Monoculture finance
Posted by aogTuesday, 05 August 2008 at 07:05 TrackBack Ping URL

In the midsts of his panic mongering, Harry Eagar did bring up one salient point — does the widespread existence of mortgage securities increase systemic risk?

It clearly doesn’t if one considers a single bank. It doesn’t matter whether the bank has $1B of debt in the form of individual mortages, or $1B in mortgage backed securities. The overall worth of the debt is the same in both cases, dependent on the aggregate worth of the mortgages. That was my original thought, but it occurred to me that it might be different if one considers the overall banking system. At the extreme, if there was a single tranche of mortgage backed securities that included every mortgage that was owned by most banks, then a downturn in the housing market would affect all banks simultaneously, which is the root of a bank panic. It’s the vulnerability of all monocultures.

Obviously, it’s not the case that there is only one tranche of mortgage securities, but it does seem a valid question to wonder how much diversity is present (direct mortgages only being the other extreme on the diversity scale). While there are multitudes of financial organizations offering putatively different mortgage securities, my impression is that the financial world suffers from the same inbred copy-cat faddishness that Hollywood does, so that many of these are really the same securities under different labels. However, even if the structuring is identical, if the securities are backed by disjoint sets of actual mortgages, then they are diverse in the sense that is under discussion, i.e. the risk is not signficantly larger than for a fully diverse system.

This is a nexus in which it’s not so clear that government regulation improves the situation. One of the primary effects of regulation is uniformity, which we can see is the root of the problem. The particularly type of uniformity matters and so it is, in my view, bogus to claim that “regulation” would be an improvement without specifying the particulars of that regulation.

Comments — Formatting by Textile
Hey Skipper Tuesday, 05 August 2008 at 12:51

You should write for The Economist.

Tom C Tuesday, 05 August 2008 at 14:18

Why would the widespread existence of (sound) mortgage paper create sytemic risk? It doesn’t. Mortgages written on other than sound lending principles creates risk. Why that’s happened is the question. Look to monetary and fiscal policy, the political influences on banks and the gse’s themselves to find the causes of what has become the epitome of ‘moral hazard’ in action. The ‘Community Redevelopment Act’ is a good place to start.

Annoying Old Guy Tuesday, 05 August 2008 at 14:33


It creates risk to the extent it reduces the diversity of holdings. What creates panics is not the failure of a bank with bad loans, it’s the simultaneous illiquidity of many banks. Mr. Eagar is quite right on that point. The less diverse the mortgage paper, the more likely the “simultaneous” part. That’s the root of the risk.


Obviously not, or I would not have confused Tom.

Tom C Tuesday, 05 August 2008 at 14:43

aog- Whose holdings? It still comes down to the quality of the paper. Where did all the low quality, risky paper come from? Why are they loaded up with this stuff?

Annoying Old Guy Tuesday, 05 August 2008 at 14:52

Bank holdings. Yes, it comes down to the quality of the paper, but the risk source under discussion is “what if all the paper is exactly the same quality because it’s all based on the same set of mortgages?”. A diverse situation is precisely when there is a variety of qualities because the backing mortgages are different.

erp Tuesday, 05 August 2008 at 16:04

Tom, you’re right about CRA’s. They are creating havoc in our little rural Central Florida town of less than 5,000 and I’ve read that they are in large part to blame for the current mortgage mess. Killing them off would go a long way to solving the problem.

What say you Harry?

Tom C Tuesday, 05 August 2008 at 17:24

aog- The diversity of holdings, as you put it, is the cause of the problem. Holding a non-diversified bundle of traditional lending practice type mortgages is not the problem. The problem consists of mortgages written for other than sound business reasons. The CRA program coerced lenders under threat by politically connected interest groups to lend money where there was a good chance they would not be repaid while the GSE’s stood behind them. The belief was widely held, and encouraged by the central bank through cheap money and congress through ‘politically correct’ policy, that real estate prices only go up and unqualified borrowers should be homeowners. The gse’s got into the act a few years ago guaranteeing this dreck. Thus the problem of ‘liquidity’. There’s no clearing market for many of these securitized loans.

Harry Eagar Tuesday, 05 August 2008 at 18:46

Oh, give it a rest. CRA is not responsible for the failure of, eg, a builder of million-dollar condos in Florida today.

Nor is CRA responsible for the situation in Las Vegas, ground zero for mortgages in trouble.

The moral hazard was that the people getting the premiums for writing mortgages were not also the people losing capital when they weren’t paid.

Nothing — I repeat — nothing to do with CRA.

But I am amused to hear you guys complaining that lobbyists managed to suborn the regulation of F&F. That’s true, they did. But it’s funny to hear you guys claim it as a bug. For you, it’s a feature, isn’t it?

The reason mortgage-backed securities are more problematic than a stack of individual mortgages — even if the same mortgages are under consideration — is that you can tell whether each individual mortgage is a bad bet to pay off. It’s much harder to divine the actual risks of nonpayment with securitized bundles of millions of mortgages. Therefore, all except plungers will value all the mortgages in the bundle at or near the risk of the worst.

