I've always thought that there are significant inefficiencies around our leisure activities - be it plane flights, hotel nights, restaurante outings, etc... Seats, rooms, tables are given out to parties without necessarily there being optimal transactions between willing parties.
An example is somebody given a middle seat on a plane espite the fact that he/she would have been willing to pay an amount of money that somebody at an aisle or window seat would have been willing to receive in exchange for their seat, or significantly more price differences in a hotel due to the differing characteristics of each room, or in restaurant tables - why can't table X with a slightly better view of the sea at restaurant y be worth more than the other table? or theater seats, or sport seats (it is already widely practiced in sports stadiums - significant number of price levels according to quality).
There would be business models to solve this inefficiency albeit complex: 1) an online exchange to buy-up the better seats, rooms, tables, 2) service provided to corporations to map out their various levels of product (best to worst rooms), best to worst seats and to differentially price according to it...
Of course, there might not be enough incentives for business owners to achieve this since ultimately it could end up being the case that less money is collected by price discriminating among customers.
Sunday, November 25, 2007
Mortgage Mess: Who's to blame?
Buyer beware? Lender responsibility? Investor responsibility?
Income is tightly correlated with the sophistication to understand what it being sold to somebody. Does the government have a responsibility to protect those that are less "able" to make the correct decisions, and if the government protects these people, where is the line drawn? (to not intrude into the decisions of those that are able to take their own decisions given full information and which make economies grow and markets move?) Perhaps the old liberal vs. conservative argument - should the government help some people and by establishing policies to help such people, do you then perhaps create an environment that is less conducive to growth (and thus end up with a smaller pie, and helping them less to start with).
Back to the mortgage market - I personally find it hard to believe that given the extent of the paperwork, and the size of the economic transaction, that these people were actually taken for a ride. I think it was wishful thinking (to buy a home knowing very well the risks inherent in the mortgage), the same wishful thinking that the experienced people went through - that home values would never decline, that refinancing is always an option (that led these people to take out these loans).
Why were minorities overrepresented in sub-prime pools - partly because of lack of education (taken for a ride) and partly because they are poorer and have worse credit on average (than non-minorities). Having said that (even if they were taken for a ride), it doesn't mean that they didn't make the decision (to buy a home or refinance) knowing that there wasn't a risk...
Income is tightly correlated with the sophistication to understand what it being sold to somebody. Does the government have a responsibility to protect those that are less "able" to make the correct decisions, and if the government protects these people, where is the line drawn? (to not intrude into the decisions of those that are able to take their own decisions given full information and which make economies grow and markets move?) Perhaps the old liberal vs. conservative argument - should the government help some people and by establishing policies to help such people, do you then perhaps create an environment that is less conducive to growth (and thus end up with a smaller pie, and helping them less to start with).
Back to the mortgage market - I personally find it hard to believe that given the extent of the paperwork, and the size of the economic transaction, that these people were actually taken for a ride. I think it was wishful thinking (to buy a home knowing very well the risks inherent in the mortgage), the same wishful thinking that the experienced people went through - that home values would never decline, that refinancing is always an option (that led these people to take out these loans).
Why were minorities overrepresented in sub-prime pools - partly because of lack of education (taken for a ride) and partly because they are poorer and have worse credit on average (than non-minorities). Having said that (even if they were taken for a ride), it doesn't mean that they didn't make the decision (to buy a home or refinance) knowing that there wasn't a risk...
In general, I don't support the supposition that on average, the customer was taken for a ride - its too much of an important transaction for anybody, no matter their financial circumstances to claim that it wasn't their fault. Make buyers very responsible for the decision and potentially we would not have had this extent of a mess.
Sunday, November 18, 2007
Mortgage Market: The actors in the crisis and their role
There were a confluence of factors and no shortage of actors, each with their own incentives, but, I will focus on a couple here as possible spark plugs for what we just saw happened.
Number 1
A belief by all actors in the system that home prices simply went up (and thus, that there would always be alternatives to a foreclosure - selling the home or refinancing).
This led to the creation of products that expanded the buck and focused on simply the initial payments to qualify a borrower. "Tomorrow is always better than today" - and the adjustment periods became shorter.
