just sayin'

Mortgages had one key advantage over junk bonds: they were rated AAA by the major credit-rating agencies. The U.S. government felt that home mortgages were important and it subsidized them, not only allowing taxpayers to deduct interest payments, but by implicitly backing the payments on mortgage bonds.

Salomon stripped these mortgages into pieces in the same way First Boston had stripped junk bonds. Salomon created a trust . . . transferred a pool of mortgages into the trust, and then created a structure to separate the mortgages into different tranches. . . . These strips of mortgages were generally known as Collateralized Mortgage Obligations, or CMOs, and the different varieties had fantastically colorful acronyms . . . In most cases, the wilder the name, the riskier the bond. The riskiest versions were sometimes just called "nuclear waste."

-- Frank Partnoy, Infectious Greed at 103, describing the creation of Collateralized Mortgage Obligations in the early 1990's.

As average investors learned about the losses, they became upset with Wall Street, and bankers briefly became pariahs, as they occasionally do. . . . The bankers didn't seem to care about all the fuss. They knew it would go away soon, as it always did. Instead, they disclaimed any responsibility, and blamed investors for making stupid bets and for failing to supervise their investments.

-- Frank Partnoy, Infectious Greed at 137-38, describing the climate in December 1994 and early 1995 as news began to spread of major losses due to derivatives trading, especially losses in Collateralized Mortgage Obligations due to the Federal Reserve's increase in interest rates on February 4, 1994.

For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions -- along with low interest rates -- made it easier for Americans to get credit. . . . Easy credit -- combined with the faulty assumption that home values would continue to rise -- led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

-- President George Bush, Address to the Nation, September 24, 2008, describing the economic crisis of 2007-2008.

As we all know, lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing. This simply put too many families into mortgages they could not afford. . . . A similar scenario is playing out among the lenders who made those mortgages, the securitizers who bought, repackaged and resold them, and the investors who bought them. These troubled loans are now parked, or frozen, on the balance sheets of banks and other financial institutions, preventing them from financing productive loans. The inability to determine their worth has fostered uncertainty about mortgage assets, and even about the financial condition of the institutions that own them. The normal buying and selling of nearly all types of mortgage assets has become challenged.

-- Treasury Secretary (and former CEO of Goldman Sachs) Henry Paulson, Statement to Congress, September 19, 2008, describing the economic crisis of 2007-2008.

Mortgage and asset-backed securities include residential and commercial whole loans and interests in residential and commercial mortgage-backed securitizations. Also included within Mortgage and asset-backed securities are securities whose cash flows are based on pools of assets in bankruptcy-remote entities, or collateralized by cash flows from a specified pool of underlying assets. The pools of assets may include, but are not limited to mortgages, receivables and loans. Additionally, the Company’s mortgage-related trading positions consist of loans purchased as non-performing loans, equity interests in commercial properties and asset-backed securities that are backed by mortgage loans or other assets.

It is the Company’s intent to sell through securitization or syndication activities, residential and commercial mortgage whole loans the Company originates, as well as those acquired in the secondary market. The Company originated approximately $0.5 billion and $2 billion of residential mortgage loans for the three and six months ended May 31, 2008, respectively, compared to the $17 billion and $32 billion for the three and six months ended May 31, 2007, respectively. The Company originated approximately $2 billion and $4 billion of commercial mortgage loans for the three and six months ended May 31, 2008, respectively, compared to the $19 billion and $32 billion for the three and six months ended May 31, 2007, respectively.

-- Lehman Brothers, Quarterly Report on Form 10-Q, July 10, 2008.

Lehman Brothers reported a preliminary net loss of approximately ($3.9) billion, or ($5.92) per common share (diluted), for the third quarter ended August 31, 2008, compared to a net loss of ($2.8) billion, or ($5.14) per common share (diluted), for the second quarter of fiscal 2008 and net income of $887 million, or $1.54 per common share (diluted), for the third quarter of fiscal 2007. The net loss was driven primarily by gross mark-to-market adjustments stemming from writedowns on commercial and residential mortgage and real estate assets

Net revenues (total revenues less interest expense) for the third quarter of fiscal 2008 are expected to be negative ($2.9) billion, compared to negative ($0.7) billion for the second quarter of fiscal 2008 and $4.3 billion for the third quarter of fiscal 2007. Net revenues for the third quarter of fiscal 2008 reflect negative mark-to-market adjustments and principal trading losses, net of gains on certain risk mitigation strategies and certain debt liabilities.

