How Mortgages Turned into a Trillion Dollar Disaster

Ok, another batch of questions have come in, all variants on
the same theme.

The question is, if mortgages are at the root of the current economic disaster, how can it possibly result in close to a trillion dollars worth of losses?

It definitely seems strange, on two different levels. On an absolute scale, it’s hard to see how mortgage losses could add up to a trillion dollars. And on a relative scale, it’s hard to see how the foreclosures could really overwhelm the lenders when even an extremely high foreclosure rate represents a fairly modest loss considered as a percentage.

Let’s look at the relative scale first. If we use extremely
pessimistic numbers, the loss looks bad, but not excessively so.
Take a pool of 100 mortgages for $100,000 each. We’re looking at
total loans of $10,000,000. If 20% fail, then ignoring any interest
earned on the others, we’re looking at a loss of $2,000,000. But
those houses aren’t worthless. Imagine that they’ve lost 40% of
their value – which would be very surprising. Then we’re able to
collect, in some form, about 60% of that $2,000,000 – or about
$1,200,000. So we’re looking at a loss of around 12%. And that 12%
loss is assuming absolutely astonishing rates of default, and
record-setting losses of home values, in excess of what we’ve
really seen. So how is it that losses that realistically can’t be
more than 10% can somehow blow up into this thing that’s
potentially taking down the entire economy?

And what about the absolute scale? The figures I can find
in a Google search suggest that the total value of all outstanding mortgages in the US is around ten trillion dollars. For mortgage failures to represent a ten trillion dollar loss, that would mean that one in ten mortgages is foreclosing – and that’s assuming
that a foreclosure represents a total loss of every penny of the loan. But the actual foreclosure rate – a record high – is barely more than 2%! That doesn’t make sense.

So how can mortgage failures be at the root of this disaster, where a $700 billion bailout might not be enough to prevent
financial ruin?

There’s a couple of answers.

First, it’s not just mortgages. It’s credit of all kinds. People were loaning money not just for mortgages, but for damned near anything you can imagine. Want to buy stock? The banks would loan you money. Want to build a bigger baseball stadium? The banks would loan you money. Want to buy a shitload of lottery tickets? The banks would loan you money. There’s a lot of loans
in this mess beyond just the mortgages.

That’s important, and it’s a big part of the mess, but it’s not the real key. What really created the disaster is a combination of leverage – that is, borrowing money to amplify an investment, and derivatives – fancy investments that are really nothing more than bets.

Leverage is easy to understand, and it’s easy to see how it leads to disaster. Suppose you’ve got $10,000 to invest, and there’s a really good investment that you think is going to make around 5%. But you want to make more than 5% on it. Now, suppose that you can borrow money at 2% interest. So you borrow $90,000, and invest $100,000. You’ll make $5,000 on the investment, and you’ll owe $1,800 in interest. So your profit on your $10,000
has been increased from $500 to $3,200. Now, think of what happens if your investment, instead of earning 5% ends up losing 2%. You wind up with $98,000; you owe $91,800. Your loss has been amplified from 5% to 18%!


Investment firms were leveraging investments by a factor of close to 30 to 1.

Then we get to the derivatives and related “financial instruments”. A derivative is really a fancy term for a legal bet in the financial market. You think that some kind of asset is going to change value – so you bet that it will. It’s called a derivative because its value “derives” from the value of the asset that the bet is related to. But you don’t have to own anything to buy a derivative. It’s really a pure bet. The payoff of a derivative is really just the odds on the bet. So essentially,
investment firms were being high-class bookies.

So, if you thought that the dollar was going to go down, and
you wanted to make money off of it? Fine, no problem. No need to do something as complicated as pick a different currency,
whose value you think will increase. Just make a bet: buy a derivative. If it’s paying 2:1 – if the dollar goes down by 10%, you’ll make 20%!

Derivatives don’t represent anything real – they’re not built
on buying or selling things that have real value: they’re just
a fancy form of gambling. The idea behind them is that they’re like a kind of insurance. If you’re afraid of the dollar
going down, you buy some derivatives that will pay off if it does – so that you’ll be protected. Someone will take your money if it goes up, in exchange for paying you if it goes down.

The way that derivatives play into this isn’t particularly simple – there are tons of varieties of derivatives, corresponding to gambles on different assets. But the key features are:

  1. They’re completely artificial. There is no asset, no fundamental value underlying a derivative, beyond the contract, which is basically like the ticket you get at a racetrack.
  2. Since there is no valuable asset underlying a derivative, if a derivative goes wrong, you can lose everything.

Now, here’s where it gets interesting. Combine leverage and derivatives. You’ve got people buying derivatives, leveraged with huge loans – people borrowed money to bet on derivatives. And they used things like mortgage bonds as collateral on those loans.

The problems here should be obvious. You’ve got people betting borrowed money in ways where they can easily lose everything, including the entire amount they borrowed. And they “secured” those loans using bad mortgages.

So when a bunch of mortgages start to fail, suddenly you’ve lost the collateral on your bigger loan – and you’re expected to pay that back. And lots of those derivatives were the basis of the “insurance” backing the mortgage bonds; so you had loans built on loans.

Many of the big investment firms were letting people buy things like derivatives with as little as 3% down – leveraging
an investment by borrowing 30 times the amount of the investment.