Also, additional risk layers (that permitted the borrower to take more risk- not necessarily tied to an adjusting payment- but to borrow more relative to the value of the home or borrow more from their own income to pay for the mortgage) were permitted for a low price (again, the belief that the risk of default was very low).
Investment Banks (nothing new)
The investment banks saw an opportunity to deliver paper to hungry investors (for yield) and simply looked for ways to deliver that yield - ever more risky assets ended up in paper that was sold to the market. It was then not the assets themselves but their structuring that let to the higher yield. Perhaps investors were not willing to take on higher yield in a risky asset by itself, but, if it was packaged in a particular way, then they were able to take it.
These two were not only spark plugs, but, they were necessary conditions for the feeding frenzy to continue (with one additional item - the appreciation of homes - for the party to continue homes actually had to appreciate in value).
While there were spark plugs and necessary conditions. There were other things that permitted to fire to expand so fast. Like the wind is to a fire, there was the channel itself - Wall Street needed paper with a higher yield to put into securities (because they were able to convince investors, for whatever reason, that it was good), well, "we know how to find mortgages" and by the way if you didn't like the yield I found you the last time (high LTV, high DTI), here is how we can find more yield (stated income, lower FICO)... So, what is the channel? it is composed of mortgage bankers, mortgage brokers, realtors (who were able to sell more homes), appraisers (who were able to make more appraisers), and others...
So, it was a great, great world - borrowers were able to get better and bigger homes, brokers and mortgage bankers made fortures, realtors sold homes like never before, appraisers had more business than ever (and btw, to remain competitive they needed to become more lax in their stds, because otherwise, the bank - who pays them would simply go next door - this is a different topic, how do you uphold your stds in feeding frenzies and still manage to do business, it is almost like losing in every direction, but, this point applies to everybody - brokers, bankers, appraisers, wall street and even investors), wall street was getting some fat fees, and investors were getting great yield.
Which gets me to the following point (which is already implied up there)... whenever
(1) a deep belief (that is contingent on certain (up to that point) illogical elements happening) is ingrained in a market (can be led by some of the players),
(2) that is linked to a (significant) profit opportunity among many dispersed players, and
(3) not everybody has the same information, and
(4) those with the most information are compensated based on commissions (not taking any risk or if they can control the risk - for example, mtg bankers taking equity out of their companies every year)
other necessary elements:
- hot potato based on risk - people believe that if you ever run into trouble, you can simply unload by selling
- belief that the private markets always come up with the optimal outcome and that they regulate themselves (i.e. excessive risk taking would come by the way of losses)...
- transaction based income for main players - no skin in the creation of the hot potato...
the results?
Investors: made yield for many years, hot potato was dispersed (although some took real risk)
Investment Banks: made money, transactions, profits during those years? hot potato write-off (the little of what remained)
Brokers: made money, transactions, no skin
Bankers: made money, transactions, pulled a lot of money out
Realtors: made money, transactions, no skin
Appraisers: made money, transaction, could lose their license.
Mortgage holders: they are the ones that are holding the two key assets: the homes (that can drop in value) and the mortgage (that they can potentially not be able to pay) - some however, got a mortgage that they would not have gotten otherwise and will still be ok...
Number 1
A belief by all actors in the system that home prices simply went up (and thus, that there would always be alternatives to a foreclosure - selling the home or refinancing).
This led to the creation of products that expanded the buck and focused on simply the initial payments to qualify a borrower. "Tomorrow is always better than today" - and the adjustment periods became shorter.
Also, additional risk layers (that permitted the borrower to take more risk- not necessarily tied to an adjusting payment- but to borrow more relative to the value of the home or borrow more from their own income to pay for the mortgage) were permitted for a low price (again, the belief that the risk of default was very low).
Investment Banks (nothing new)
The investment banks saw an opportunity to deliver paper to hungry investors (for yield) and simply looked for ways to deliver that yield - ever more risky assets ended up in paper that was sold to the market. It was then not the assets themselves but their structuring that let to the higher yield. Perhaps investors were not willing to take on higher yield in a risky asset by itself, but, if it was packaged in a particular way, then they were able to take it.