During the fiscal third quarter, the Firm is expected to incur negative gross mark-to-market adjustments on assets of ($7.8) billion, including gross negative mark-to-market adjustments of ($5.3) billion on residential mortgage-related positions, ($1.7) billion on commercial real estate positions, ($600) million on other asset-backed positions and ($200) million on acquisition finance positions. These mark-to-market adjustments were offset by $800 million of hedging gains during the quarter and $1.4 billion of debt valuation gains. The Firm is also expected to record losses on principal investments of approximately $760 million.

-- Lehman Brothers, Press Release filed with Current Report on Form 8-K, September 10, 2008.

I thought the symmetry was striking. What does it all mean? I dunno. You decide. I just blog here.

Oh, here's one more:

Turmoil in the credit markets has pushed Libor—the London interbank offered rate—to an all-time high, according to the British Bankers' Association. . . . Libor . . . [is] the rate at which banks lend to other banks that need temporary funds, by way of the London interbank market. This benchmark is significant because it represents the rate at which the world's most preferred borrowers are able to borrow money, and it's also a widely used reference point for short-term interest rates. . . . After the rejection of the bailout bill by the House of Representatives, banks hoarded cash, driving Libor up to 6.88 percent.

-- U.S. News & World Report, The Low-Down on Libor: Why its Surge Signals Despiration in the Credit Markets, September 30, 2008, noting that more than half of U.S. adjustable rate mortgages are tied to Libor.

sub-ocean methane leaking

I'm surprised this news hasn't gotten more coverage: there's preliminary news that, as the permafrost is melting, methane that was previously trapped beneath the Arctic Sea is bubbling to the surface and escaping to the atmosphere. Methane is about 20 times as powerful a greenhouse gas as carbon dioxide. It's not yet clear just how much methane is escaping, but it does raise the concern of a positive feedback loop, where more methane escapes, warms the climate, causing more permafrost melting, more methane escaping, and so on.

One More Question

Mr. President, there's one more question that's been bothering me. In a free market, I would expect assets to move to the entity best equipped to extract the most value from them. For instance, I would expect banks to hang onto their mortgages, because banks are in the best position to make sure that the mortgage holder makes payments on time. If the bank sells the right to receive mortgage payments to someone else, and the mortgage holder defaults, won't that someone else have to go back to the bank to harass the mortgage holder into paying up, or to seize and sell the house? It seems to me that having to go back to the bank would increase transaction costs, making the right to payment worth less to that someone else than it is to the bank. So the bank shouldn't normally be willing to sell that right in the first place.

Yet, according to your speech, mortgage securitization, selling that right to get payments, is a big part of the mess we're in. A really big, $700 billion size, part. That means a lot of banks have been selling mortgages that basic economic theory says they shouldn't be able to sell. And it wasn't a fire sale, because they were doing it in a period of rapid economic growth. What's going on?

The only thing I can think of is that someone was either fibbing or asleep at the switch. Maybe the people buying the securitized mortgage debt didn't know how to value it properly, either because they had bad information from the sellers or because they simply weren't financially sophisticated enough to value it, despite the accredited investor safeguards we have in place. Or maybe that debt was being repackaged into securities designed to skirt around laws and regulations that would normally prevent purchasers from buying that kind of debt.

In any case, I'd really like to know. Preferably before we commit to giving these people $700 billion of our tax money. After all, if they're not savvy enough to value the mortgage debt properly, are we confident they'll use the money wisely? And if they were fibbing, then we'll want to keep an extra close eye on them, maybe closer than what a few members of a bipartisan panel can keep.

Follow-up: if you're not sure what I'm talking about, you can find a readable summary of mortgage securitization, complete with "chicken parts" analogy, here.