And there’s not just one level of this. There are loans to purchase derivatives based on assets that are based on loans to purchase other derivatives based on ….

Each level of leveraging represents a dramatic increase in the
amount of money at stake. So that original 10% loss on the mortgages can balloon by twenty to thirty times in one step of leveraging. Now consider that between all of the financial
constructs that the big firms were working with, you could easily have ten or twenty levels of leverage (which were justified by fake “insurance”, as I discussed in an earlier post), and you can start to see how losses that should have been no big deal can balloon
into something like what we’re seeing.

0 thoughts on “How Mortgages Turned into a Trillion Dollar Disaster

  1. mike

    The largest numbers circulated in the mass media, those from Bush’s ‘bad-bank’ plan, come from the mass buying of bad mortgages, and just mortgages.

  2. liveparadox

    Holy cow. I had vague, confused thoughts that this was what had been going on, but this makes it stark and clear. Thanks for the explanation.

  3. llewelly

    The figures I can find in a Google search suggest that the total value of all outstanding mortgages in the US is around ten trillion dollars. For mortgage failures to represent a ten trillion dollar loss, that would mean that one in ten mortgages is foreclosing …

    Don’t you mean ‘For mortgage failures to represent a trillion dollar loss’ ?

  4. Nattering Nabob of Negativism

    The insurance business is nothing simply gambling. When bad gamblers have unlimited credit, their losses will be astronomical.
    Yet it is nearly a zero-sum game. With all those players losing, the house has been winning. The ‘house’ here is a trillion dollars to the good on the financial losses alone. Maybe the Iraq Peace (which followed the 6-week Iraq War in 2003) whetted their greed.

  5. Mozglubov

    You know, I remember studying the stock market crash of 1929 in my U.S. history class back in highschool, and I could have sworn the moral of that lesson was, “buying things like stock and other risky ventures using borrowed money is likely to bring disaster and is therefore no longer allowed to be done.” I guess I must have somehow gotten confused and imagined the ‘therefore’ part of that moral…

  6. Eric Lund

    Mozglubov: IIRC standard practice in the 1920s was to allow 10:1 leverage on stocks, but for retail investors the limits were reduced to 2:1 (at least as of the early 00s; it would not surprise me to learn that the limits have been relaxed since then) after the Great Depression.
    Which brings up another way in which things can go wrong when people buy stocks “on margin” (as leveraging for that purpose is usually called). If the value of the stocks in your margin account fall so as to put you beyond the leverage limit, you get a “margin call” which forces you to deposit additional funds in your margin account to bring it back to the limit (you have at most a few hours to do this), and if you fail to do so some of your investments will be sold for you to bring your account into compliance. This often means that you are forced to sell otherwise good investments at a low price to cover your margin call. If this happens to enough people, as it did in 1929, the result can be that the otherwise good investments crater too, because the number of margin call sales greatly overwhelms the number of available buyers.
    Not that I have much personal experience with leverage; in fact the only leveraged investment I have ever made was the purchase of my house, at 4:1 leverage (because I made a 20% down payment–this was still SOP ten years ago when I bought the house, whereas more recently down payments as low as 3% were standard and 0% doable with slight effort). And the purpose of a fully amortizing mortgage is to reduce that leverage to 1:1 (by repaying with interest the amount borrowed) over the specified period of the mortgage.

  7. Moopheus

    “Imagine that they’ve lost 40% of their value – which would be very surprising.”
    Actually, it would not be surprising at all. In the most bubbly, or post-bubbly now, areas, such as Southern California, Nevada, Phoenix, Florida, etc., many folks who bought houses in the past few years and are in trouble now are seeing real losses of that magnitude, or even more. In other areas, foreclosure losses of 20-30 percent aren’t uncommon. And it’s just going to get worse.

  8. Rolf Andreassen

    “But you want to make more than 5% on it.”
    I think you mean $500, not 5%.
    “So your profit on your $10,000 has been increased from $500 to $3,200. Now, think of what happens if your investment, instead of earning 5% ends up losing 2%. You wind up with $98,000; you owe $91,800. Your loss has been amplified from 5% to 18%!”
    I think your arithmetic’s off, there. The loss doesn’t start at 5%, it starts at 2%. And if you start with 10000 and end with (98000-91800=7200), your loss is 28%, not 18%.

  9. Flooey

    Not only have home prices dropped significantly, but foreclosing on a home doesn’t get the bank cash that it can do something with, it just gets it a house, often a house that’s not been taken care of (because the person living in it didn’t have enough money to pay their mortgage, let alone keep it in good repair). So, the bank forecloses, and it’s stuck with a crappy house in a down market that it needs to sell quickly in order to get actual cash. That’s caused a lot of houses to be sold for a lot less than they are theoretically worth, and a lot of banks (WaMu, for instance) to have serious problems problems despite having lots of assets on their balance sheets, because they’re a bunch of assets that they can’t actually use to pay their bills.

  10. Josh in California

    Don’t you mean ‘For mortgage failures to represent a trillion dollar loss’ ?

    No, he means ten trillion dollars. It’s the leverage. Let’s take the current foreclosure rate of around 2% and figure out what happens when firms are leveraged 30-to-1 using mortgages as collateral.
    2% of ten trillion dollars is 200 billion dollars. Now imagine that those bad mortgages were used as collateral for loans.
    With a 30-to-1 ratio, every dollar of collateral gets you 30 dollars on your loan. Multiply 200 billion dollars by 30 and you get 6 trillion dollars in loans.
    Obviously Mark is making a different assumption about the leverage or the percentage of bad mortages that were used as collateral, but you can see that the losses are an order of magnitude larger than the collateral used to obtain the loans.

