Paul Krugman: Just Say AAA

Paul Krugman looks at "the fuss over C.D.O.’s," and the responsibility of bond-rating agencies and regulators for some of the consequences of the collapsing housing bubble:

Just Say AAA, by Paul Krugman, Commentary, NY Times: What do you get when you cross a Mafia don with a bond salesman? A dealer in collateralized debt obligations (C.D.O.’s) — someone who makes you an offer you don’t understand.

Seriously, it’s starting to look as if C.D.O.’s were to this decade’s housing bubble what Enron-style accounting was to the stock bubble of the 1990s. Both made investors think they were getting a much better deal than they really were...

To understand the fuss over C.D.O.’s, you first have to realize that in the later stages of the great 2000-2005 housing boom, ... there was an explosion of subprime lending...

For a while, the risks of subprime loans were masked by the housing bubble itself: as long as prices kept going up, troubled borrowers could raise more cash by borrowing against their rising home equity. But once the bubble burst ... many of these loans were bound to go bad.

Yet the banks making the loans weren’t stupid... Subprime mortgages ... were securitized..., banks issued bonds backed by home loans, in effect handing off the risk to the bond buyers.

In principle, securitization should reduce risk... But ... it’s now clear that many investors ... didn’t realize what they were getting into.

And it’s also becoming clear that ... many investors were fooled by fancy financial engineering ... into believing they had protected themselves against risk, when they had actually done no such thing...

C.D.O.’s are ... supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated ... with a high rate of return, while leaving other investors with a “synthetic” asset that is, well, safe as houses.

S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along..., telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds. And investors have ... “snapped up” these securities “because they typically yield more than bonds with the same credit ratings.”

But the securities were never as safe as advertised, because the risk transfer wasn’t anywhere near big enough to protect investors from the consequences of a burst housing bubble. It’s not quite the metaphor I would have come up with, but here’s what ... Bill Gross had to say about C.D.O.’s...:

“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”

Now we’re looking at huge losses to investors who thought they were playing it safe. Estimates ... range from $125 billion to $250 billion, with some analysts warning that a wave of distress selling will deepen the housing slump even further.

Now, you might have thought that S.& P. and Moody’s, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious. And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets.

But apparently not. And the housing bubble, like the stock bubble before it, is claiming a growing number of innocent victims.

_________________________
Previous (6/29) column: Paul Krugman: The Murdoch Factor
Next (7/6) column: Paul Krugman: Sacrifice Is for Suckers

Comments

[Steve]

I was astounded to hear about the CDO market when I moved to the US from Australia 9 years ago. I thought the bundling of mortgages was risky but assumed that the buyers were putting adequeate safeguards in place to check the quality of the paper they were buying. Once again, investors were sold a crock. When are we going to learn that Wall Street is a group of commissioned salesmen who will do and say anything for a percentage of the transaction? If its too good to be true its probably too good to be true.

[Lafayette]

Steve: When are we going to learn that Wall Street is a group of commissioned salesmen who will do and say anything for a percentage of the transaction? If its too good to be true its probably too good to be true.

As PT Barnum (of Barnun & Bailey, a traditional American circus company) said: "A sucker is born every minute". A sucker that buys a ticket to a circus is one thing, but that same sucker on Wall Street who, as Krugman notes, should have known better from past mistakes, makes again the same is either a damn fool or a crook. (Given than nine out of ten of them possess a degree in Finance or an MBA, we must presume the latter.)

Who should not be un-licensed so as to never work again in financial services. More so, a nice fine levied on the companies they worked for, who should have done the overseeing and whose management certainly sanctioned the purchase of CDO's should also be fined. (And, those receiving the stock options be required to give them back.)

When bad boys will be bad boys, only salutary punishments will have a lasting affect. Think of all the new friends they can meet in prison.

Or, do they think they are like Paris Hilton and needn't go to jail because "mommy knows people" ... ?

[anne]

Bill Gross has a creepy way of making and using metaphors, and Paul Krugman needs to have more judgment than to use sexist metaphors even though they are all the fun rage. know, no big deal, but why are preferred metaphors so easily derogatory of women?

