The Financial Engineers, Unbundling and Innovation
Or, at least that was the case until the financial engineers showed up. First, they challenged the idea of the uniformity of a bond by unbundling. A bond is not a bond; rather, it is a bundle of differentiated cash flows.
The first coupon on, say, a thirty-year annual coupon bond is the same as a one-year bond. The second coupon is the same as a two- year discount bond, and so forth. A thirty-year bond can be split up into thirty-one separate cash flows (one for each coupon and one for the repayment of principal). Each can be traded, bought, or sold, sliced or diced in any shape or form. The market for thirty-year bonds is thus also thirty-one different underlying markets—more diversity and homogeneity and the possibility of earning from differences in the different markets.But that still left the idiosyncratic risks. This was taken care of by the process of securitization. We can skip the consumer loans, the auto loans, and the credit card loans, and go straight to the mortgages. In the words of Lewis Ranieri (2000), who worked for Salomon Brothers and is credited with the creation of the collateralized mortgage assets that created so much difficulty in the current crisis, the “objective was to try to create a mortgage asset that was the equivalent of a bond, which was stripped of its idiosyncratic nature, of its diversity, to reduce the diverse mortgages to homogeneity.”
The goal was to create an investment vehicle to finance housing in which the investor did not have to [...] know very much, if anything about the underlying mortgages. The structure of the deal was designed to place him or her in a position where, theoretically, the only decisions that had to be made were investment decisions. No credit decisions were necessary. The credit mechanisms were designed to be bullet-proof, almost risk-free. The only remaining questions for the investors concerned their outlook on interest rates and their preferences on maturities.
(Ranieri, 2000, 38)But,
many of the factors that gave standard mortgage products high credit quality were missing in new mortgage products we devised. One such product was the GPM, to assist families that could not previously afford home ownership. This product is based on the principle that inflation enables workers to get annual wage increases of 6 percent or more each year. The mortgage was designed with a rising payment schedule that gives credit for these wage increases. Therefore, a lender can qualify a borrower at a low monthly payment today and then step up the payment up 6 to 7 percent a year. This enables more households to qualify for mortgages. (ibid., 40)
This is a description of an adjustable rate subprime mortgage that came to dominate the mortgage market. Ranieri notes, however,
Unfortunately the GPM proved to be a failure [...] because we overlooked a fundamental reality—everyone does not succeed. In fact some of us fail. Most simply get along. Therefore, a pool of GPM loans has default rates well above the actuarially allowable standard of three or four out of a hundred. Furthermore, if pay raises slowed or a recession occurred, defaults could be catastrophic. We learned that structures that depend on people succeeding and earning more each year do not follow the same actuarial trend as traditional mortgage products. [.] A second new product that suffered from structural flaws was the adjustable rate mortgage (ARM). The early adjustable rate mortgages [.] were designed to float within external market rates or a cost of funds index. However, when the interest rate index rose, which in turn increased the borrower’s monthly payments, mortgagees protested the payment hike, and many defaulted on their mortgages. Securitization starts to break down as a concept when the issuer imposes on the investor the responsibility of analyzing the underlying collateral. As a general principle, we found that in order to successfully securitize an asset type, one must be able to predict the actuarial experience of defaults.
Single family homes have an actuarial foundation. [.] This problem could not be mitigated by insurance because the premium would be prohibitively expensive. (ibid., 40-41)In simple terms, Ranieri is saying that his attempt to convert diversity into homogeneity failed. And as a result, there was no “commodity,” no “market” and no efficient market “price.” We could say that the fundamental theoretical error behind the subprime crisis was the failure to distinguish diversity from uniformity and the failure to realize that without a logical foundation for a uniform homogeneous commodity, there can be no market—and with no market, there can be no market prices to provide perfect information to inform decisions. The market was an imaginary construction, based on imaginary commodities, and decisions were based on imaginary prices. And on this basis, Foster would quickly tell us, maximum satisfaction clearly did not produce sustainability and the ability to continually be able to feed ourselves. More than simple regulations are needed to improve the operation of markets; institutions need to be reformed to restore viability to the financial system as a support for the financing of productive activity that provides employment and incomes.
But the real world keeps throwing up examples of the difficulties involved in resolving the paradox of uniformity and diversity The scandal over the manipulation of the London Interbank Offered Rate (LIBOR) is an attempt to create a uniform, homogeneous rate of interest as a benchmark. But interbank lending takes place on a bilateral basis, between banks of diverse credit quality, of different amounts, at different times and places. LIBOR is an attempt to make these diverse bilateral exchanges appear as if it is the rate that would be created by the textbook definition of a competitive market producing a single price. Obviously, this could never be achieved, and the traders who manipulated the rate were working to their own advantage, but they were able to do so because of the paradox of diversity and uniformity.
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