Saturday, November 22, 2008

ECONOMICS II – More Terms and 3 Case Studies

Ok, so I hope the first part was helpful. Either it was and there were absolutely no questions or I'm just writing to myself. So I have decided to finish off the section this time instead of drawing it out even further.

American Express has been granted the right to become a bank? Democrats and car manufacturers request government bailouts for the auto industry?
I think it's strange how economists, especially academic economists, see this as exciting times in finance (a subtopic in economics). I suppose it really strange that commercial banks can take over investment banks so the lines are blurred. Or it's strange how the government can now hold majority ownership in private companies and banks. But it's all at the cost of people's jobs. And it seems like it will get worse. It's all due to greed, but let's get back to the story of greed.

We saw how investment banks came crashing down through vehicles like CDO's and the lack of the agencies to assess the quality of the credit in those vehicles. But AIG, an insurance company, was bailed out. And so was Fannie Mae and Freddie Mac. They were set up to support the housing industry. So why did those fail if their not insurance companies with tons of bad debt/credit in the housing market. Well, this may be easier to see for some since Fannie Mae and Freddie Mac are completely mixed into the housing market, and AIG is the largest insurance company in the world.

So what we'll do this time is follow Steve Levitt's column and explain the crisis situation through the eyes of his colleagues Diamond and Kashyap, University of Chicago professors of economics. I will add more explanation, but I am assuming you understood the terms in part I from the last update.

Holding Company – a company that holds partial or complete interest in another company; usually this means a company holds enough stock (voting stock) in another firm to control the operations and management by influencing and/or electing its board of directors (a bank holding company is a company that does holds partial or total voting stock in a bank)

Derivatives – it's an investment that depends on the value of an underlying investment (confusing I know); the underlying investment can be a stock (or currency or a commodity or other securities); types include options and futures; options are a contract that guarantees the holder the right (or the option, but not the requirement) to buy or sell 100 shares of the underlying stock at a fixed price by a certain date; if you buy an option you are the holder of the option while the seller is the writer of the option; if your option allows you (the holder) to buy 100 shares at a certain price it is a called a call option; if it allows you to sell 100 shares of an underlying stock then it's called a put option (like put it away); hard to make money with derivatives and not for the beginning investor; there are pros and cons but just understand that they exist; people tend to use it as insurance or leverage (if you hold some stock but are not sure that it may lose it's value you can buy a put option; if it loses its value at least you can exercise the put option and sell shares and still get some money out of it; that's just one example), they can help guard against price fluctuation [futures are like options but they are required not optional; so at a specified date in the future at a specified price some commodity or stock or bond is required to be delivered for some payment; there's a winner and a loser depending on what happened to the security before the payment date]

2ndary mortgage market – the buying and selling of mortgages and mortgage-backed securities

mortgage-backed securities - securities that depend on underlying mortgages but are traded separately; so rather than buying and selling someones mortgage, you are buying a selling a security invested against a pool of mortgages [so that when the mortgage payments come in you receive your investment back (plus interest) though you do are not the mortgage-issuer directly]

amortization - The process of paying off a debt liability and accrued interest through a series of equal, periodic payments. You normally do this with car loans or mortgages when your monthly payment partially pays for interest accrued on the outstanding balance and partially reduces the balance.

CDS – credit default swap – just think of it as a buyer (person who purchases a CDS) paying the seller a premium so that if an underlying security defaults or goes bust the buyer gets paid some money from the seller (similar to insurance in that way but the buyer does not need to own the underlying security)

Case Study 1: Fannie Mae and Freddi Mac – Secondary Mortgage Market and Mortgage Banks

Ok, remember from last time, Fannie Mae and Freddie Mac (1970's) were setup to support the housing industry, but they are completely in the secondary mortgage market, so they are mortgage banks or mortgage companies, buying and selling mortgages in pools or blocks. At the same time that there freedom eventually led to the financial crisis, we must understand that having a secondary mortgage market actually allows for more mortgages to be sold. If I take out a mortgage with Company B for $150,000 for house C, that's the only one like it. And Company B has specific terms with specific interest rate, principal, etc. In comes Fannie Mae which started selling whole loans. Fannie Mae takes mortgages and sells actual mortgages in blocks to others. Why? Well for a single investor to be interested in my $150,000 mortgage in a diversified (mixed) portfolio (bag of investments) so that the mortgage was only 10%, he would need a $1,500,000 portfolio of investments. Mortgages are awkward and bulky to have for an individual investor.

In steps the Fannie Mae and the 2ndary mortgage market after WWII in 1938. Mortgages are now sold in blocks (“whole loans”). If you combine mortgages into a pool, you can talk about the pool's global characteristics, it's weighted average maturity (instead of the maturity of one of the mortgages) or the remaining amortization. Now you can make sure that no one mortgage is too large a portion of the whole. And a servicing agent can collect the mortgage payment and pass them to a central paying agent who passes it to the final investor. Now it looks like a normal bond.