[paine]

this is investment grade lame- ness

"Now, you might have thought that S.& P. and Moody’s, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious. And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets.

But apparently not..."

for god's sake obviously the raters know exactly what their doing

what
i can't fathom is why polite
progressive dialoguers like st paul here
won't rate the raters as the z market trash mongers
they are

the capture of such institutions
by the regulated
is in most cases
even easier then gubmint analogues

[anne]

"I know, no big deal, ..."

What has been puzzling me for months is whether smaller retail investors are effected. Were mutual funds buyers of sub-prime debt filled debt obligations? Vanguard has owned no such debt, evidently recognizing the riskiness despite the high investment grade rating. But, why when it was so obvious that Vanguard was avoiding the debt were other institutions so readily using it? I know how such investments are pushed, but I am puzzled at the buyers.

[sam]

what makes one think that S&P/Moody ets suckers?
Being a party to the scam, they are not suckers at all.
I remember reading about a Goldman Sach's folks meeting w/ rating guys over a cuppa and came to a mutual understading about certail security..
Wink, wink...

[dd]

"And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets."

Of course the Fed & the regulators learned and kept a watchful eye. What they learned was the importance of "claiming a growing number of innocent victims," as that spreads the losses and makes them manageable.

says...

I don't know if I should post this link here, in the one about "the greatest fools", or in the post about European rigidities or in the one. All I know is that, personally, I feel kind of relieved...

http://www.oecd.org/document/38/0,3343,en_2649_34593_38208614_1_1_1_1,00.html

[Lafayette]

anne: (I) know, no big deal, but why are preferred metaphors so easily derogatory of women?

Because that is what Krugman had on his mind at the moment of writing. Frankly, I thought it a bit crude and so did he (or he wouldn't have acknowledged it).

Not to worry. Metaphors or no metaphors, the handwriting is on the wall. This Information Age is one of brains and not brawn ... so the girls will probably do just as well as the boys, if not better.

In fact, I suspect most of the "suppressed venom" (some of which leaks out now and then into the media) is a realization of just how tough the competition is going to get for some men who, despite their intelligence, have muddled through chiefly because of their masculinity.

I know it scares the hell out of me.

[Isabel]

Says, above, was me, Isabel.

[anne]

Lafayette

That was a nice and intelligent comment about uncertainty and dislocation that can be taken further.

[kharris]

anne,

Freddie and Fannie reportedly have exposure to subprime mortgages in the small billions each. That is according to a report in the British press someplace or other (sorry). So anybody who has Fannie of Freddie bonds apparently has modest exposure. That's a lot of people. Till I read that bit of news, I was under the impression that Fannie and Freddie owned no subprime debt.

The upside is that the two agencies are looking to regain lost market share as subprime lenders die off. I don't know which effect is larger.

[anne]

Funny, I had read the same about Fannie Mae and Freddie Mac holding sub-prime debt and simply passed on. I would however assume they are because of asset depth not threatened. Now, we have to consider why the idea that sub-prime lending was a proper way to expand home ownership became so easily accepted. Warren Buffett sold Freddie Mac, with never an explanation as usual, when the company was most sound. I noticed immediately, and turned from the company thinking there must be something I do not understand in terms of credit quality.

[ECONOMISTA NON GRATA]

I found the metaphor kinda gross.... (no pun intended). However, all seriousness aside, this exposure of the risk which was quite evident years ago as stated by anne as it realates to vanguard is clearly a direct outcome of the rating agencies providing cover for the IBs. In court it can be argued that my fiduciary authority compeled the purchase of these AAA rated securities.

Furthermore, I would site the agreements that were signed stipulating the inherent use of the rating agencies as diligent application.

Having said this, the financial system is being stress tested note the pressure on the dollar over the last two trading sessions. The market forces will most likely force Bernake's hand sooner rather than later, futher agravating the already endemic situation.

The latest talking point on Wall Street is, "LET'S GET THROUGH ANOTHER WEEKEND."

Best regards,

Econolicious

says...