  11. a lurker

    Now here is what is puzzling me on your description. Every time that I have borrowed money from a bank, they have asked me why I wanted the money. And indeed each and every time they wrote the checks directly to the people and/or businesses I claim I wanted to spend the money on. They took that precaution in spite of the fact that I have an excellent credit rating.
    Now I go to the bank and tell them that I think x is a sure thing to return 5% on investment per year and that I want a loan at 2% per year so I can do it. One would think that if the bank thought this was a good investment that they would just invest directly in in x and forget the middle man (me). If they would not do the investment themselves then why lend someone else to do it especially without significant collateral.
    Maybe the law prevent the bank from that investment (though I thought that the repeal of such rules saying banks can’t do this and that was part of the problem. (I am clearly not an expert here.) Of course the banks might not actually be asking those questions.

  12. automandc

    lurker said:

    Now I go to the bank and tell them that I think x is a sure thing to return 5% on investment per year and that I want a loan at 2% per year so I can do it. One would think that if the bank thought this was a good investment that they would just invest directly in in x and forget the middle man (me). If they would not do the investment themselves then why lend someone else to do it especially without significant collateral.

    The reason the bank might do this is because they consider your 2% interest multiplied by the risk you might not repay them to be a better investment than the 5% return in the thing you want the money for when that investment’s risk is factored in. Obviously, the bank should only lend you the money if it thinks there is a good chance that you can repay even if you lose everything in the planned investment — which is why it ought to be much harder to get a loan to do anything with versus a loan for a specific use that the bank can monitor.
    One of the additional factors in this crisis is the fact that the banks didn’t just give first mortgages directly tied to the equity in a home; they also handed out a ton of equity lines of credit that went up to (or over) 100% of the sale price of the house. These loans were advertised as “free cash”, meaning the banks knew full well that people were not going to invest the money in a way that would return value (such as renovating the house, or investing it in a mutual fund) — the banks knew people would buy HDTVs with that money. So, when the housing market collapsed, not only were the first mortgages affected, but all that cash the banks pumped into the economy has essentially vanished (sent over seas to China, Japan, Korea, Saudi Arabia etc. which sell us the goods and energy that consumers used the money to buy). We are simply facing the fact that we have run up a massive debt both individually and collectively, and at some point we are going to have to start paying it down. Borrowing another $700 billion to make payments on the already existing debt doesn’t seem very smart to me.

  13. Moopheus

    “One would think that if the bank thought this was a good investment that they would just invest directly in in x and forget the middle man (me). If they would not do the investment themselves then why lend someone else to do it especially without significant collateral.”
    In addition to the above, remember that up until recently, banks were tightly regulated, and could not by law make too risky investments directly with depositors money. Then, they were allowed to offer higher return (risk) products to compete with money market funds and investment banks, and then the repeal of Glass-Steagal allowed them to merge with other financial services, such as insurance. This is why the banks are so tightly interlocked so that disturbances in one area set up huge shocks through the whole system.

  14. Chris' Wills

    I do wonder about the logic of the taxpayer (via the goverment) buying up bad loans made by poor investment choices.
    It tells the world that thieves and conmen should be rewarded and that sensible bankers are stupid.
    Let them crash and burn, most of the money isn’t, as far as I can see, real in any true sense and it would make sense in the medium/long term to let those banks that have been sensibly run (there are some) to win.
    Reward the good punish the bad seems a proper course of action rather than the reverse that goverments seem intent on.
    It would also make sense to have a serious investigation of these bankers who have made such ridiculous loans and bets. Perhaps banning them from working in the market ever again and from being directors,

  15. Ian

    Mark, since you’re so good at this, can you hazard a guess at how the hell they came up with the $700 billion figure for the bailout? Did they pull it out of a hat, or was there actually some math behind it?!

  16. amk

    Regarding Moopheus’s note about a 40% drop not being unreasonable: here’s a 2006 graph of US housing prices adjusted for inflation.
    This graph shows that housing isn’t actually a very good investment because it mostly matches inflation. There’s a flat-but-noisy stretch from 1890 to 1915, a lower level from 1915 to about 1942, and a higher plateau from 1947 to 1997. Then the graph line just takes off, spiking to almost double the previous level. It seems impossible to sustain this spike.

  17. cmm

    Thanks, I enjoyed reading this post. It made me think … if much of the investment bank losses are do to failed bets on leveraged derivatives, then there ought to be some big winners somewhere else. Trading derivatives is a zero sum game, and the counter parties to the investment bank’s derivative positions should have won big money. My guess is that hedge funds absorbed the bulk of these gains.

  18. MartinB

    Thanks for this post – when you write about economics, it almost makes sense (almost because people gambling like this with money they don’t even have still seems crazy).

  19. Sili

    Thank you. You may insist that you’re no economist, but you do a good job of communicating to other non-economists, who also think the subject in general is boring.

  20. Anonymous

    Re Ian #16:
    As far as I can figure out, the $700 billion number was pulled out of Paulson’s ass. Despite my best efforts to find any reasoning behind the number, there’s nothing that makes any sense. All I can find from people who know more than me is complaints that the number is arbitrary.

