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March 21st, 2008

that housing crisis thing

This is a really bad explanation of why the housing crisis turned into a generalized liquidity crunch that is threatening, well, everything:

http://www.nytimes.com/2008/03/19/business/19leonhardt.html?bl&ex=1206244800&en=614ffbdad4adc4cb&ei=5087%0A

So. He mentioned leverage. He mentioned CDOs. How did he manage to miss with these two crucial components?

(1) He mentions that CDOs were sold to "investors". He does not mention anything about "bond insurance" or that a lot of "investors" are institutions (like pension funds, mutual funds, endowments, etc.) with rules about what they are allowed to buy/hold. There was some extremely funny math that was used to "prove" that CDOs had very little risk (considerably less than the underlying mortgages) because of the way they were broken up into tranches. For good measure, bond insurance was bought for these products, which put them smack into the A and up category that virtually any fund can buy. Further, financial institutions who loan money have rules about how much they have to have on hand to cover for the stuff they loan out, and what form that can take. Again, the CDO product met these criteria. As a result, CDOs wound up being held by a lot of people who _can't_ buy other things (and the CDOs had better rates of return) AND financial institutions believed the funny math and held the CDOs themselves.

(2) The funny math was wrong. It was wrong because, well, it was funny, but on top of that, it had a lot of assumptions built into it like, lenders would do due diligence on the people they loaned their money to and the market as a whole wouldn't all tank simultaneously. The lenders did NOT do due diligence (and sometimes committed fraud) and the market as a whole did (more or less) tank simultaneously, because all this funny money inflated a preexisting bubble.

(3) When the CDOs fell apart, the bond insurers were on the hook to cover. Should be fine, right? But remember, bond insurers are financial institutions who have to have some stuff at home to cover for the money they loan out (or whatever). And guess what their capital was in? Well, at least some of it was in CDOs. And in any event, these guys are basically just bookies anyway and the odds weren't priced right (see #2, funny math being wrong). The bond insurers started wobbling and Moody's changed their ratings, which changed the ratings on the CDOs insured by the bond insurers which meant the institutions couldn't hold them anymore because they had too low a rating which meant everyone had to sell.

You can kind of see how this would not go well.

Leverage made it worse because, repeat after me, boys and girls, it is _always always always_ true: whatever happens will happen harder if you are leveraged. You'll go up faster and down harder. Splat.

A couple of other factors played into this. Money to buy a house got so easy there for a while that our previous child care (and remember, this is a woman who couldn't scare up the deposit for moving to a different apartment) was shopping for a condo. Her thinking was she'd get a zero or low money down alt-a or subprime, wouldn't have to document any income, and once she had the place, she could use the ever-increasing equity to buy her groceries via an HLOC. When people say that people were treating their houses like cash machines, do not think this was meant as a joke, or hyperbole, or anything like that. Previous child care did not actually buy a condo (she was late to the game otherwise who knows, she probably would have pulled it off), but we all saw the rates of appreciation the last few years of the bubble. That money came from nowhere and is going _right back to nowhere_. In the meantime, a lot of people took money out while the bubble was in full flower (er, sorry about that), in much the same way I cashed out a chunk in 1997/8. That is money from nowhere that now has to be replaced by money from somewhere, to reimburse nowhere. So to speak.

Is there unjustified panic?

Fuck no. People aren't scared enough. Everyone's so busy griping about the cost of gas no one seems to care to ask the question of why oil is so freaking expensive, which is, of course, the wrong question. The right question is, why is the dollar worth so freaking little?

And the answer is: got to reimburse nowhere.

Before I moved back to Seattle in early 2005, oil prices were already climbing steadily and people were trying to decide whether this was for real or another one of those spikes that causes people to buy solar panels and then regret it. I said at the time that it was going to get a lot worse before it got better, if, indeed, it ever got better, and I was busy reading about Peak Oil and the history of oil and so forth. As a result, I watched the tail end of the real estate bubble with complete dismay, since a lot of it involved far flung suburbs that I was then and am now completely convinced are unsustainable against the backdrop of Peak Oil.

While I was in Seattle, I was reading Financial Times which, _unlike_ the New York Times, covered the problems with CDOs in detail, well before the crisis started developing. When we moved back here to Brookline, I spent a lot of time staring at articles in FT, trying to figure out where on earth I could stash my money to be safe from this particular disaster, and came up completely short. Other than what we were already doing (living a prudent lifestyle with no debt, and betting fairly hard that oil and other commodities were going to go up), I couldn't find _anywhere_ in the system that wasn't entangled in these new, untried and stupidly risky investments that everyone persisted in characterizing as No-Fail.

I have to say I'm personally offended that some idiot at the New York Times can write an article like that one and have it published. That is some stupid.