I'm sure that I've seen, somewhere in the deep well of knowledge at CalculatedRisk, some chart ot pie, or whatever, about the exposure of GSE to subprime. There is no way I can find it now, although I did find this, for example:

"...GSEs started buying some subprime for their portfolios, so you couldn't always assume GSE = prime without carefully specifying that you meant the standard MBS programs..."

http://calculatedrisk.blogspot.com/2007/03/tanta-makes-argument-for-conformism-and.html

Or this, from an eternity ago:

http://www.nhi.org/online/issues/125/goingsubprime.html

[im1dc]

I believe our Professor Krugman is saying that this is going to get worse before it gets better.

I agree b/c I've read that if Subprime CDO's do not perform (loans in the some CDO's are already 20% to 50% or so delinquent or in default) then CMO's are next which can and probably will affect everyone else with ARM mortgages and everyone who wants a mortgage, i.e., higher interest rates ahead and less lending.

It that were to happen then we're talking amounts of at least a $Trillion, not $Billions.

The FedRes can't fix a catastrophe that size.

Let's hope Wall Street ponies up the money to save the CDO's as BearStearns did for the larger of the two of their's that MerrilLynch held in technical default. Better to spend $Billions to keep this ship afloat than allow it to sink and probably affect the American and global economies.

I believe the blog CalculatedRisk had some good stuff about this last week.

[anne]

The reason I use Vanguard as a bond market pointer, is that the asset size, broad mix of bond indexes and managed funds and minimal cost will show off general problems if there are any, while the conservative mix of bond selections shows whether the problems are other than in what should be suspect paper.

Vanguard is able to offer relatively high returns on highly conservative portfolios because of the low costs for investors. When the company stays away from an asset, we should wonder why, and sub-prime mortgages were avoided completely as far as I could tell. Also, I considered mortgages a trickier long-term investment before sub-primes were packaged.

[anne]

Even the safest of mortgage packages, GNMAs, seem to have changed in charater since about 1992, to make them suspect for shrewd bond-holders. The possibility of GMNA capital gains has been increasingly limited, relative to other bonds. Why bother then? After all, why not the real estate investment trust index in a low interest rate market?

I guess the reason for institutional investors reaching for riskier mortgage debt goes beyond being fooled by vredit ratings. These folks will often well understand. I guess the reason is cost cost cost. When you charge lots for your investment services, there is a temptation to use riskier securities to generate returns that will cover the cost of services.

[anne]

Vanguard has a huge asset base and does well with low cost. Heck, so does Yale management or Berkshire Hathaway. But, if clients are paying even .5% for the cost of bond management, let alone 1% or 1.5%, when bond traders will fist fight for far less and use swords for less than .5%, then look for risk. Risk covers cost, when risk is being sold.

[anne]

Then, the guess would be the structural fault rests with the continual attempts by highly expensive advisory services to justify themselves. I was with a highly-regarded theoretical mathematician this weekend, who believes there are advantages in mathematically based investment that change specifically but are fairly lasting generally. But, though I did not ask, he wondered whether the price of the most advanced technicians limited even most of the returns in excess of indexing.

[murdock]

oops...

From Mr. Krugman's June 20, 2003 New York Times column, "Still Blowing Bubbles")

The big rise in the stock market is definitely telling us something. Bulls think it says the economy is about to take off. But I think it's a sign that America is still blowing bubbles — that a three-year bear market and the biggest corporate scandals in history haven't cured investors of irrational exuberance yet.

And.

In short, the current surge in stocks looks like another bubble, one that will eventually burst.

[im1dc]

CORRECTION:

My apologies for the error in my prior post this morning.

The CDO insights/info I referenced came from HERE:

Regular Big Picture Readers will recall last week's posts on each of these subjects:

CDO Hedge Funds = Enron ?
and
10 Questions About CDOs

link: http://bigpicture.typepad.com/

The first is especially good.

[anne]

So that foolishness is answered, not that fools can ever be answered, the assumption the Paul Krugman and Warren Buffett and Brad DeLong made about stock market values several times over with other analysts following, missed projecting the pronounced continual rise in corporate profits that would justify stock prices. Now American stock prices since 2003 have been among the weakest internationally, but American corporate profits which began at record levels relative to returns to labor continually increased relative to labor from 2003.

Krugman however has been wrong in projections before and will be again, as has Buffett and DeLong, but I bet with them and guess where DeLong suggested betting in 2003 and guess how right the bet was.

