What should we rescue? And what can we rescue?

October 5, 2008 at 5:06 am | Posted in economics, Housing, regulations, Uncategorized | Leave a comment
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The housing and related market has several layers to it. There are a whole lot of individual mortgages. Many of these are sensible mortgages on affordable terms made to people who have been reasonably prudent. Some of them were risky, for a variety of reasons, including individuals who got greedy for more house than they could afford, or lenders / brokers who put buyers into unaffordably large mortgages or with onerous terms. Some of the risky mortgages have defaulted or are otherwise in trouble, and things will continue to worsen for some time.

Tightening credit norms are making it difficult for buyers to buy homes now, even as prices are slipping and inventory is rising, further causing prices to spiral downward.

Most of these individual mortgages were put together into pools of mortgages, and investors bought securities created out of these pools. The idea is that each mortgage-backed bond represents tiny fractions of thousands of mortgages, and so should be safe even if a few of those mortgages go bad. These securities are then broken up into tranches, with the worst tranches the first to absorb any losses from defaults, and the best tranches only taking a loss if the lower-ranked tranches were wiped out.

So far, so good. The value of these mortgage backed securities is similar to the value of the mortgages underlying these securities. But then, we add derivatives on these MBS’s. There is no real limit to the number or value or complexity of derivatives. We can bet that one security will be worth more than another, or that the defaults in one security will exceed (or be below) a certain level, or a host of other such bets. And we can then create securities that pay off based on the outcome of other bets. The size of the derivatives market has been estimated at nearly $700 trillion – A thousand times the size of the proposed bailout, and ten times the size of the global economy.

I guess thats a bit like horse racing – The amount of money that changes hands based on the outcome of a single race is many times the amount of money spent by the breeders, or the prize money they may win.

I think that if the bailout money was used to buy mortgages, the price support is more likely to buoy the prices of the derivatives, than if the attempt was to either support the derivatives directly, or to rescue the bank after the derivatives caused big losses. After all, with the money, one could buy up over 5% of mortgages, and thus support the value of derivatives that depend on the value of the underlying mortgage for their own value, or make the tiniest dent in the derivatives market. If the derivatives got support from underlying values, there wouldn’t need to be as much of a writedown.

Obviously, every trade has a counterparty. For everyone who bought a derivative, someone sold it. If the value of the derivative tanks, someone loses big, and someone makes a killing. Supporting the derivatives market via underlying mortgage action will reduce the change in the derivative value. People won’t lose as much, or make as much.

Clearly, this is distortionary – If the investors believed the government would rescue the derivatives, they would not have made the same trades. But I think that the only area where a rescue could work is at the underlying mortgage level – and if derivative investors see bets they called correctly going against them because of the rescue, I feel for them, but still think the economy is better off than if the bailout money was used to rescue the financial sector from the results of mortgage defaults.

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