We left off talking about Rating Agencies and how it was their blessing that allowed the public pools of money to invest in anything, from shares in Apple to Mortgage Bonds created by Goldman. We uncovered the junk bond logic that taught us that by pooling a bunch of risky assets together, the sum of those assets are worth more than the individual parts.
But does this logic truly extend to personal loans, like mortgages, credit-lines and credit cards? It is true: by pooling mortgages together, the risk that a handful of people will default is mitigated by the diversity of the pool. But because these are personal loans, there’s a conflicting economic principle that prevents the entire pool being worth more than its individual parts.
In the summer of 1998, I worked as a bank teller at the Royal Bank in Streetsville. It was me and a collection of middle-aged women that enjoyed pinching my cheeks and sharing their lunch with me when I forgot mine. As Autumn approached, the bank knew I was leaving for school, and they gave me an incredible parting gift. It was a $20,000 unsecured line of credit at the prime rate. “Use it if you need it.” Oh man, did I ever need it!
Let’s be clear: they didn’t just trust me; they believed in me. I wasn’t going to be paying this back for at least five years. In the end, it was a profitable loan for the bank. I paid every single penny of interest and principal back. But what if someone like Goldman wanted to pluck the loan and make it a part of a larger credit derivative transaction? What did my loan look like to a third party?
Immediately, it’s not looking good. No assets, no reliable source of income, and an insufficient credit history. Dig a little deeper and analyze the activity of the loan, and we discover that I was using the loan itself to pay the interest, and there was an “incident” on my record where I had gone over the maximum, for which my bank called my mother and let her know that they cleared my payments anyway.
I’m not saying the loan is worthless, but with an unsecured loan like this, a third party would be able to command a considerable discount when purchasing the loan. The Royal Bank in Streetsville, the original issuer of the credit line, is always in the best position to know what the loan is worth. Third parties don’t care about what a good guy I am, or what I plan to be when I grown up. When you summarize the stats, details like that fall off the table. This is why personal loans are always worth more to the issuing bank than a third party. Third parties can command serious discounts, because they will constantly stress they don’t know who the hell I am.
Collection agencies make a living like this. They buy other peoples’ loans in exchange for cash, but they always pay you less. That’s how they make their money - discounts. They are taking on the risk of collection.
But somehow, under the confused logic of Wall Street, our money managers weren’t under the impression that they were taking on collection risk. Oh no! This is a derivative! Have you seen what a shiny, fancy, black box that spews money from every direction even looks like??? We’re not a collection agency! Haha-LOL!!! We are sophisticated money managers!!!
The public pools of money bought these securities blindly, and overpaid for personal mortgages with our money. The packaged credit securities were too complicated to evaluate or understand, as our money managers demonstrated. It’s been well documented that surging house values was holding up everyone’s confidence in these Mortgage Bonds, while the ability of the borrower to pay back the loan was largely ignored. Needless to say, a personal loan is very much backed by the person who is borrowing the money. Which is to say, a drop in housing prices does not affect a person's ability to repay the loan. In hindsight, defaults/foreclosures have had a tremendous impact on housing prices.
As much as third parties try and objectify personal lending by calculating credit scores and appraising assets held for collateral, it can never compensate for a borrower that feels obliged to repay the loan. The junk bond logic falls apart with personal loans, because once you translate a person into a credit score with an asset, you have lost the most important piece of information: Trust.
So why did our money managers fall into a hysterical buying binge when it’s clear they didn’t understand what the product was? The popular answers are: corporate greed, short-term thinking, personal greed, bonuses, faulty valuation models, rating agencies, stock market madness in general, sub-prime loans, excessive risk-taking, the science of bubbles, Freddy and Fannie, Jim Cramer, Capitalism, Greenspan, Ayn Rand, CNBC, and now Goldman Sachs. Basically all things we can’t do anything about. These are all symptoms of the problem, but to see the problem itself we need to take a step back.