[kthomas]

nice reply, anne. out of the park.

[lemmoth]

New to this forum. I was just curious if the learned Anne could comment on the fact that the liquidity of the home mortgage market, made possible in the first five years of this century by the securitization of mortgage obligations, was not in the long run a good thing , both for individuals who otherwise couldn't have had the possibility of home ownership, but for the economy as a whole. Ok - so now we have a downturn, that's how markets work. Those willing to take some risk for a greater return did so. As long as the models upon which the ratings were based were mathematically legit, you can't find fault with the ratings agencies, can you?

[anne]

Thank you, KThomas.

We are by the way continuing through what must be the most powerful international economic growth period and echoing bull markets in stocks and possibly still commercial and home real estate since at least 1945. While the bull market in home real estate has generally ended here, there have only been selectively limited halts internationally with Germany scarcely begun and extending to South Africa.

[baileyman]

"And the housing bubble, like the stock bubble before it, is claiming a growing number of innocent victims."

Of course. The whole point is to create victims.

[anne]

Lemmoth, excellent question.

I have similarly wondered about the lonbg term benefits of the latest housing boom. The finest home market expansion I know of came with subsidized mortgages through the GI bill after the World War. The long term attractiveness lay in the low mortgage rates. Also, I think the increased competitiveness and alternate products offered for prime mortgages from 1980 highly attractive. From 1980 on, a homeowner would never have been disadvantaged by a variable rate mortgage.

Sub-prime is the trick, and here I would worry but do not really know how much to worry. The only way sub-prime mortgages made sense is in a perpetually rising home price environment which could not be. What then of households being formed where otherwise impossible. Darn, I do not know. These newest products however bother me, and I sure would not have suggested them or invested in them.

[James Killus]

Just to maybe hammer the point home, when someone like Krugman, DeLong, or even Warren Buffet makes a wrong call on a market, the consequences are fairly small. When Moody's or Standard and Poor's gets a risk factor for an entire economic sector wrong, the consequences begin at tens of billions and move rapidly toward outer space.

[anne]

Possibly the way to think of the question is whether the sub-prime market offers any advantage for relatively lower income households. Heck, expensive credit extension would not seem to be the way.

[Lafayette]

im: The CDO insights/info I referenced came from HERE

Ah!, so now there are CDP insights?

You people are chasing a phantom. It was a scam. Admit it and let's move on.

[Lafayette]

S&P, Moody's Mask $200 Billion of Subprime Bond Risk

[Jeffrey Miller]

"S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along..., telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds. And investors have ... “snapped up” these securities “because they typically yield more than bonds with the same credit ratings.”

Higher yield means lower price; the market therefore did "know" that these securities were riskier than high grade bonds, whatever the rating agencies were saying. And I'm always a little suspicious of claims made by investors who are astonished, in hindsight, that what they thought was a free lunch (high yield and low risk) turned out to be otherwise.

[anne]

Again, my emphasis would be more on the problem of sub-prime mortgage extension in lieu of mortgage subsidies that were once used to expand home ownership, with the GI mortgage program after the World War as an example. My concern is less on the problems of sub-prime debt for institutional bond buyers and more on the impossible problem of the mortgages for home owners when property prices cease to rise and in a low wage and sluggish wage increase environment.

[Lafayette]

anne: My concern is less on the problems of sub-prime debt for institutional bond buyers and more on the impossible problem of the mortgages for home owners when property prices cease to rise and in a low wage and sluggish wage increase environment.

This sub-prime problem arose within a particularly specific economic context, as you describe. However, what about periods less dramatic than those where people think they can make-a-million by flipping a condo? Normal times, that is.

You say "sluggish wage increases", but since when did that predetermine hallucinatory mortgage defaults? Unemployment is at its historical lows. Expenditure for a residence is among the first priorities of a person/family.

May I suggest that the simple act of buying a house, though not elementary, is an important step in building one's personal equity base? Is it therefore not a matter of assuring that a mortgage should be possible without the sort of fraud involved in sub-prime loans?

And, as regards that matter, is it not the responsibility of the Fed to assure that mortgaging be conducted coincident with the highest standards of honesty?