  21. arby

    “It’s not based on any particular data point. We just wanted to choose a really large number.” Treasury spokeswoman on the $700 billion bailout figure to Forbes. From the Doonesbury page at Slate and elsewhere. rb

  22. jack lecou

    The $700B is, by the Treasury’s own admission, largely arbitrary. However, that’s not necessarily as crazy as it sounds if you recognize that a large part of its purpose is to send a signal to the financial markets.

  23. MPL

    It is worth pointing out, despite all the current vilification of derivatives, that it is quite possible to make responsible use of them. When someone locks in their heating oil prices for the winter, they’re essentially doing something similar to a forward contract. Someone who hedges against loss of their stocks with options is reducing their risk as well.
    The point is that the stupid is in the investor, not in the investment. The solution is regulation of investment companies.

  24. Slawekk

    “We are simply facing the fact that we have run up a massive debt both individually and collectively, and at some point we are going to have to start paying it down.”
    I think this comment is spot on. Americans have been consuming more than producing for decades. It was obvious that this can not go on for ever and I always wandered how technically it will stop. Now I think I know.
    The problem that the bailout is trying to solve is that banks don’t want to lend money to each other because they are afraid that the other side might have too much of toxic paper. Now the treasury will be known to own this stuff and it will be much more difficult for it to borrow money. The dollar will devalue and all the prices of imported products will increase. The consumption will drop. Everything will be back to normal.

  25. Rolf Andreassen

    The point is that the stupid is in the investor, not in the investment. The solution is regulation of investment companies.
    Indeed? Just how is regulation going to deal with the problem of stupid investors? You cannot make a law to make stupid, greedy people smart and responsible.

  26. Shaneal Manek

    *But the actual foreclosure rate – a record high – is barely more than 2%!*
    Hi Mark. I showed this to some friends of mine in finance, and they tell me the foreclosure rate is already over 10%. That didn’t sound right to me, but I’m having some trouble finding a good source.
    Would you mind providing a citation for your 2% figure? Thanks.

  27. Shirakawasuna

    As described, the math (and risk) would seem to make the investors look like idiots, which seems strange to me. Are the investors shielded from the losses, were people lying to each other more than usual? Having say a 30:1 leverage on a loan for supporting a derivative seems like an opaquely *terrible* idea.