The Bush Economy Speech

Dear Mr. Bush,

Thank you for taking time out of your busy day to explain to us why your administration is proposing this $700 billion Troubled Asset Repurchase Plan. I feel it is the least I can do to respond to some of the points you have raised.

First, you mentioned a number of questions that you knew many Americans have tonight: "How did we reach this point in our economy? How will the solution I've proposed work? And what does this mean for your financial future?" I would like to add two more: How will we prevent this situation in the future? And why is the solution you have proposed the appropriate one?

I couldn't help but notice that your discussion of how we reached this point in our economy did not touch on some factors that are probably significant. You mention large amounts of foreign investment, easy credit, a faulty assumption that house prices would continue to increase, and a large number of mortgage defaults triggered by an oversupply of housing. But you did not discuss the role of deregulation in creating a complex, intertwined financial system, in which no one knows the size of the Credit Default Swap market, an issue that led to the government's $85 billion line of credit to American International Group.

You also did not address the role of the credit ratings agencies and their failure to properly rate this mortgage debt. Nor did you touch upon the role moral hazard plays, in which a free market, hands-off philosophy only during good times allows financial companies to keep their profits but encourages them to take on too much risk, on the belief that the government will bail them out. Finally, you did not provide your thoughts on whether compensation packages that reward chief executive officers for short term gain, coupled with severance packages that do not take into account the long term financial position of the company, create an incentive for too much risk.

In fact, Mr. President, your discussion of how to avoid this situation in the future was limited to Mr. Paulson's suggestion that the Federal Reserve (not the SEC?) "take a closer look at the operations of companies across the financial spectrum and ensure that their practices do not threaten overall financial stability" and that Congress consider "other good ideas," but with the stern caution that they must "ensure that efforts to regulate Wall Street do not end up hampering our economy's ability to grow."

That last caution was enough out of step with the rest of our address that it seems necessary to address some of its implications. In justifying this deviation from your normal inclination against intervening in the markets, you said that "these are not normal circumstances" and that "the market is not functioning properly." Mr. President, I put it to you that, by the time a company has grown "too large to fail," it is already operating outside the free market system--by definition. Once it has reached that size, the market forces that apply to that company are already not functioning properly.

You also did not address why the solution you propose is the correct one. You made a case for quick action, painting a gloomy picture of the consequences of inaction and noting that the government's top economic experts are warning there must be immediate action. But from there, the primary justification you offer for this particular economic rescue plan is to say "after much discussion, there is now widespread agreement on the principles such a plan would include." I cannot help but note that the news reaching us taxpayers does not portray anything approaching "widespread agreement" from Congress.

Why are you confident that $700 billion, spent primarily to buy bad debt from financial institutions, is the appropriate fix for this problem? What will be the long term effect on the economy of raising the debt ceiling? Is it appropriate to delay addressing those "good ideas" to prevent this problem in the future until after spending the money, rather than building provisions into the contracts with the firms that will receive the money, or at least building in additional latitude such as the ability to obtain a significant voting block of stock?

Finally, I understand there is only so much you can fit into a fifteen minute appearance, and you no doubt had good reasons to limit your talk to fifteen minutes. In the future, however, may I suggest asking your speech writers to include a good sound bite. Here's a good starting point: "we have nothing to fear but fear itself."

Conjugal

Cory Doctorow has a wedding ring designed by Bruce Schneier. It's a secret encoder ring, naturally. Now they're looking for an encryption algorithm that can use the ring. I hit a slow patch at work, waiting for some documents to arrive (which means it's going to be all the worse when they actually do arrive), so I spent a few minutes on one. I'm going to post the short version of the algorithm at boingboing, but here's the long version, implemented in Perl. (I deliberately avoided using Perl tricks to keep it clear.)

Update 9/10/08: you get better results if you calculate the advance a bit differently. Start with 1. If ring 2 has a dot above, add 2; if it has a dot below, add 1. If ring 3 has a dot above, add 6; if it has a dot below, add 3. I'm still experimenting with the advance, though.