You can work your way out of that trap, at considerable cost, and it takes a while.

Not a huge problem if you have a while. Bear Stearns could (maybe) have unwound if it had had a breather.

Anyhow, I at least did specify the kind of regulation I wanted: a Glass-Steagall for non-bank banks.

Annoying Old Guy Tuesday, 05 August 2008 at 22:57

But I am amused to hear you guys complaining that lobbyists managed to suborn the regulation of F&F. That’s true, they did. But it’s funny to hear you guys claim it as a bug. For you, it’s a feature, isn’t it?

No, it’s a bug. What you seem to not understand about the free market viewpoint is that we regard such subornation as inevitable and therefore the best way to avoid it is to not start down that road.

cjm Wednesday, 06 August 2008 at 00:35

a certain percentage of existant mortgages (about 4% iirc) are at risk or likely to go into foreclosure. individual banks are at risk according to how much of this necrotic debt they hold relative to their capitalization. the overall system should not be in danger from that 4% number. here is where i think the systemic danger lies: that 4% is like the initial snow mass in an avalanche — as it rolls down the mountain it picks up more and more otherwise sound mortgages until there is a critical mass that does bring the entire finance system down. as foreclosures drive down home values, more people get “upside down” and walk from a property they could carry but choose not to. already there are many documented cases of people buying a new house (new to them, if not newly constructed) and walking from their existing homes.

this massive fraud scheme was just one more thing that happened because bush just wasn’t upto the job. this is all his and it’s a really big bad thing. compared to this mess, enron and worldcom were kiddy parties gone wrong. this is the kind of problem — should it reach worse case proportions — that genuinely can end America as we know it.

Harry Eagar Wednesday, 06 August 2008 at 03:26

Panicmonger alert!

Is it getting crowded in here, or am I gaining weight?

Sure, Bush & Co. turned a blind eye, and it suited what passes for economic sophistication in their milieu, but this was going to come up anyway. Recall that Glass-Steagall was repealed during the FIRST Clinton administration.

Everybody wanted free lunch.

erp Wednesday, 06 August 2008 at 07:34

“Nothing — I repeat — nothing to do with CRA.”

Thanks for clearing that up Harry — let me guess, was it Ronald Reagan then?

Tom C Wednesday, 06 August 2008 at 08:13

Harry- Market problems are sourced at the margin. Easy money, political rather than economic considerations- at the margin -, implied guarantees from the gse’s. Put it all together and you’ve got the trifecta of moral hazard. Learn a little about the money shoveled around post the new and improved CRA circa 1997. How much money was involved? More than you are aware of, obviously. What kind of pressure was put on the banks? While prices were going up, why fight the now annual audits? Get your facts straight. Go beyond Paul Krugman and the politically connected hacks he listens to. Facts are facts.

cjm Wednesday, 06 August 2008 at 08:36

facts are also sometimes a convenient excuse, after the fact (so to speak). it wasn’t anything but greed and indifference to the damage they were doing, that made banks throw all their lending standards out the window. the fees were just too tantalizing to resist. at the end of the day, all the ‘geniuses” collecting big bonuses were and are poseurs. you could put a chimp in thier chairs and get better results. don’t get me wrong, i understand and support a market based economy, but i also understand human nature. bush intentionally let loose the flood gates of consumer spending to avert a recession; whether this turns out to be a net good or bad remains to be determined.

Tom C Wednesday, 06 August 2008 at 10:01

I don’t disagree. The president’s ‘ownership society’, ‘third way’ inclinations added little other than market/price distortions to housing. Combining such policy with Greenspan’s easy money, the additional political pressures of the new and ‘improved’ CRA, the GSE’s lobbying and campaign contibutions as well as the patronage possibilities those organizations presented to their congressional overseers were an almost perfect storm once the music stopped. It didn’t start with Bush, by a long shot but, should have known better.

Harry Eagar Wednesday, 06 August 2008 at 13:09

Unlike, I bet, any of you, I go down to the courthouse once a week and read all the foreclosure complaints.

CRA had nothing to do with it.

True, the real estate market in my county is an oddball, but the latest big stack of foreclosure suits all concern modest condos that were purchased by off-island by investors for $200K or thereabouts, rented to working people for $1300 - $1400 a month, refinanced to take out imaginary equity up to $350K - $400K, with rents falling to around $1100 - $1200.

Now the borrowers are upside down. But sure, let’s blame the people in the nation with the least economic resources and zero clout.


The details differ in more typical markets, but CRA is not the problem

Tom C Wednesday, 06 August 2008 at 16:57

A problem, not the problem.It won’t be a problem anymore since the banks will throw the annual CRA audit/examination boys out the door. I know I would.

Hey Skipper Wednesday, 06 August 2008 at 17:35

Obviously not, or I would not have confused Tom.

If I was worried about confusing Tom, I would have suggested you write for Time.

[/tongue in cheek]

Harry Eagar Wednesday, 06 August 2008 at 18:48

I cannot tell you how amused I am to see greed being excoriated in this thread.

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