Lunchblogging - Finance Edition

I was talking to my mom last night about the election returns and just what's going on, and the whole mortgage crisis thing came up, so I thought I'd blog about it.

My parents live in a fast growing suburb in the South. They have been adding school after school there (they just opened a third Highschool recently, tons of new elementary schools). Anyway, one of the new elementaries is near three new developments, one of which my Mom passes on her way to work. According to her, the one that she passes by is maybe 1/4 full, and the school built to serve that area has been, um, under-pupiled? Whatever.

The rash of vacant and abandoned homes in Southern California and other high growth areas is well known, but it was interesting to me that the effects of the mortgage/credit crisis was hitting my home town. I hope that this doesn't follow.

This is especially interesting in light of this.. This is one of the smartest investors in the world "the oracle of Omaha" trying to make money off the core of the mortgage crisis. Let me try to unwind it in a couple paragraphs. NOTE: I am not an econ or finance major. All of the below is merely my understanding from reading what I believe to be reliable sources and accounts on the subject. There may be and probably are factual and/or chronologial errors.

Basically, you started with so called "monoliners." They were bond "reinsurers" for municipal bonds only (thus the "mono"). Municipal bonds are very low risk, since they are guaranteed by the future revenue of the municipality that issued them, and even though New York once famously came close, municipal entities tend to not go bankrupt. However, to sell a bond with a AAA rating (i.e. the highest grade bond, which pays the lowest interest rate, thus being "cheapest" for the borrower) you still need insurance. So These monoliners made a nice, stable, profitable business out of writing (and being paid for) mini-bond reinsurance, generating nice AAA credit ratings for themselves in the process, since writing insurance policies for AAA bonds - bonds that by definition had a very low risk of default - tends to be a pretty low risk business.

Enter the consolidated debt offering (CDO). Mortgages are much too small to issue as bonds tradable on a typical bond market. Commercially traded bonds are generally designed to fund very large commercial or municipal projects secured by the future revenues of that project, company, or municipality. Well, someone looked at mortgages and said "hey, if I buy a whole bunch of mortgages issued to owners with AAA credit ratings, then I bundle that income stream (i.e. the payments made by all those homeowners) together and use it as security, I can sell a AAA bond based on that credit rating." Now in principle there's nothing wrong with this. If you have a pool of small seperate AAA credit risks and you gather them together in a CDO, your resulting bond should be AAA (in fact, maybe even better to the risk-averse, since the obligations are seperate, your variance will be lower).

The problem comes in when you look at what happens to the incentives. Traditionally (without CDOs) the issuer of the mortgage was typically a local bank branch that would hold the mortgage until it was paid off. Thus the issuer had a strong incentive to make sure that the borrower was assessed accurately, because if they defaulted, it would have to clean up the mess. This meant both that the mortgagee would undergo intense credit scrutiny, and the mortgagor would not want to sell a product that the mortgagee was unlikely to be able to pay off.

Once selling mortgages to second parties for consolidation and then reissuance (and reinsurance) became the model, each party had less incentive to scrutinize the transaction. The banks that would create the initial mortgages just wanted to make deals and then sell them on to the consolidator. The consolidators wanted more and more loans so they could put them together, buy insurance and then sell them on the bond market. The bond buyers were so far removed from the transactions, that they simply relied on the market valueation and the bond rating, and heck, they were insured! So that leaves the rating companies and the insurers. The rating companies (there were at the time three of them) were being paid by the consolidators, so consolidators could "shop around" for the best rating.

And the insurers, well that brings us back to the Buffet article at the top of the post. You see, Ambac, MBIA, and FBIC are all monoliner bond reinsurers. As discussed above, they had this tidy little low risk business insuring muni bonds. Then they started thinking, hey, we can expand a lot if we start branching out and insuring more than just munis. We can insure these CDO things. As long as we only buy AAA CDO bonds, we still get our profits and we keep our AAA credit rating and we do more business. Keeping the AAA credit rating is important because the credit rating of a bond's insurer is an important factor in the bond's rating. If a bond insurer's credit rating drops, the value of EVERY BOND THEY INSURE also drops, because the risk of default for all those bonds goes up. But who is rating these monoliners? Why the same rating agencies that are rating the bonds in the first place. If Moodys says the bonds you insure are AAA bonds, well how could they say that your company is anything but an AAA credit risk itself? So they insured more and more of these CDOs.

What Buffet is offering these companies is the following. "Look, you say all your credit risk is AAA, and you are only suffering a liquidity crisis. Ok, I'll reinsure your bond insurance to the tune of 800 Billion with a B, but only on the MUNI BONDS. I'll take all the income streams from the insurance premiums and risk of default on those AAA municipal bonds, and give you this sack of cash. You keep all the premium incomes and risk of default on those CDOs. If those CDOs are really AAA risk bonds like you continue to say they are, well, this should be a fine deal for you, since you'll get most of those premiums and be able to pay off defaults and have money left over to pay off any creditors."

The truth is though, that there's no way those bonds they have are AAA worthy. There's been a lot of mortgage defaults, and there'll be more in the next couple quarters. If they sell off those assets now and the money they get for them isn't enough to pay off defaults, they just explode. If, on the other hand, they keep those munis, they have a potent threat against the bond market. Remember, if they lose their credit rating, Billions (maybe trillions?) of dollars in bonds suddenly lose value. Bonds held by many, many players in the market. Bonds issued by many, many cities and states throughout the country. They are banking that it would be so catastrophic for that to happen that there would be a bailout before it happened. They may be right too.

Whew. I have to learn how to do the short post that opens into a longer post thing.

UPDATE: Apparently the "chief risk officer" at Ambac was, um, let go. Don't worry though. Lovely parting gifts. $800,000 and all.