Neither the market nor any regulating entity can tell what the likelihood of mortgage default is after a new innovation, just like junk bonds in the 80s or the dot.com bubble in the 90s.

One HUGE moral hazard is to allow the rich early movers to skim the revenue side of the risky behaviour without paying the cost side when the risk comes up.

Regulators can only stop new mechanisms—but in the case of the subprime mortgages, there was a big increase in the number of homes constructed, thanks to the money available to borrow from the sub-prime borrowers.

What is the default rate??? 10%? 50%? 90%? I heard before that usual rates were about 10%, and it’s now up to 15%. Whatever the higher than expected default rate, it’s important to remember that those NON-defaulters are enjoying newer/ bigger/ better houses than they would have without the easy money available.

A big cut in the interest rate, helping the risky rich reduce their losses while helping the homeowners reduce defualt, seems a reasonable balance. Thanks to Friedman’s monetarism, it’s known how to avoid a depression … more money/ lower rates from the central bank.

I’m glad Citi lost big—I wish there was a way for the gov’t to “claw back” undeserved prior profit-sharing of those who got big buck bonuses on risky revenue that was more risky than expected. (sigh, wishful thinking for more justice)

The level of defaults in mortgages is unprecedented

1/ Rating agencies don’t have magic spying powers that allow them to see the truth about a company’s finances.
2/ Big downgrades are not evidence of being asleep at the wheel. Your A rating is gained by paying your debts and seeming to have enough money to pay the ones you still have. A big change that happens quickly can leave you in a very different position. The level of defaults in mortgages is unprecedented, and ACA wrapped a lot of bad bonds. How is S&P supposed to know that the mortgages were that bad? It doesn’t get to interview the people who took them out. It always gets a hiding when it is lied to, but it is defenceless against liars, just as you are when you make investments based on companies’ accounts and financial reports.

It’s important to remember all the risks.

The big risk-reduction with MBS is in the interest risk side, not the exposure to housing side—until now, the exposure to housing side has been fairly safe. A disaster concentrates the mind wonderfully. The last mortgage related disaster happened when banks had mortgages outstanding at 6%, and inflation jumped—so they had to pay 10% interest to depositors. Selling MBS spread that risk around quite well.

He has apparently been saying similar things (about a specific company) for years, and has written a book on the topic. In the case he is purely playing the market, the writing of the book is a signal,or a bluff: see, I believe it enough to spend time on bookwriting. Now he hopes enough people believe him to make the stocks drop, so he can profit. This only works if the drop in stocks is large enough, and his position short enough, to make up for the time he spend writing the book. I suppose hedge fund manager hourly pay is high enough to make this an expensive book.

Now the fun thing is that the drop in stock prices will be stronger if people believe his book, and people will be more likely to believe him if they think he has little to gain by them believing it.

So, option one: The guy is truly concerned about the system, and wrote a book to warn other people. Because he is also a smart hedgie, he is short on the companies involved because he believes they will drop, but that’s separate from his concern.

Option 2: he truly believes the systems has flaws and those companies will eventually fail, but doens’t care about other people. He just wrote the, honest, book to convince others that he’s right and thus accelarate the fall in stocks .

Option 3 is the cynical case above: he doesn’t believe there is a flaw in the system, or not to the extend he claims he believes it. He just wants other people to believe it and profit from the temporary drop in stock prices.

Of course reality can be mix of it all, plus he could have the book written by a ghostwriter, so that it appears he is concerned enough to write book, but really just pays the ghostwriter a fee. I like the mess…

Please keep posting. I, anyway, am learning a lot.

They were super senior positions in CDOs of mezzanine securities. In other words the actual tranches held by Citigroup were paid first in the CDOs, but the tranches underlying the CDOs were not. Highly correlated mezzanine CDOs are the worst of all worlds – it only takes a relatively small but widespread amount of losses to wipe out the entire CDO, whereas a super senior position in a “high grade” CDO can withstand much higher industry-wide losses.

“Maybe there’s some technical difference between what Citi was doing and warehouse lending, but it seems pretty similar to me.”

The difference is that a warehouse traditionally involves mortgages (or other assets) themselves, and is provided to a mortgage lender. The CDO positions came from packaging securities backed by mortgages and selling them on. In some cases this may be through providing a securities warehouse to a CDO manager, but in most cases they were just buying (or structuring) the securities themselves.

But anyway, ginger yellow writes, “in Citigroup’s case, a lot of the exposure was initially placed with investors, but contained a put option that brought it back on balance sheet right as the crisis broke.” Isn’t this just what I said initially? Citigroup bought mortgages (or some other kind of loan) and bundled them up, hoping to sell them to institutional investors. But in the current crisis they were unable to sell them (or were forced to buy them back when investors exercised their put options). Maybe there’s some technical difference between what Citi was doing and warehouse lending, but it seems pretty similar to me.

I may well be misunderstanding here, but that makes no sense to me. How can the same debt be both “super senior” and “residual” ? A residual position is the bottom tranche that’s left after the senior tranches are bundled up and sold, no?

“Ginger: Isn’t the issue with the monolines that if they get downgraded that every bond they ensure gets downgraded with them, forcing banks to raise their capital reserves, and some other regulated entities to sell the bonds en masse?”

In a nutshell, yes. A downgrade from AAA to AA, however, won’t require all that much of a capital increase (compared to what we’ve seen so far). The nightmare scenario is what happened with ACA happening to a bigger monoline, but nobody’s really expecting that and if it were to happen there would certainly be a bailout.