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Why exactly are those mortgage-backed securities so hard to trade?
With emphasis on that word "exactly," here is Gary Gorton's superb paper The Panic of 2007.
Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed. You are confused because it is confusing. Then I got to p.45 (!) and I almost split a gut (and cried, simultaneously) when I read the sentence:
Now we come to the first information issue.
It then goes like this:
What is the loss of information? The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone. It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined. But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages.
His examples show this in detail but I do not know a simple way to blog it. Scroll to pp.23-30, and p.35 for a dose of how these securities were structured.
Gorton is also highly critical of "mark to market" (p.62) and he pinpoints the collapse of certain parts of the REPO market (p.66) as a critical development. He ties it all in to Hayek and Grossman and Stiglitz and discusses how we ended up having assets with non-transparent, non-backwards-translatable prices and what that means for economic calculation. He contrasts a private clearinghouse (and monitoring) vs. rules of accountancy and how we ended up relying too much on the latter.
Starting on p.67, there is a sustained and mostly convincing argument that securitization has not been much at fault.
If you are interested in the nuts and bolts of the current financial crisis, and its origin in 2007, this paper is essential reading.
Posted by Tyler Cowen on October 7, 2008 at 07:49 AM in Economics | Permalink
Comments
Additionally, it's worth reading Ashcraft and Schuermann's 2008 paper for reference.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1071189
Posted by: Paul at Oct 7, 2008 8:37:05 AM
The paper is indeed terrific.
Notes on hubris: Garton records working for 12 years as a consultant for AIG Finacial Products. This was the group within AIG that wrecked the world's largest insurance company.
Posted by: Diversity at Oct 7, 2008 8:49:27 AM
I bet that once a risk completes a circle, there isn't a unique solution any longer. So what determines what something is worth is no longer an underlying value, but rather which of many solutions the system stumbles into.
Separate areas can come up with differing evaluations, and then interact to fight out whose solution prevails, if either. It's not an averaging process but a winner-take-all encounter.
Just to say that careful analysis can no longer get very far. I mean, it might be able to sketch out the various static solutions that the system has, but no dynamics are available to figure out which one prevails or what happens.
You want to build as few of these systems as possible.
Posted by: rhhardin at Oct 7, 2008 9:20:16 AM
Something to remember as the Treasury prepared by buy this junk (page 5):
"The sell-side of the market (dealer banks, CDO and SIV managers) understands te complexity of the subprime chain, while the buy-side (institutional investors) does not"
And this reminder that there's no conservation of information in the financial world:
"... Neither group knows the value of every link in the chain. The chain made valuation opaque; information was lost as risk moved through the chain."
Posted by: ZBicyclist at Oct 7, 2008 9:21:48 AM
This is a great paper. And this kind of paper shows the difference in the type of complexities that face practitioners and academics. Trust me, that's not a knock on academics.
Posted by: MJG at Oct 7, 2008 9:24:55 AM
Couldn't ask for more from an academic/expert blog. Thanks!
Posted by: Hopefully Anonymous at Oct 7, 2008 12:37:22 PM
I still don't understand why it took so long for the ABX indices to get up and running? Or more fundamentally, why were so many, and for so many years, content to buy blindly into subprime securities? I believe he points to the essential misjudgment that home prices would never decline. That's hard to swallow. I mean I'm just a home owner, not a mortgage derivatives expert, and I tried to sell my place in DC in 2003 because I thought the prices were unsustainable. The deal fell through, and I decided not to sell because I figured the DC market would be the last to turn down. I've been right on that. Now it looks like the whole thing is going to @#$^. I just don't understand why high flying bankers with kabillions on the line would expect home prices nation wide to continue up forever.
Posted by: will mcbride at Oct 7, 2008 4:59:52 PM
i would expect home prices to continue increasing "forever" if i was counting on a loose fed money policy to exacerbate inflation
Posted by: at Oct 7, 2008 5:35:14 PM
I'm thinking if you don't understand what you're buying, don't buy it.
And, make sure there's another way to make money when things go wrong. Basic Warren Buffet stuff.
Posted by: Alan Brown at Oct 7, 2008 7:23:55 PM
High flying bankers knew exactly that home prices couldn't go up forever. They were just counting on:
a. Being able to unload the junk before the crap hit the fan
b. Getting their bonuses before accounting rules would expose the house of cards.
By and large they were highly successful.
Posted by: foo at Oct 7, 2008 7:26:08 PM
I can't wait to read this paper. Thanks for the link.
Posted by: Sean at Oct 8, 2008 12:50:36 AM
Skimmed the paper. There is one thing I don't like. He says that securitization is not to blame. But he also says that complicated forms of securitization end up obscuring important information. I don't really see how these points can be reconciled. His main argument is a form of special pleading...subprime securitization is the problem because subprime has exposures to housing prices and the risks associated with these exposures are obscured via securitization. However, don't other securitized assets have exposures to other risks that will also be obscured. He claims that other securitizations do not have these type of risks...this would include conventional RMBS, ABSs and CMBSs. I didn't see anything in the paper to back this point up. It just appears in the conclusion.
Posted by: assman at Oct 8, 2008 4:21:36 AM
thanks Tyler, and Alex, for all your blog postings and the valuable links and opinions herein. I've been out of the profession of economics for many years, but have been trying to catch up by rapidly devouring all the economists' perspectives on this current crisis, so your blog has been a great help.
This paper, The Panic of 2007+, is an excellent read.
Posted by: Kevin Lacobie at Oct 8, 2008 7:45:05 PM
I beg to differ; this paper is absurd and simply reflects his hubris. He says the risk can't be quantified and then he proceeded to develop models for this. Excuse me, but if you can’t quantify the riks and its parameters how the hell can you create a model that is in any sense meaningful? As AIG proves this is nothing but black magic as a model -- With due respect to Decartes a model must be something more that “I feel therefore I must be right”. .
Posted by: Herbert at Nov 3, 2008 1:43:10 PM