Then in the 1970's Freddie Mac came along and instead of selling the actual mortgages (whole loans) allowed people to sell mortgage-backed securities. That means take say $50 million worth of mortgages and just separate them into a pool of funds and issue securities against the pool (this means people pay you money to take on the underlying debt of the mortgages hoping to receive payment when the underlying mortgages are paid). Now these mortgage-backed securities are actively traded and are attractive to people who don't normally buy and sell mortgages.

This is what was going on with the secondary mortgage market when everything went haywire. Freddie and Fannie were issuing their own debt (taking in money from investors in this secondary mortgage market) and the government was supposed to guarantee it (remember Freddie and Fannie are only supposed to be guaranteeing or taking on mortgages that meet a certain standard). Because the government was backing Fannie and Freddie, they got very risky and racked up more debt than they should have done so. This was because the more debt (good debt) you take on, the more money you make. And since people thought the government backed Fannie and Freddie, they saw investment in these mortgage-backed securities as safe as government bonds.

So with weak supervision and buying mortgages that were not meeting good standards, a problem was occurring. With the sub-prime mortgage market situation, Fannie and Freddie lost a lot of money from people who defaulted on their mortgages, and with all the debt Fannie and Freddie issued they had too little capital. So the government (as it was supposed to do) guaranteed the debt because it would have sent the markets reeling.

The problem is that once the government guaranteed the debt, no self-interested investor would give more money to Fannie and Freddie Mac to help its losses (because investors are afraid of losing money), so the government took over Fannie and Freddie Mac.

Case Study 2: Lehman Brothers – Investment Banks – Mortgage Investors

This one is what we talked about last time. So it's no different. Investment banks do a lot of day trading remember? Why? Well, when it's hard for lenders to monitor the money they have lent, and when borrowers can quickly change the risks, lenders would rather lend short-term to get their money back quickly. Then when the borrower acts up, the lender can refuse to roll over the balance to the next day (and wait to be paid then). It's a way to keep them in line.

Lehman was no different. As an investment bank it could use derivatives to change the risk on investments. And it was going through over $100 billion a month in securities.

As stated in the last update, rumors began to spread about how bad the subprime crisis was. As more news came out (especially with Fannie and Freddie's losses), people lost faith in Lehman. Why?

Well, people believed that Lehman (like other investment banks) held a lot of this bad mortgage investment (money they would not ever get back). So if you think you are lending to a risky borrower you raise your interest rate. So the cost of borrowing money rose for Lehman (remember Lehman depends on borrowing money each day to trade; investment banks trade vastly more money than they actually have in assets and make up any losses today with more borrowing and trading tomorrow) and the value of Lehman Brothers' stock fell. So then Lehman's credit rating dropped legally preventing some institutions from lending money to Lehman. The ones who could still lend money did not want to risk it not knowing if they would get their money back because they feared Lehman would default in the future.

With no ability to borrow, share prices plummeting, and investors wanting their money back, Lehman sank.

Case Study #3: AIG – Mortgage Insurance

This is the last type of group to experience issues related to mortgages—the insurance company. AIG had issued $57 billion worth of insurance contracts whose payout depended on losses from subprime mortgages. And you know how insurance companies work (just like banks): if everyone claims all at once it doesn't have the money. However, all its other insurance contracts were fine. Still the subprime real-estate related insurance contracts (in the form of C.D.S.'s) were losing AIG money.

With the housing market deteriorating, the credit-rating agencies downgraded AIG's rating. With lower ratings, AIG's insurance contracts required AIG to demonstrate it had the collateral to take care of the insurance contracts. AIG needed $15 billion in immediate collateral.

Its second problem was tied to this one. If it could not post the collateral, it would be defaulting on the C.D.S.'s If it did this, other unrelated insurance (in other securities) contracts had clauses that stated its other contractual partners could demand prepayment of claims. This is to prevent AIG (and others) from using money from one part of the company to fix holes in another part. AIG had $380 billion worth of these cross-collateral claims. With the deteriorating housing situation, no lenders would give AIG money not knowing if it would receive the money back.

AIG also had bonds all over the world and bond holders were not sure they would get their money back while AIG scrambled to fix the CDS and cross-collateral damage, looking for money to pay all these contracts. Other companies even guaranteed some of A.I.G.'s debt (bonds) by writing C.D.S.'s. The intertwined nature and coupled influence of AIG in many financial institutions was evident.
So the FED gave AIG money to honor its contracts. That money has now increased. You can read below.

More on AIG

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