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Paul McCulley with Pimco is one of my favorite economists to listen to or read about. He has some great ways of describing the markets, and especially the current credit crisis, against the backdrop of classic economic theory. I have a few recent articles that are each insightful and interesting, and couldn’t throw into the recycle bin before reading a few times. Here are some highlights, with links through to each:
“Indeed, I’ve taken to calling the 2004-2006 vintages of limited or no document, no down payment, negative amortization (pay-option) subprime ARM loans as not loans at all, but rather free, at-the-money call and put options on property prices. Not exactly free, to be sure, as the putative borrower was obligated to pay something in cash interest, even if not the full amount, with the unpaid amount being added to the principal.
But as a practical matter, the options were essentially free. If home prices went up, the putative “borrower” would stay current, as the call went into the money, refinancing before the ARM reset, essentially re-striking the option exercise price higher. Simply stated, the borrower wouldn’t default, as logical people do not walk away from in-the-money call options.
And they didn’t, until about a year ago. As a consequence, default rates on pools of such subprime loans came in amazingly low, soothing rating agencies’ nerves and re-enforcing the shadow banking system’s appetite for securitized pools of them.
But if house prices didn’t rise, the call option would fall out of the money, and the put option – the right to default on the full principal value of the loan – would go into the money. Indeed, house prices didn’t have to fall, but simply not rise for this outcome to unfold, given negative amortization. In which case, the putative borrower would no longer have any incentive to stay current: Why throw good money after bad for an at-the-money call option that you got for free, which has gone out of the money?
And so it came to pass about a year ago, when early-payment defaults became a new phrase in our collective lexicon. The home price bubble popped, the at-the-money call options went out of the money, the at-the-money put options went into the money, and the holders of them remembered the wisdom of Paul Simon’s 1975 treatise on 50 ways to leave a bad situation:
You just slip out the back, Jack
Make a new plan, Stan
You don’t need to be coy,
Hop on the bus, Gus
You don’t need to discuss much
Just drop off the key, Lee
And get yourself free
And with Jack, Stan, Roy, Gus and Lee setting themselves free, the shadow banking system was revealed to be caught between the longing for love and the struggle for the legal tender, living life as Jackson Browne’s Pretender, ships bearing their dreams sailing out of sight, with the junkman pounding their fenders. To wit, a run on the asset backed commercial paper market!”
– March 2008 (interviewed by Katheryne M Welling)
“Only the rating agencies? I’d say the creators and issuers of all that funny paper bear some burden.
They were clearly at the scene of the fraternity party. But it was the rating agencies that were providing the kegs. You couldn’t have played the game without the rating agencies.
I’d say Wall Street and the banks provided the kegs and the rating agencies provided the false IDs.
Touché. Good analogy.”
– May 2008
Read the whole thing via the link above. A great walk-through of the role and responsibility of the Federal Reserve, and some throwbacks to McCulley’s often-quoted evident mentor, Hyman Minsky, who was a noted specialist in Financial Instability Hypothesis.