  28. Jonathan Vos Post

    Big picture of Banking, Credit cards, and the fall of the Germanium Standard:
    (1) The Banking Industry has “lost” more money in the past 2 years than had previously been “made” in the entire multi-millennium history of the industry.
    The word “bank” reflects the origins of banking in temples. According to the famous passage from the New Testament, when Christ drove the money changers out of the temple in Jerusalem, he overturned their tables. Matthew 21.12. In Greece, bankers were known as trapezitai, a name derived from the tables where they sat. Similarly, the English word bank comes from the Italian banca, for bench or counter. Monte dei Paschi di Siena 1472-present is the oldest surviving bank in the world, founded in 1472 by the Magistrate of the city state of Siena, Italy.
    To slightly edit [with my comments]
    The invention of banking preceded that of coinage. Banking originated in Ancient Mesopotamia where the royal palaces and [religious] temples provided secure places for the safe-keeping of grain and other commodities. [This was the culmination of 25,000 years of developing settled agriculture, a project interrupted by the most recent Ice Age, and the benign climate a millennium after that ice age ended, and farms, cities, kings, and war became feasible]
    Receipts came to be used for transfers not only to the original depositors but also to third parties. Eventually private houses in Mesopotamia also got involved in these banking operations and laws regulating them were included in the code of Hammurabi. [Congress carefully avoided learninmg this History.]
    In Egypt too the centralization of harvests in state warehouses also led to the development of a system of banking. Written orders for the withdrawal of separate lots of grain by owners whose crops had been deposited there for safety and convenience, or which had been compulsorily deposited to the credit of the king, soon became used as a more general method of payment of debts to other persons including tax gatherers, priests and traders. Even after the introduction of coinage these Egyptian grain banks served to reduce the need for precious metals which tended to be reserved for foreign purchases, particularly in connection with military activities. [The Knights Templar ran the earliest Europe-wide/Mideast banking network ca. 1100-1300. The Bank of Sweden initiated the rise of the national banks, begin operations in 1668, followed by the Edinbugh Scotland invention of Bank of England, established in 1694. A major theorist here was Ben Franklin, cf. The Pennsylvania Land Bank, founded in 1723 and receiving the support of Benjamin Franklin who wrote “Modest Enquiry into the Nature and Necessity of a Paper Currency” in 1729; cf. Alexander Hamilton and the Federal Reserve. Today, the priesthood, commercial power-brokers, and war profiteers are still in bed together. USA invaded Iraq while toying with an Oil Standard to replace the Cold War’s Plutonium Standard].
    The break with precious metals [or, in James Blish’s “Cities in Flight” trilogy, the “Oc dollar” backed by the Germanium Standard, which led to the collapse of the galactic economy], helped to make money a more elusive entity. [cf. Bank of America’s re-invention of centralized check and payment processing technology] Another trend in the same direction is the growing interest in forms of electronic money from the 1990s onwards. In some ways e-money is a logical evolution from the wire transfers that came about with the widespread adoption of the telegraph in the 19th century but such transfers had relatively little impact on the everyday shopper.
    The evolution of money has not stopped. Securitisation, the turning of illiquid assets into cash, developed in new directions in the 1990s. [Then “quants” or “rocket scientists” in a Finance industry that lined its pockets and fatally began to believe its own lies, made derivatives upon derivatives until absolutely nobody could establish any valuation of what anything was worth]. One much publicised development was the invention of bonds backed by intangible assets such as copyright of music, e.g.Bowie bonds, named after those issued by the popstar David Bowie. Cf. Something Wild, the first novel dealing with Bowie bonds. We are now de facto using John Lennon “Imagine there’s no countries, it’s easy if you try” congressionally socialized buyout of a failed industry]
    Noteworthy Points Regarding the Origins of Money
    Some of the points stressed by Glyn Davies in his book are:
    * Money did not have a single origin but developed independently in many different parts of the world.
    * Many factors contributed to its development and if evidence of what anthropologists have learned about primitive money is anything to go by economic factors were not the most important.
    * Money performs a variety of functions and the functions performed by the earliest types were probably fairly restricted initially and would NOT necessarily have been the same in all societies.
    * Money is fungible: there is a tendency for older forms to take on new roles and for new forms to be developed which take on old roles, e.g. (this is my example) on English banknotes such as the 5 pound notes it says “I promise to pay the bearer on demand the sum of five pounds” and below that it carries the signature of the chief cashier of the Bank of England. This is a reminder that originally banknotes were regarded in Britain, and in many other countries, as a substitute for money and only later did they come to be accepted as the real thing.
    One of Glyn Davies’s main motives for writing the book was that, as he writes in his preface around the next corner there may be lying in wait apparently quite novel problems which in all probability bear a basic similarity to those that have already been tackled with varying degrees of success or failure in other times and other places. [and here we are!] Furthermore he is of the opinion that economists, especially monetarists, tend to overestimate the purely economic, narrow and technical functions of money and have placed insufficient emphasis on its wider social, institutional and psychological aspects.
    (2) The origin of credit cards in the United States is in the 1920’s where customers were issued with credit cards (Early tokens of credit seen its paper, metal, fiber, or celluloid) by hotels and oil companies, though references to credit cards can be found as early as 1890 in Europe.
    Earlier type credit cards sales were transactions between the customer and the merchant who offered the credit card. Companies started accepting each other’s cards in an ad hoc way by 1938.
    John Biggins was the inventor of the first credit card to be offered by a bank. He also invented a program called “Charge It” between local merchants and bank customers. The issuance of credit card by Diners Club occurred in 1950. Frank McNamara who was the “founder” of Diners Club, by which customer could eat at restaurants without cash or check. The restaurant would get the payment from Diners Club, which was paid by the holder of the credit card. Technically, rather than being a credit card it happened to be a charged card, as the payment had to be made fully by the customer when it was billed.
    The issuance of first credit card of American Express was in 1958, which year also saw the birth of BankAmericard (now commonly known as Visa).
    (3) The Black-Scholes equation does not model the real world. But that’s technical, and I’ll skip it for now.

  29. RBH

    Mark, I’ve been following these posts with interest, and they’ve been mostly accurate. However, your description of derivatives is pretty far off the mark. As someone up-thread noted, simple derivatives — plain vanilla options and futures — were invented to provide a way of hedging risk. For example, a farmer could lock in a future price for his crop ahead of time, reducing the risk of an adverse price move just when it came to harvest. Similarly, a consumer of farm goods (say, a flour miller) could lock in a future price for his wheat purchases and could plan operations knowing what he’d pay for raw materials.
    The ‘gambling’ comes when other participants besides hedgers — to with, speculators — enter the market. They buy or sell futures contracts (which are relatively simple derivatives) or options (more complicated derivatives) in the hope of making money on movements of the futures contract through time. The economic purpose purportedly served by speculators is to give liquidity to the markets for futures and options so that genuine hedgers could readily find buyer or sellers of the contracts.
    For futures and options markets where there is a regulated exchange and a central trade clearing body the kind of shenanigans we’ve seen in the mortgage-backed securities markets and the other collateralized debt obligation markets don’t occur.
    You’re right that the leverage issue is a central contributor to the current mess. Other large contributors are the opacity of the markets (they’re over the counter markets) so comparative prices are largely invisible to market participants and the public, and the frequent dependence on financial models for pricing and especially for risk estimation. As Jonathon vos Post remarked, Black-Scholes (a standard pricing model for options) does not model the real world. Far from it. It’s worth noting that two of the three economists who got the 1997 Nobel Memorial Prize in economics for work on that option pricing model were partners in Long-Term Capital Management, the huge hedge fund that blew up in 1998. 🙂

  30. Chris' Wills

    I happened across something that may show how big the real problem is. How can the value of derivatives be so high, surely the value can never be realised?
    The GWP (Gross World Product) is US$65 million million, the value of derivatives traded is US$681 million million, how is it possible for more than 10 times the GWP to be traded just as derivatives?
    I realise that the overall value of the world is more than its GWP, but to have more than 10 times being traded just as derivatives seems to imply that a lot of double counting (plus some deception) is going on somewhere.