So, what is it about this affair that I do not understand? It never should have happened and it certainly never should happen again. But, what is being done about it to prevent it happening again. Nothing.

People who perhaps should never have obtained a loan, did so fraudulently. Incompetence has been committed and yet no one blamable?

It's as if this matter was of no extraordinary importance either to the government or the Fed or both. Such indifference is scandalous.

There's no smoking gun? Nowhere? Incredible ...

[anne]

Lafayette has been properly clearer in emphasizing the problem resides in the nature of the mortgage market in recent years.

Several widely sold mortgage products have become ways of stripping value from homes beyond local home price changes. From "sub-prime" to "reverse" mortgages, to supposed rescue agreements for home owners who are troubled in meeting payments, to marketing quite risky debt as minimal risk debt, severe exploitation can be found.

[Barry]

(Prof. Krugman, re: the various agencies learning from previous bubbles): "But apparently not. And the housing bubble, like the stock bubble before it, is claiming a growing number of innocent victims. "

I think that what they learned from previous bubbles was that they could get away with a lot. In the case of Enron, the Supreme Court just legalized aiding and abeting fraud; those supposedly disinterested firms who became conspirators with Enron were (legally) justified.

[anne]

Beyond corporate favoring Supreme Court rulings on workers rights and environmental interests, my impression is that corporations, especially financial corporations, have gained more of a legal cushion in terms of what I would consider financial responsibility. This is only an impression however, and I have to ask.

[kharris]

One point that may be relevant to thinking about whether recent innovation in the mortgage market is a good thing overall is that we are talking about a recent innovation. Once retail investors at the deep end of the pool become sophisticated, the early troubles with financial innovation may be reduced. Not knowing what the structure of a particular instrument is, what happens to various forms of risk in various economic and market conditions, who the holders of similar instruments are - these things all mean innovation in the mortgage market brings risks.

We do not yet know if greater familiarity can reduce the risk of a CDO^3. We do not yet know know whether "assigning" risk to various tranches of a CDO allows realistic matching of risk and return, or understanding of risk in the higher tranches as the lower tranches come under pressure. It may be that this will always be an inherently shakey market. Alternatively, we may learn to model the market more effectively, learn to identify clusters of risk that result from securitizing mortgage payments into a variety of cash flows. We are going through the early part of the experiment. Next time there is a heavy round of complex mortgage securitization, followed by stress to the real estate or mortgage market, we'll find out how much we have learned.

[reason]

Lafayette...
I agree with you, but I have another puzzle, why didn't market discipline work? Why could firms making such stupid deals (and at such a stupid price) find people willing to give them money? It is not just the packaging of the morgages, it is the flow of credit in the first place. Something clearly stinks about our financial system at the moment, but I don't know where to point the finger exactly. I suspect it has to do with the (mis)use of limited liability in breaking risk into small disposable pieces (if Citibank was doing everything in its own name this wouldn't happen). But surely the LENDERS will end up getting burned in the end. Is the US in danger of turning into 1990 Japan?

[anne]

Remember, by the way, there has been continuous open hedge fund investment against the riskiest mortgage securities issuers. Gretchen Morgenson has described this.

Paul Krugman and KHarris may however be failing to ask whether the helpful gain in housing activity and the spread to relatively lower income households can be far more safely facilitated, as seems to be the case through Europe and australia.

[Lafayette]

KH: Next time there is a heavy round of complex mortgage securitization, followed by stress to the real estate or mortgage market, we'll find out how much we have learned.

Surely you jest. Why should there be a "next time". Wasn't this house of cards already once too often.

Some people should NOT be given mortgages if they do not have the proper resources. Sub-prime risks exist because they were considered "acceptable" and the risk rolled-over into a debt instrument.

You are "securitizing" the insecure. It's nonsense.

That's like saying, "OK, drunk drivers are now acceptable insurance risk. We just farm out that risk to any sucker who will buy a CDO".