The problem is that we have propped up too many money managers who stand to benefit from other peoples’ money.
"Nobody spends somebody else's money as carefully as he spends his own. Nobody uses somebody else's resources as carefully as he uses his own. So if you want efficiency and effectiveness, if you want knowledge to be properly utilized, you have to do it through the means of private property."- Milton Friedman
When Friedman said this, he wasn’t talking about the Investment Management industry. His point was that big, bureaucratic institutions like the government didn't spend our money well. They still don't. And I'm saying Mutual Funds, Pension Funds and Insurance Funds act like big, bureaucratic institutions. I can't think of a single more bureaucratic organization than a corporation that has no true owner and is made up entirely of other peoples' money: the Fund. The essence of the quote is that if you want money to be spent wisely, the owners of capital (that's us! private individuals) have to stay close to the money.
We have allowed large private corporations to spend our money for us, expecting them to have the same sense of duty and responsibility as we would with our own money. This crisis wasn’t a failure in government regulation, nor was it a failure of capitalism. It was a failure of Funds to act in a capitalistic way. We are guilty too. We don't want to think about it. Just make my money grow, okay?
Combine that with our fear of the complex financial world, and it's only natural that we handed off the burden of personal financial decisions to “experts,” who represented us in a game they had no idea they were a part of. They played because they were being paid to, not because they were good at it. This is a game that we financed every step of the way. We paid the Fund to invest our money in Mortgage Bonds. We paid Goldman through the Fund, for the privilege of investing in Mortgage Bonds. Sometimes, we pay one group of Funds to invest in other Funds. We signed off on all of this.
In the fourth and final installment, we'll explore our big pools of money more specifically and see if we can get any of our money out of this ridiculous game. Perhaps more importantly, we'll try and determine what the hell to do with the money once we get it out.
But does this logic truly extend to personal loans, like mortgages, credit-lines and credit cards? It is true: by pooling mortgages together, the risk that a handful of people will default is mitigated by the diversity of the pool. But because these are personal loans, there’s a conflicting economic principle that prevents the entire pool being worth more than its individual parts.
In the summer of 1998, I worked as a bank teller at the Royal Bank in Streetsville. It was me and a collection of middle-aged women that enjoyed pinching my cheeks and sharing their lunch with me when I forgot mine. As Autumn approached, the bank knew I was leaving for school, and they gave me an incredible parting gift. It was a $20,000 unsecured line of credit at the prime rate. “Use it if you need it.” Oh man, did I ever need it!
Let’s be clear: they didn’t just trust me; they believed in me. I wasn’t going to be paying this back for at least five years. In the end, it was a profitable loan for the bank. I paid every single penny of interest and principal back. But what if someone like Goldman wanted to pluck the loan and make it a part of a larger credit derivative transaction? What did my loan look like to a third party?
Immediately, it’s not looking good. No assets, no reliable source of income, and an insufficient credit history. Dig a little deeper and analyze the activity of the loan, and we discover that I was using the loan itself to pay the interest, and there was an “incident” on my record where I had gone over the maximum, for which my bank called my mother and let her know that they cleared my payments anyway.
I’m not saying the loan is worthless, but with an unsecured loan like this, a third party would be able to command a considerable discount when purchasing the loan. The Royal Bank in Streetsville, the original issuer of the credit line, is always in the best position to know what the loan is worth. Third parties don’t care about what a good guy I am, or what I plan to be when I grown up. When you summarize the stats, details like that fall off the table. This is why personal loans are always worth more to the issuing bank than a third party. Third parties can command serious discounts, because they will constantly stress they don’t know who the hell I am.
Collection agencies make a living like this. They buy other peoples’ loans in exchange for cash, but they always pay you less. That’s how they make their money - discounts. They are taking on the risk of collection.