#!/usr/bin/perl -w

# Calculates how many positions to advance a ring to get to the desired letter
sub calcAdvance {
    my ($pos, $newPos) = @_;
    my $advance = $newPos - $pos;
    if ($advance < 0) {
 $advance = $advance + 26;
    }
    return $advance;
}

# Ring1 is inner-most, Ring3 is outer-most.
#
#                A B C D E F G H I J K L M N O P Q R S T U V W X Y Z
my @ring2Dots = (9,9,0,0,3,3,9,9,0,0,3,3,9,9,0,0,3,3,9,9,0,0,3,3,9,9);
my @ring3Dots = (2,2,2,0,0,0,1,1,1,2,2,2,0,0,0,1,1,1,2,2,2,0,0,0,1,1);

#
# The Conjugal Encryption Algorithm.
#
# Initialization using the crypto key.
#
# Start by aligning all the "A"'s.
my $ring2Pos = 0;
my $ring3Pos = 0;

# Then initialize the ring.
my $key = "congratulations";
while ($key ne "") {

    # 1. Get the next character of the key
    my $keyChar = substr ($key, 0, 1);
    $key = substr ($key, 1);

    # 2. Rotate rings 2 and 3 together so the A on
    #    Ring 1 aligns with the key character on 
    #    Ring 3.
    my $advance = calcAdvance ($ring3Pos, 
          ord (lc ($keyChar)) - ord ("a"));
    $ring2Pos = ($ring2Pos + $advance) % 26;
    $ring3Pos = ($ring3Pos + $advance) % 26;

    # 3. Calculate an advancement amount.
    #    a. Start with 1.
    #    b. Look at the Ring 2 letter next to the A of Ring 1.
    #       If there's a dot above, add 9.  If there's a dot
    #       below, add 3.
    #    c. Look at the Ring 3 letter next to the A of Ring 1.
    #       If there's a dot above, add 2.  If there's a dot
    #       below, add 1.
    $advance = 1 + $ring2Dots[$ring2Pos] + $ring3Dots[$ring3Pos];

    # 4. Advance Ring 3 that many letters.
    $ring3Pos = ($ring3Pos + $advance) % 26;
}


# Generate some useful output
my $plaintext = "Wishing you a happy life together!";
print $plaintext, "\n";

# Skip whitespace and punctuation when encrypting.
$plaintext = lc($plaintext);
$plaintext =~ tr/a-z//cd;
print uc($plaintext), "\n";

#
# Encrypt text.  Initialization vector omitted for clarity.
#
my $cyphertext = "";
while ($plaintext ne "") {

    # 1. Look at the letter on Ring 3 adjacent to the A on Ring 1.
    #    Rotate Rings 2 and 3 together so that same letter on
    #    Ring 2 is adjacent to the A on Ring 1 (and some different
    #    letter on Ring 3 will now be adjacent.)
    my $advance = calcAdvance ($ring2Pos, $ring3Pos);
    $ring2Pos = ($ring2Pos + $advance) % 26;
    $ring3Pos = ($ring3Pos + $advance) % 26;

    # 2. Calculate an advancement amount.
    #    a. Start with 1.
    #    b. Look at the Ring 2 letter next to the A of Ring 1.
    #       If there's a dot above, add 9.  If there's a dot
    #       below, add 3.
    #    c. Look at the Ring 3 letter next to the A of Ring 1.
    #       If there's a dot above, add 2.  If there's a dot
    #       below, add 1.
    $advance = 1 + $ring2Dots[$ring2Pos] + $ring3Dots[$ring3Pos];

    # 3. Advance Ring 3 that many letters.
    $ring3Pos = ($ring3Pos + $advance) % 26;

    # 4. Get the next character of the plaintext.
    my $plainChar = substr ($plaintext, 0, 1);
    $plaintext = substr ($plaintext, 1);

    # 5. To encrypt this letter of plaintext, find the
    #    plaintext on Ring 1 and write down the matching
    #    cyphertext on Ring 3.  (To decrypt, look at
    #    the cyphertext on Ring 3 and write down the matching
    #    plaintext on Ring 1.)
    my $ring3CryptoPos 
 = (ord ($plainChar) - ord ("a") + $ring3Pos) % 26;
    $cyphertext = $cyphertext . chr ($ring3CryptoPos + ord ("A"));
}

# Print the cyphertext.
print $cyphertext, "\n";