[ECONOMISTA NON GRATA]

Everyone was a real estate genius, a mini Donald Trump if you will... "Easy money, fast money... Real estate sales people breeding like rabbits, mortgage brokers collecting fat front end fees on bad loans. "Make it happen!" No docs...? No problem.... No down payment... Don't worry... Buy now, sell later.... Land Rovers, Harleys, Jetskis, on the house.... Hardwood floors, Vaulted ceilings, Granite countertops and stainless steel appliances.... I'm feeling like Jaqui OHhhhhhh....

Is there a doctor in the house....?

This market is F--kd big time... What the regulators really need to do, is to look out for the unsuspecting teacher before they dump the toxic waste in her retirement account... It's already happening and that's where the rating agencies come in as cover for the fund managers.... This whole BS fiasco was an accident of timing and has really put a dark cloud on the master plan.. How are we ever going to pass this crap off to the retirement funds if these whole tranches get downgraded... It's a suitability issue and now the cat is out of the bag.... Expect massive resistance from the rating agencies and their customers. They have to get this shit (excuse the language) off of their books.

Best regards,

Econolicious

[im1dc]

Do I get the last word here? From WaPo 4th of July, 2007:

Hedge Funds Mystify Markets, Regulators
Deeply Powerful, Largely Unchecked

By David Cho
Washington Post Staff Writer
Wednesday, July 4, 2007

The takeaway:
"They assure everybody that everything's going to be okay, and we are forced to believe them."

IMO, that is the fly in the ointment. The fads of Wall Street Financial Instruments created and aimed at making the Capital Lenders piles of money continue to work until they stop working and they ALL stop working eventually, historically.

Still knowing What, Why and How doesn't tell us When.

link: http://www.washingtonpost.com/wp-dyn/content/article/2007/07/03/AR2007070302240.html?hpid=topnews

Page 3 "In the case of the Bear Stearns funds, the managers appeared to struggle to value their assets accurately or find buyers for them. In May, they said the funds had lost 6.75 percent of their value in April. In June, they revised that loss to 18 percent. The revision spooked traders, and ultimately some of their assets had to be dumped in a fire sale. Bear Stearns also lent $3.2 billion to bail out one of the funds after Wall Street banks demanded their money back."

"Analysts worried about the ripple effects. Other hedge funds holding similar securities had to mark down the value of their assets. Banks suddenly got skittish about making big loans."

"Some analysts wondered whether the era of easy money was ending. Daniel A. Strachman, author of "The Fundamentals of Hedge Fund Management," noted that the markets had put a lot of confidence in the new hedge-fund-dominated financial system even though it had not been tested seriously during the economic expansion of the past five years."

"I think there are a significant amount of people who call themselves hedge-fund managers who have been very lucky because they were able to ride the market wave," he said."

"But as the Bear Stearns case showed, it may be impossible to know from where the next crisis will emerge and whether there are other troubled hedge funds."

"Wall Street creates all these increasingly sophisticated financial products, and no one really seems to understand them but the people involved in creating them," Freed said. "They assure everybody that everything's going to be okay, and we are forced to believe them."

[Lafayette]

"They assure everybody that everything's going to be okay, and we are forced to believe them."

Yeah, right, if your an IDIOT you are forced to believe "them".

How do you know when a CDO broker is lieing? When they move their lips.

[anne]

"Wall Street creates all these increasingly sophisticated financial products, and no one really seems to understand them but the people involved in creating them," Freed said. "They assure everybody that everything's going to be okay, and we are forced to believe them."

No; bonds and bond packages can be simply examined and understood, especially when that is you job. I understood why I should not be interested in buying mortgage debt for years with minimal effort and I am not crowing.

Who is forced to believe a self-interested salesperson? Who is forced to believe? Who bothered to pay attention to warnings about sub-prime mortgage debt that was all over the New York Times and which debt hedge fund managers were openly betting against.

Please, please, do not force me to believe.

[anne]

Want to read the bond market well, then look to Vanguard portfolios which are transparent. Vanguard may well be the largest non-governmental bond buyer. Risks are for stocks and real estate, bonds are for relative safety. When Vanguard is not buying, there may be fine reason why.

The idea of vastly paid portfolio managers being the toys of Wall Street brokers is absurd, though we might well look to the selection of managers. The point is absurdly high costs lead managers to assume unwarranted risk for clients, again and again.