  31. AJS

    So if I’ve got this right, people have been investing borrowed money — which they borrowed without having to offer any collateral, just on the basis of a vague prediction that the investments were going to increase in value — and then the investments didn’t actually increase in value, leaving the people whose money they borrowed out of pocket? And since this has been going on at every single level, the original “lenders” are actually ordinary savers?
    That ought to have been so easy to prevent, as well.

  32. baoshan

    [Disclaimer: I am naive on this topic.]
    Good insight on the amplifying mechanism. But still there are questions on the macro-level:
    1. It cannot be every one are losing money, someone has to be making them. The questions is who?
    2. On derivatives (or those fancy wall-street money), my understanding is these sort of thing are zero-sum, that is if you are losing, some other guy in the same game must be winning; and the rest of us not in the game should not feel a thing. Why it’s not the case?
    3. Is it possible people are being herded from insanely optimistic about making money, to unreasonably pessimistic about losing money? Should there (are there) any cool heads?
    With that being said, should the rescue plan be that: instead of buy back the bad assets whose value no one really knows, ask the better backs to manage the $700B, which are to be loaned to “real” business (companies that actually produce visible stuff)? This way, one are really solving the credit crunch. Put money directly into wall street seems such a bad idea; let themselves sort it out.

  33. Chris' Wills

    By Nassim Nicholas Taleb
    His article on the limits of statistics explains some of the things that went wrong and that bailouts just hide and do not cure.
    He has been warning about the problem for some time.

  34. Mark C. Chu-Carroll

    Re baoshan (#34):
    That’s a surprisingly difficult question.
    Part of it is the investment bankers and brokers made a killing. Look at the bonus package set up by Lehman before it filed for bankruptcy – that’s how they rewarded the failures. The successes were even more astonishing. G.E., which now makes most of its money as a money-lender gave their former CEO a retirement package that included flowers delivered daily to three NY apartments – so that whichever one he went to would always have fresh flowers.
    Part of it is that it’s no really a zero-sum game. An awful lot of what was going on was completely artificial: “assets” were created which had no real value. There was a lot of “wealth” created that only existed on paper. Part of the current situation is that people are now refusing to accept that these things actually have any value. In theory, economies are driven by the production of things of value: either concrete items, or
    units of service provided by one person to another. In principle, then, there’s a floor to what anything is worth, which is loosely based on something like barter – an item is worth what someone will trade for that item or service. But financial systems can create pieces of paper that they assert have value, and sell them – but there’s nothing there but the paper and the belief that someone else will buy that piece of paper.
    So you’ve got worthless pieces of paper being traded.
    What makes this particularly damaging is that it’s not one person selling worthless paper to everyone else. It’s every large investment selling worthless paper to everyone else – and that paper is being bought by other people producing worthless paper. It’s a giant tangle – so the people who are making money selling paper are also losing money because they bought paper.
    There’s also another factor, which involves accounting. (And I may convert this into a top level post later.) Basically, a company’s balance sheets consist of a set of assets (stuff that they own, or stuff that they’re owed), and a set of liabilities (stuff that they owe to someone else). The value of the companies assets needs to equal or exceed their liabilities.
    Suppose you’ve got a company that’s operating at a 10% profit, meaning that their assets are 10% larger than their liabilities. Now imagine that they’ve got 20% of their assets invested in subprime mortgage bonds. No one is willing to buy those now – so for the moment, they’re effectively worth nothing. So now the company has less in assets that they can draw on than they have in liabilities.
    Now, suppose that one of the people that they own money to comes to them demanding payment. They’re currently effectively underwater – they’ve got money tied up in unsellable mortgage assets. In the long term, those assets are worth probably 60% of their face value – which would put the company in the black. (Even with astonishingly high foreclosure rates like we’ve been seeing on subprime, where you’re looking at 40-50% default, you’ve still got 50% making their payments!) But they can’t get at that money, because no one will buy those assets. So effectively, they’re now bankrupt.
    In fact, they can be as little as 1% below break-even after writing off the mortgage bonds – but if a debtor calls in the debt, they can’t pay it, and since no one is loaning money, there’s nothing they can do except file bankruptcy.
    That’s the basic logic behind the bailout stuff; that these companies are, fundamentally, still solvent; it’s just that for the moment, these bonds that do have value are unsellable, and so they’re effectively bankrupt. The bailout would give them money for those assets, and then hold on to them until people were willing to buy them.
    I remain a skeptic of the bailout, because my understanding is that there’s still too much of the fake assets out there – too much of what’s going on is worthless paper that no one will buy because it’s truly worthless. If it’s a fake paper asset not actually connected to any real tangible asset, then it’s never going to be worth anything. So buying time for it to gain value isn’t going to accomplish anything; it’s not worth anything today, and it’s not going to be worth anything tomorrow, next week, next year, 10 years from now, or ever.
    There’s so much money tied up in worthless stuff… It’s going to be brutally painful to a lot of innocent people to see those worthless investments collapse. But my view is that it is inevitable; postponing it will only make it worse. Let the shit collapse, and save the money for picking up the pieces afterwards.