These two were not only spark plugs, but, they were necessary conditions for the feeding frenzy to continue (with one additional item - the appreciation of homes - for the party to continue homes actually had to appreciate in value).
While there were spark plugs and necessary conditions. There were other things that permitted to fire to expand so fast. Like the wind is to a fire, there was the channel itself - Wall Street needed paper with a higher yield to put into securities (because they were able to convince investors, for whatever reason, that it was good), well, "we know how to find mortgages" and by the way if you didn't like the yield I found you the last time (high LTV, high DTI), here is how we can find more yield (stated income, lower FICO)... So, what is the channel? it is composed of mortgage bankers, mortgage brokers, realtors (who were able to sell more homes), appraisers (who were able to make more appraisers), and others...
So, it was a great, great world - borrowers were able to get better and bigger homes, brokers and mortgage bankers made fortures, realtors sold homes like never before, appraisers had more business than ever (and btw, to remain competitive they needed to become more lax in their stds, because otherwise, the bank - who pays them would simply go next door - this is a different topic, how do you uphold your stds in feeding frenzies and still manage to do business, it is almost like losing in every direction, but, this point applies to everybody - brokers, bankers, appraisers, wall street and even investors), wall street was getting some fat fees, and investors were getting great yield.
Which gets me to the following point (which is already implied up there)... whenever
(1) a deep belief (that is contingent on certain (up to that point) illogical elements happening) is ingrained in a market (can be led by some of the players),
(2) that is linked to a (significant) profit opportunity among many dispersed players, and
(3) not everybody has the same information, and
(4) those with the most information are compensated based on commissions (not taking any risk or if they can control the risk - for example, mtg bankers taking equity out of their companies every year)
other necessary elements:
- hot potato based on risk - people believe that if you ever run into trouble, you can simply unload by selling
- belief that the private markets always come up with the optimal outcome and that they regulate themselves (i.e. excessive risk taking would come by the way of losses)...
- transaction based income for main players - no skin in the creation of the hot potato...
the results?
Investors: made yield for many years, hot potato was dispersed (although some took real risk)
Investment Banks: made money, transactions, profits during those years? hot potato write-off (the little of what remained)
Brokers: made money, transactions, no skin
Bankers: made money, transactions, pulled a lot of money out
Realtors: made money, transactions, no skin
Appraisers: made money, transaction, could lose their license.
Mortgage holders: they are the ones that are holding the two key assets: the homes (that can drop in value) and the mortgage (that they can potentially not be able to pay) - some however, got a mortgage that they would not have gotten otherwise and will still be ok...
Monday, November 5, 2007
On religions, nationalism
I used to be a very nationalistic person growing up, and my feelings towards that happen to be the same as they are today about religion.
I feel that there are simply two routes to tolerance and peaceful living for human beings:
1) Preferred but impractical (hard to believe everyone can achieve this and even a minority not achieving it can create problems): go beyond our borders to learn about other people's culture and/or religion, and understand them as we do our own. Only doing that will we grow to respect them and enrich our own views.
2) The only practical solution in today's world (because of the inability to do the above): Leave culture and religion in a second degree to a secular/global vision of the world (probably following a liberal mindset) where we put our commonalities ahead of our differences and we see ourselves as citizens of the world (and not of a particular country or members of a particular religion).
I feel that there are simply two routes to tolerance and peaceful living for human beings:
1) Preferred but impractical (hard to believe everyone can achieve this and even a minority not achieving it can create problems): go beyond our borders to learn about other people's culture and/or religion, and understand them as we do our own. Only doing that will we grow to respect them and enrich our own views.
2) The only practical solution in today's world (because of the inability to do the above): Leave culture and religion in a second degree to a secular/global vision of the world (probably following a liberal mindset) where we put our commonalities ahead of our differences and we see ourselves as citizens of the world (and not of a particular country or members of a particular religion).
Right in the middle of another bubble...
I've found myself within two bubbles - Internet 99-00 and the Mortage Industry 05-07.