[anne]

A critical characteristic of the notably successful Yale endowment is severly low comparative cost allowing for higher returns from conservative investment products for clever and still awfully well-paid managers.

[im1dc]

anne & Lafayette:

You two 'hard noses' belong to Herbert Hoover's laissez-faire "Caveat Emptor" B-School.

I thought that one died in 1932 and gave birth to the Modern Central Bank and Bankers ala Alan Greespan? Remember the S&L fiasco under #41? Or, LTCM under #42?

Let's not forget the SEC, NASD or US Treasury either.

You both failed to factor in and acknowledge that the CDO's referenced by Our Professor Krugman's article are to some degree INSURED, i.e., an implied warranty, AND "Rated" by the best of the best of the Bond Rating Agencies.

A true laissez-faire Caveat Emptor situation never existed b/c investors did not rely solely upon Seller's assurances, but those of two reputable outside professional organizations (Bond Raters and Mortgage Insurers).

The 'Risk' of widespread default was supposedly looked at and 'Rated' by impartial third party 'rating' professionals AND 'managed' by the manager of the CDO as well as to a degree by the guarantor of the mortgage principal.

What is appalling here is that those involved in bringing these instruments to the market have refused to take responsibility. "Who me?"

B/C of the above imo, culpability does not lie solely with Investors.

What follows is an Editorial that backs up my earlier post that the Subprime mortgage Default rate is not limited to the packages of Subprime CDO's that are now in default.

This could become a disaster of $Trillion proportions.

From Barry Ritholtz's blog Big Picture today:

Underwater ARMs?

Sunday, July 08, 2007 | 06:30 AM

How bad is the Adustable Rate Mortage (ARM) situation? Stephanie Pomboy via Barron's Alan Abelson has the straight dope:

"After modest reflection, any disinterested observer can't help but find that accompanying table quite alARMing. It's from a recent MacroMavens report, the handiwork of the incomparable Stephanie Pomboy, whose rants and raves we've had the pleasure of occasionally sharing with you. What its blood-curdling numbers depict is that the woes of mortgage lenders are not, as so widely believed, confined to the beleaguered subprime contingent, but are casting a much larger and chillier shadow.

More specifically, the table shows all too clearly that an astounding percentage of adjustable-rate mortgages already are underwater, and it estimates how much equity would be wiped out if home values decline by 5%, 10% and 15% and translates the corresponding losses into dollars.

Go to Big Picture to view 'House of Cards' Graphic link: http://bigpicture.typepad.com/

As Stephanie comments: "Based on the share of ARMs in some state of negative equity at the end of last year and the decline in home prices so far in 2007, a stunning $693 billion in mortgage loans are already in the red. Assuming lenders are able to recover 70% of those assets -- which seems optimistic given the massive amount of housing inventory yet to be unwound -- that means mortgage lenders are already grappling with $210 billion in outright losses."

And that, she points out, is merely the direct hit. Thanks to what she nicely dubs the "divine miracle of leverage," the total financial exposure to these claims is many multiples of that. To which we say, ugh!

What's more, Stephanie notes, these horrendous losses are coming at a time when the financial sector is "uniquely unprepared to withstand them." Commercial banks, she points out, have let their loan-loss provisions sink to 20-year lows while increasing their exposure to real estate to record highs. Mortgages, she reckons, account for a tidy 55% of total bank loans -- and that doesn't include the trillion dollars worth of mortgage-backed securities on bank balance sheets.

So much for the myth that banks have cleverly "offloaded" their real estate risk.

SNIP

"Well Contained": They keep using that word. I do not think it means what they think it means..."

Sources:
Truly Al-ARM-ing
ALAN ABELSON
Barron's Monday, July 9, 2007
UP AND DOWN WALL STREET
http://online.barrons.com/article/SB11836860017145876

[im1dc]

anne & Lafayette,

An Update on "Paul Krugman: Just Say AAA"

Shortcut tinyURL link: http://tinyurl.com/yrd6qh

[anne]

Thank you, and I promise to think this problem through again thoroughly. I am however only going to be worried if I can find a reason to think more than sub-prime mortgages are a problem and the general bond market could be thereby effected as sub-prime package problems spread in the legitimately investment grade mortgage package market.