  35. Chris' Wills

    Just wondering if anyone has read the save the plutocrats thieving asses bill that USA representatives have been asked to approve, it’s 450 pages long.
    Why so long?
    The pork of course.
    Now you may agree with some of these but it looks like bribes to me and nothing to do with what the bill is meant to be about, not that I agree with the main proposal in the bill.
    Seems that even in emergencies politicians just can’t avoid digging their snouts in.
    I suspect that similar things will happen if an EU package is approved, though we probably won’t be allowed to see that document until after it is passed.
    Some of them are listed below, there are more.
    Title III
    Sec. 308 – Increase on limit on cover over of rum excise tax to Puerto Rico and the Virgin Islands
    Sec. 309 – Extension of economic development credit for American Samoa
    Sec. 310 – Extension of mine rescue team training credit
    Sec. 314 – Indian employment credit
    Sec. 316 – Railroad track maintenance
    Sec. 317 – Seven year cost recovery period for motorsports racing track facility
    Sec. 319 – Extension of work opportunity tax credit for Hurricane Katrina employees
    Sec. 322 – Tax incentives for investment in the District of Columbia
    Sec. 325 – Extension and modification of duty suspension on wool products; wool research fund; wool duty refunds
    Title IV
    Sec. 401 – Permanent authority for undercover operations
    Sec. 402 – Permanent authority for disclosure of information relating to terrorist activities

    Title V
    Subtitle A – General Provisions
    Sec. 502 – Provisions related to film and television productions
    Sec. 503 – Exemption from excise tax for certain wooden arrows designed for use by children
    Sec. 504 – Income averaging for amounts received in connection with the Exxon Valdez litigation
    Title VI
    Sec. 601 – Secure rural schools and community self-determination program
    Sec. 602 – Transfer to abandoned mine reclamation fund

  36. Jonathan Vos Post

    So, Chris’ Wills , we’re backed into the corner, and have to agree with Treasury Secretary Henry Paulson that Congress should make a “clean” bill? That is, without pork?
    Is this why the blank check seems to have drifted upwards from $0.7 x 10^11 to $0.85 x 10^11?

  37. Chris' Wills

    Posted by: Jonathan Vos Post
    So, Chris’ Wills , we’re backed into the corner, and have to agree with Treasury Secretary Henry Paulson that Congress should make a “clean” bill? That is, without pork?

    Not necessarily Jonathan, the representatives could throw it on a bonfire made of the vanities from whence it hailed.

    Is this why the blank check seems to have drifted upwards from $0.7 x 10^11 to $0.85 x 10^11?

    Could be, but what’s a 150 billion between friends, a mere bagatelle.

  38. Chris' Wills

    Bailout Fixes Nothing, Banking System Collapse Approaches Climax
    An interesting analysis of some of the other problems that papering over the cracks won’t solve and it isn’t just the USA that’ll be damaged.
    Does anyone think that any banker/investor will be punished?

  39. Doug Spoonwood

    Mark, you said:
    [Derivatives don’t represent anything real – they’re not built on buying or selling things that have real value: they’re just a fancy form of gambling. The idea behind them is that they’re like a kind of insurance.]
    How in the world did people think this? I mean for a person buying insurance, insurance decreases his/her economic risk. In my opinion, that’s the key concept about insurance. Betting, whether you call a gamble a “derivative” or a bet, still increases the economic risk for the person betting. It’s pretty much the exact opposite of insurance. The only similarity I see that they have lies in that an analysis of both use probability theory. But, so what?

  40. Mark C. Chu-Carroll

    The idea of derivatives as insurance is based on hedging.
    Suppose you invest $1 million oil futures, based on the assumption that oil is going to go up to $200/barrel; so you buy the futures for oil at $150/barrel. Then the price of oil plunges to $90/barrel: suddenly you’re losing a ton of money.
    You want to protect against that. So you buy a derivative
    that’s betting on the price of oil going down. You buy enough of it so that if the price of oil goes down, you’ll make enough from the derivative to break even. Now between the derivative and the oil futures, you’re guaranteed to at least break even.
    That’s the idea of derivatives as insurance: you make an investment that might lose money, and then you buy a derivative betting that you’ll lose money; then if you lose, the derivative covers you, and if you win, the cost of buying the derivative was the cost of insurance.

  41. Humphrey Bogus

    “Suppose you’ve got a company that’s operating at a 10% profit, meaning that their assets are 10% larger than their liabilities.”
    This statement is incorrect, as it mis-states the relationship between a balance sheet item an income statement item. A 10% profit does not indicate that assets are worth 10% more than liabilities; the two are unrelated.
    First, the proper relationship on the balance sheet is assets = liabilities + shareholders equity, not assets = liabilities. Shareholders’ equity can be positive or negative, but it always equals Assets-Liabilities.
    Second, profit margin (the 10% in your example) is an income statement number, which represents the accrual-based earnings generated by a company over a given period of time. A company with a 10% profit margin does not necessarily have assets that are 10% greater than their liabilities; the two have nothing to do with each other. The balance sheet indicates how the company is capitalized at a given moment in time, while the income statement attempts to measure how assets are turned into income over a period of time. (The cash flow statement reconciles net income to changes in the balance sheet via cash inflows/outflows, and it can be completely derived from the income statement and starting & ending balance sheets for a period.)
    A company’s profit margin has little to do with its shareholders equity. Companies in Silicon Valley frequently have negative shareholders equity (due to accumulated historical losses included in retained earnings), but positive profit margins (or vice-versa).