I ended up fully immersed within the first one, believing (like many people did) that we were experiencing a new paradigm - a new economy, new productivity, therefore new valuations. I ended up believing that the traditional valuation models were not accurately measuring the potential of the new economy - forget Graham, Buffet, or any other traditional financial mind. Buffet himself said he would never invest in MSFT because he didn't understand it. I left the bubble promising myself that I would never committ the same mistake twice - traditional finance will never grow old, stick to traditional fundamentals when evaluating any business.
With that same mindset I arrived in the mortgage industry in late 05. I had been following the "housing bubble" for quite some time (since late 2001), and the fact that it had not burst yet, made me doubt, but, sticking to fundamentals had been deeply ingrained by then. Applying that traditional logic to the mortgage industry didn't lead me to doubt about its sustainability. Mortgages were originated and then sold off into securities (that had many forms - MBS, CDOs, etc), so as long as the market was willing to invest in these securities, mortgage origination equity would never go bad. The housing bubble did burst (as expected), but, it took with it the whole non-agency mortgage origination industry. Where had I been wrong? Was I fooled for a second time? I was inside and I ended up believing in things in the same way I did in 1999?
Yes and no. Yes, I could have seen what happened within before, in fact I did see it, but, I wasn't able to understand the ramifications until they really hit the industry.
Here was some of my faulty logic:
Stated Income loans - I knew it was pretty crazy; I questioned why lenders would ask for the income in the first place (if it was a lie anyway), but, I believed that since the market was pricing that risk, it was already being taken into consideration (by means of a higher yield).
I should have asked myself if the market was actually pricing it correctly and if the market actually knew the fundamentals of this type of lending (no and no)
Negative Amortization loans - I fully understood what they were and understood that you needed high FICO scores to get them... should I have asked myself that in a situation where property prices are depreciating, not even high FICO scores would repay those loans.
Fee structures not being transparent to borrowers - instead of taking it as industry practice, should I have asked myself if that was actually right and if things needed to be that way?
The whole market banking on eternal home price appreciation -> pretty foolish, but, we all got carried away.
In hindsight, everything is easy, the hard part is really learning from every single situation.
I ended up fully immersed within the first one, believing (like many people did) that we were experiencing a new paradigm - a new economy, new productivity, therefore new valuations. I ended up believing that the traditional valuation models were not accurately measuring the potential of the new economy - forget Graham, Buffet, or any other traditional financial mind. Buffet himself said he would never invest in MSFT because he didn't understand it. I left the bubble promising myself that I would never committ the same mistake twice - traditional finance will never grow old, stick to traditional fundamentals when evaluating any business.
With that same mindset I arrived in the mortgage industry in late 05. I had been following the "housing bubble" for quite some time (since late 2001), and the fact that it had not burst yet, made me doubt, but, sticking to fundamentals had been deeply ingrained by then. Applying that traditional logic to the mortgage industry didn't lead me to doubt about its sustainability. Mortgages were originated and then sold off into securities (that had many forms - MBS, CDOs, etc), so as long as the market was willing to invest in these securities, mortgage origination equity would never go bad. The housing bubble did burst (as expected), but, it took with it the whole non-agency mortgage origination industry. Where had I been wrong? Was I fooled for a second time? I was inside and I ended up believing in things in the same way I did in 1999?
Yes and no. Yes, I could have seen what happened within before, in fact I did see it, but, I wasn't able to understand the ramifications until they really hit the industry.
Here was some of my faulty logic:
Stated Income loans - I knew it was pretty crazy; I questioned why lenders would ask for the income in the first place (if it was a lie anyway), but, I believed that since the market was pricing that risk, it was already being taken into consideration (by means of a higher yield).
I should have asked myself if the market was actually pricing it correctly and if the market actually knew the fundamentals of this type of lending (no and no)
Negative Amortization loans - I fully understood what they were and understood that you needed high FICO scores to get them... should I have asked myself that in a situation where property prices are depreciating, not even high FICO scores would repay those loans.
Fee structures not being transparent to borrowers - instead of taking it as industry practice, should I have asked myself if that was actually right and if things needed to be that way?
The whole market banking on eternal home price appreciation -> pretty foolish, but, we all got carried away.
In hindsight, everything is easy, the hard part is really learning from every single situation.
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