But somehow, under the confused logic of Wall Street, our money managers weren’t under the impression that they were taking on collection risk. Oh no! This is a derivative! Have you seen what a shiny, fancy, black box that spews money from every direction even looks like??? We’re not a collection agency! Haha-LOL!!! We are sophisticated money managers!!!
The public pools of money bought these securities blindly, and overpaid for personal mortgages with our money. The packaged credit securities were too complicated to evaluate or understand, as our money managers demonstrated. It’s been well documented that surging house values was holding up everyone’s confidence in these Mortgage Bonds, while the ability of the borrower to pay back the loan was largely ignored. Needless to say, a personal loan is very much backed by the person who is borrowing the money. Which is to say, a drop in housing prices does not affect a person's ability to repay the loan. In hindsight, defaults/foreclosures have had a tremendous impact on housing prices.
As much as third parties try and objectify personal lending by calculating credit scores and appraising assets held for collateral, it can never compensate for a borrower that feels obliged to repay the loan. The junk bond logic falls apart with personal loans, because once you translate a person into a credit score with an asset, you have lost the most important piece of information: Trust.
So why did our money managers fall into a hysterical buying binge when it’s clear they didn’t understand what the product was? The popular answers are: corporate greed, short-term thinking, personal greed, bonuses, faulty valuation models, rating agencies, stock market madness in general, sub-prime loans, excessive risk-taking, the science of bubbles, Freddy and Fannie, Jim Cramer, Capitalism, Greenspan, Ayn Rand, CNBC, and now Goldman Sachs. Basically all things we can’t do anything about. These are all symptoms of the problem, but to see the problem itself we need to take a step back.
The problem is that we have propped up too many money managers who stand to benefit from other peoples’ money.
"Nobody spends somebody else's money as carefully as he spends his own. Nobody uses somebody else's resources as carefully as he uses his own. So if you want efficiency and effectiveness, if you want knowledge to be properly utilized, you have to do it through the means of private property."- Milton Friedman
When Friedman said this, he wasn’t talking about the Investment Management industry. His point was that big, bureaucratic institutions like the government didn't spend our money well. They still don't. And I'm saying Mutual Funds, Pension Funds and Insurance Funds act like big, bureaucratic institutions. I can't think of a single more bureaucratic organization than a corporation that has no true owner and is made up entirely of other peoples' money: the Fund. The essence of the quote is that if you want money to be spent wisely, the owners of capital (that's us! private individuals) have to stay close to the money.
We have allowed large private corporations to spend our money for us, expecting them to have the same sense of duty and responsibility as we would with our own money. This crisis wasn’t a failure in government regulation, nor was it a failure of capitalism. It was a failure of Funds to act in a capitalistic way. We are guilty too. We don't want to think about it. Just make my money grow, okay?
Combine that with our fear of the complex financial world, and it's only natural that we handed off the burden of personal financial decisions to “experts,” who represented us in a game they had no idea they were a part of. They played because they were being paid to, not because they were good at it. This is a game that we financed every step of the way. We paid the Fund to invest our money in Mortgage Bonds. We paid Goldman through the Fund, for the privilege of investing in Mortgage Bonds. Sometimes, we pay one group of Funds to invest in other Funds. We signed off on all of this.
In the fourth and final installment, we'll explore our big pools of money more specifically and see if we can get any of our money out of this ridiculous game. Perhaps more importantly, we'll try and determine what the hell to do with the money once we get it out.
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2 comments:
interesting, Umar thanks.
I would be interested to know what to do with the small amt of money I have - at this point I don't trust managers to outperform the market.
At least not consistently.
Do you?
i am on the same page as you. i don't trust anything or anyone right now.
like, i've been tied up but a part of me is screaming to write about that 1000 point drop in the Dow, and then the immediately recovery right away.
it was very poorly reported (nobody could explain the mechanics of the "glitch." and everything is okay because it went back up, but i'm pretty sure we can't ignore it when one bank does something that shakes the entire market like that.
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