  42. Kaleberg

    One of the reason the losses are so big is that the entities involved were banks. Banks can create money, which is one of the reasons that they were heavily regulated from the Great Depression until recently. Consider the gold standard which was in effect in January 1932. According to Fortune:
    “With a single $25,000 gold brick in its vaults, the United States Federal Reserve System may extend some $71,000 of credit to its member banks. And upon that credit the member banks may extend further credit of $550,000 with which to facilitate the commerce of the world.” – Fortune 1/32 p120
    So, for each gold ingot deposited in the Federal Reserve, banks around the country could put 22 times as much money into circulation as the value of that ingot. This sounds weird, but if a bank has to keep 100% of its assets in reserve, it can’t lend money to anyone. That means it couldn’t pay interest on its accounts.
    What if everyone walked in and demanded their money on the same day? It’s like the internet, a highway or the phone system. It’s capacity is designed based on statistics. If everyone tries to use the resource at full speed, it slows down or collapses, but usually it works.
    Of course, the leverage factor has been much higher than 20 lately. It’s almost like quantum mechanics with all the little loops and Feynmann diagrams. If a bank lends some money, it basically turns it into cash flow. The cash flow can then be used to borrow more money. That money can be leveraged and lent, or loaned if you prefer, and generate further cash flow. Where does all the money come from? The banks issue it. That is one of their functions.
    Unfortunately, Greenspan kept interest rates extremely low, so leverage was high, and he encouraged banks to issue money, lending it out as mortgages. Everyone could see the brick wall approaching, except for economists. Greenspan needed to pump money into the economy to compensate for the tax cuts he had backed a few years earlier. He couldn’t afford to hit the brakes, so the brick wall kept getting closer. Well, now we’ve hit it.

  43. Alex

    This mess rather reminds me of something by Ezra Pound, the poet and original radio shock jock:
    Canto LXV
    With usura hath no man a house of good stone
    each block cut smooth and well fitting
    that delight might cover their face…
    The rest is here:
    Anyway, that being said, I would very much like to see all these thieves who stole billions get prosecuted for fraud, and get at least the same penalty that somebody gets for holding up a C-store.

  44. Steve Albrecht

    You have lost $2,000 on the $100,000 and paid $1,800 in interest. The total reduction in value is $3,800 / $100,000 = 3.8%. I don’t understand “loss amplified from 5% to 18%”, but clearly the use of borrowed money has created a greater loss both of principal (more invested) and interest cost (more borrowed). I also think he means make more than $500, b/c the 5% rate is constant on the investment, just more dollares (borrowed dollars) are going into the hopper. Excellent overall article.

  45. Hank Roberts

    Now they’re selling bets on how the previous bets will go!
    NO kidding. These people are simply unrecoverably addicted to gambling.
    The blogger here points to the story at Bloomberg and invites comments, if you don’t want to pursue it here.
    But I value Mark Chu-Carroll’s perspective, if available.
    Here’s what Bloomberg says the financial wizards are up to now…
    Credit-recovery swaps are trading on the debt of about 70 companies, including automaker General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to Mikhail Foux, a strategist at Citigroup in New York.
    The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts, Foux said. Also known as recovery locks, the agreements are bought as insurance by sellers of credit-default swaps, such as banks, hedge funds and insurers.
    “The market definitely has potential to grow,” Foux said. “As we see more defaults — and there’s no doubt we’re going to see more defaults — you’re going to see more recovery swaps trading.”
    Goldman Sachs and JPMorgan officials declined to discuss their role in the market.
    Here’s the thing: It’s sensible for an owner of an asset to hedge against the risk the asset will lose value. The problem with credit default swaps was that the buyer didn’t need to own the asset. So the swaps became ways for investors to gamble on market trends or on companies. Also, since the swaps are unregulated; details are murky, which adds to confusion.
    It’s not clear to me from this Bloomberg story what the rules are around the newer recovery swaps. Are they a legitimate hedge, or more gambling? Read the story
    ——-end excerpt———————–
    The Bloomberg story begins:
    ——excerpt follows——
    Nov. 25 (Bloomberg) — Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co., which helped turn bets on company defaults into a $47 trillion market, are among banks offering wagers on the amount investors may recover from bonds after borrowers go bankrupt.
    Credit-recovery swaps are trading on the debt of about 70 companies, including automaker General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to Mikhail Foux, a strategist at Citigroup in New York.
    The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts….
    ———end excerpt——
    I think the financial industry has discovered the Midas Touch, and the problems therewith.

  46. Sean

    I used to try to figure this stuff out for pleasure but it should probably only be done for status or career or profit.
    Whats neat about stocks, however, is that if they’re all just worth pennies…the people that own them still own the companies.

  47. Sean

    What would it do to society if you could buy a share of stock when you’re going through the supermarket line?
    I liked Al Gores lockbox but didn’t like the fact the insurance companies and government is always going for that super database in the sky. They’re like a user in tron alwasying trying to get closer and closer to the electricity that runs your motorcycle while they build walls and send those red things in.
    Derivatives are probably a problem. Huge institutional trades are probably a problem. Insider trading is probably a problem. Unfair IPO roll-outs are probably a problem. Foreign entanglement and bad trading is probably a problem. Greed for salaries is probably a problem. Natural resources going down with populations going up is probably a problem.
    This freeze/tank only hurt the poor. And, barely.
    Who knows. I don’t know. I didn’t do my homework on this. No money in it.

  48. sean

    Well, the good news is that all that money went for real goods, real estate. So, the money went to the most valuable thing. It didn’t go towards cruises and broadway shows. So, the banks can hold something in their hands.


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