tier covers a part of the bundle. So you might sell 20% of each tier. When the loans are repaid, the way that it works is that tier 1 is repaid first. When tier 1 is fully repaid, then you start paying tier 2, and so on. You can think of it like an overflowing cascade: repayments go to tier one; when it’s full, the overflow goes to tier 2; when that’s full, the overflow goes to tier 3, and so on. So if anyone doesn’t repay the money,
the people holding the lowest tier, T5, lose everything before T4 loses anything, and so on up the stack.

Let’s look at an example. Suppose you sell $100 million worth of loans. You divide it into
5 tranches. So you sell $200,000 of the value of the loans as tier 1, $200,000 as tier 2, etc.

1. During the first year of the loans, $100,000 is expected to be repaid, and $100,000 is
   repaid. Each tier gets $20,000.
2. During the second year, $100,000 is expected to be repaid, but repayment falls short. Only
   $90,000 is repaid. Tiers one, two, three, and four each get their $20,000; tier 4 takes
   the loss, and only gets $10,000.
3. During the third year, things get worse – only $50,000 gets repaid. Tier one and two each
   still get $20,000. Tier three loses half of its expected payment, collecting $10,000. Tiers
   three and four get nothing.

Tranching is a good idea. Once again, it’s a good way of dividing risk. Anyone who invests in risky
loans is taking a chance, but tranching let you divide the chances up, so that people who want safety
can buy the top tranches, get less of a profit, but know that they’re not going to get screwed unless
things really go seriously bad; people who are willing to take their chances in the lower tranches know
that they’re taking a significant risk, but they can potentially make a lot more money.

The key, though, is dividing into tranches properly. If, as in the example above, you had five tranches, each taking up 20% of the pie, then the top tranch would be pretty safe: you’d have to lose 80% of the value of the loans before that tranch lost anything – and in mortgage loans, even
shitty ones, losing 80% of the value would be quite extraordinary.

But that’s not how banks set things up. Remember that you’ve got investors practically begging to
get their grubby little paws onto these high-return, low-risk bonds. But it’s really only the upper tranch that people wanted. The lower tranches – especially the lowest – were hard to get rid of. So, what the banks did is, once again, screw around with things. Some bundles of shit loans were divided into tranches where 80% of the value of the loans were sold as
tip-top ultra-safe investments. That means that if a package of crappy high-risk loans loses 20% through
loan default and foreclosure that the principal of the ultra-safe investments are going to be
lost. That’s not what any sane person considers “ultra-safe”.

And then, they took the bottom tranches, and re-bundled them. Take the bottom tranch from a hundred different packages of shit loans, bundle it into a new set of bonds, and re-tranch it. Then sell the top 80% of that as the top tranch of a bundle. And so on. In many cases, the investors have no clue how many levels of re-bundling are going on to create their top-tranch low-risk bond. And you’ve got all sorts of people who thought they were buying conservative investments who are now stuck with their money invested in bundles of low-tranch shit loans.

Reading the news lately, I’ve come across an amazing example of how ubiquitous bad math can be used. Most of you have probably heard about what’s been called “the sub-prime crisis”. Despite a lot of media hand-wringing about how complicated it all is, the sub-prime crisis is really a very simple phenomenon: basically, you’ve got a lot of banks that have loaned out money without worrying about whether or not it could get paid back, and now those loans aren’t getting paid back, which is causing all sorts of grief to people who invested in them.

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