Even the pundits most slavishly devoted to the myth of the free market think that the economy is in dire straits. Things look bad on many fronts and even those that denied that anything was wrong even as late as August now agree that the recession actually started in December of 2007. As the elections neared last year, it was accepted wisdom that all of our woes were due to the poor taking out shaky mortgages. Once that canard failed to hold up, the media stopped trying to come up with causes and focused all of its energy on demanding that things be fixed immediately---that is, that they be put back exactly the way they were before the nightmare began. So, how were things before, when everything was wonderful for everyone? Things were quite pungently fraudulent and, once you see how things worked, it's not surprising at all that the whole house of cards came tumbling down. It's nauseating to watch as the perpetrators get off scot-free, with enormous personal wealth, and either lining up to "help fix" the system or to get a bailout from the government. So how exactly did the scam work? How are the new scams supposed to work? How, exactly, are to be taken this time? Let's start with this example from the article <a href="http://www.nytimes.com/2009/02/02/business/economy/02value.html" source="NY Times" author="Vikas Bajaj and Stephen Labaton">Big Risks for U.S. in Trying to Value Bad Bank Assets</a>, wherein the authors examine a mortgage-backed bond rated by Standard & Poor's: <bq>The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.</bq> <img attachment="deep081225.gif" align="left" class="frame">The government is going to spend $850 billion on bonds very similar to those described above. That means that the government will be willing to pay <i>at least</i> 87 cents on the dollar for an asset that no one else on the planet is willing to even look at for more than 38 cents on the dollar. It gets even better: <bq style="margin-left: 240px">The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.</bq> The rating agency deemed this kind of bond "triple-A"! And, that isn't considered fraud! If this kind of bond---one that has lost at least 10% already and is falling like a stone---is considered AAA, what exactly does the bottom of the barrel look like? For it to have gotten such a rating, it must be what is called in the parlance a "senior tranche", which means that its risks are at least partially hedged by even more appalling tranches of sliced-and-diced securities below it. But that won't help it when <i>all</i> of those tranches go belly-up, as they have been increasingly doing of late and as the fraudsters who put together this entire house of cards promised could never happen. We believed them, and let them run our system into the ground while they scampered off to their villas with billions. Wait, wait, wait. Back up a second. What the hell is a tranche? It's a "slice" (from the French) of a pile of securities. What does a "pile of securities" mean? Securities are financial instruments that come in a variety of flavors. There are stocks, which represent ownership, and bonds, which represent debt. Everyone pretty much understands the intrinsic value of those and how one can trade them. There are also derivatives, which represent the rights of ownership and it gets more exotic from there. Securities are essentially contracts with value that can be traded. Among securities that represent debt are mortgages which, because of the deflating housing bubble, represent much of the bad debt included in these securities. Ok, so say that you're a bank and you've got mortgages in your portfolio, and you'd like to trade with others but, honestly, these mortgages aren't that attractive, so you're not likely to be able to move them out of your portfolio at a decent price. Those mortgages are only one step away from actual people and thus represent a plethora of different risks, a different valuated risk for each mortgage. That's a lot of overhead and is the classic picture for a bank, where the money the bank is owed on mortgages is balanced against the risk that a given mortgage will default. These figures contribute to the overall valuation for the bank. Just spitballing, you can imagine that the value of the bank's portfolio is equal to the base value of the securities plus the expected interest income minus a percentage calculated on the risk that the mortgage will default. Now imagine how pathetic that percentage looks to a real lion of the market. A few percentage points? C'mon, you can do better. So, you start to think about it and you wonder whether you can't make some lemons out of lemonade. Some of your mortgages are probably just wonderful and you could easily sell them to a third party...because it would actually be a good investment for that third party. Others are less attractive and represent the problem. So, you could put together a package with some low-risk mortgages and some high-risk ones and only sell them together. However, any third party with a calculator would be able to easily determine the valuation on such a package, as it's just the sum all the valuations of the securities in that package. Still no takers. It's important at this point to remember why there are no takers for such a package: because it's not worth the risk. You could sell the package at a lower value in order to make it more tempting for buyers, but that would likely involve exactly the sort of low profits that you were trying to escape in the first place. So that's a dead end. The point seems to be that, as long as potential buyers can figure out how much what you're selling is actually worth on the market, you'll get a lower price than you'd like for it. It's a classic market dilemma. Now, if you're neither a criminal nor a fraudster, you're going to restrict yourself to trying to actual increase the value of what you're offering for sale, but by spending less on the added value than the market would be willing to pay for it. If you're willing to think outside of the box, you'll approach the problem from another direction: namely, that the problem to solve is that third parties can still figure out the value of what you're selling on their own. You want to figure out some way of making the actual value of your product so obscure that they'll either have to take your word for it or they'll at the very least have to trust a third party to do it for them---which is where the ratings agencies come in. Once the authority of valuation is concentrated in a small handful of ratings agencies, it becomes much easier to control ratings with a little well-placed bribery (once you've accepted your fate as a pirate on the high seas of finance, a little bribery is a logical cost of doing business). In the world of physical---as opposed to virtual---products, there are laws against doing this: think of the lemon laws governing automobile transactions. In the world of finance, what few laws and regulations there were were neatly excised by the Clinton administration.<fn> Any areas still covered by regulation were scrupulously avoided; this wasn't hard to do as, from the analysis above, the classic world of finance (which was still regulated) wasn't going to provide the sought-after profits. So, the trillion dollar question is, how do you make lemonade out of lemons? The answer is, at long last, tranches. We've established that you can't sell your high-risk securities. Mixing high- and low-risk securities is also still too transparent. So, instead of taking <i>n</i> low-risk securities and <i>m</i> high-risk securities, you start slicing up your individual securities. So, you take a mortgage worth $200,000 and slice it into 1,000 $200 bits. Then, you do this with all of your securities, throw it all into a pot and start to ladle financial olio into new derivatives called "mortgage-backed securities". In order to attract all comers, you carefully strain a higher percentage of slices from low-risk mortgages into some of these all the way down until you're scraping the bottom of the pot for the really bad stuff. After all this number-crunching, you've got a pile of computer printouts depicting the valuation of each security as a percentage risk calculated much as you would do for far simpler packages, but with a lot more wiggle room for assigning risk. A human being is no longer really capable of determining the true value of this security---and neither is a ratings agency. Instead of simply giving these securities a low rating for being so intransparent, the ratings agencies instead simply <i>took the word of the company that created the security</i> for the value of the package. And took a tidy profit for themselves, of course. After a bit of back and forth, it became easy to know just how many slices of low-risk securities had to be in a package in order to acquire a AAA rating. <img attachment="bs081222.gif" align="right" class="frame">And finally, you've acheived your goal: you're able to sell your securities at a much higher value than they actually have simply because no one can tell anymore how much it's really worth. Add to this that the ratings agencies didn't do their job, the oversight and regulation were non-existent and there was soon a tremendous amount of risk entering the market at a completely fraudulent valuation level. And, with everybody doing it, you had to keep getting more and more inventive to keep your profit margin higher than the competition's. Driven by this engine, a huge bubble ensured that you were able to move even the dregs from your pot, you could always find a buyer for even the most toxic securities in your portfolio. Now that the bubble's burst, the only buyer for any of this stuff is the buyer of last resort, good old Uncle Sam. <hr> <ft>With the help of Phil Gramm, Larry Summers, Ben Bernanke and all the other usual suspects. The Bush administration gladly took up the reins and let the jolly roger fly for eight more years.</ft>