Brad DeLong gives his stamp of approval to Steven Pearlstein’s explanation of the mortgage collapse now in progress. It is, indeed, a very clear explanation of what went wrong:
Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired. It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used — in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs — the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value. One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent. And looking across the sector, J.P. Morgan’s CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.
This ought to give pause to anybody with plans for reform of, well, anything, that relies on the financial wizardry of Wall Street to magically make things wonderful. But that’s not my reason for posting.
The question that I never quite see answered in these articles is:
What about those of use who have mortgages, but aren’t idiots?
Kate and I bought a house about five years ago, after all, and took out a rather substantial loan to do so. We did not, however, do anything extravagant– the price we paid for this house was within our means at the time, and is well within our current means. We’ve never missed a payment, and barring a total catastrophe, aren’t in any serious danger of doing so.
The question is, does this crisis– “the worst since 1929”– pose a threat to people like us? Frankly, I could care less if some financial “geniuses” on Wall Street lose their shirts because they repackaged junk investments as solid (though I doubt they will– that’s not how the system works), and my retirment is so far off anyway that I’m not terribly concerned about that money, either.
I think that we’re safe, unless this gets to the point where whole banks start disappearing, but I have to admit, I don’t understand the system that well. If it turns out that I’m at risk because some jackasses decided they could make a mint by loaning money to people with no assets and meager income… Well, I won’t join the torchbearing mob, but I’ll give them directions.