Manufacturing demand for mortgages

by Rob Horning

22 January 2008


Several people in the particular corner of the blogosphere that I frequent have linked to this transcript of a conversation n+1 had with a hedge fund manager. The very existence of this piece is encouraging, because it suggests that the sort of people who are likely to complain vociferously about capitalism are now actually taking a specific interest in the workings of capitalism. (I regard myself as one of those people, and for a long time I was content to complain about corporations without troubling to familiarize myself with a newspaper business page.) But what I found most interesting was this passage:

if you had a pool of half a billion dollars of mortgages, maybe there would be 300 million dollars of triple A paper you would sell to fund that, and then there would be smaller tranches of more junior paper. And the buyers of that paper, particularly the very senior paper, the triple-A paper, were not experts, they’re not mortgage experts, they say, “It’s triple-A? I’ll buy it.” This is money market funds, accounts that are not set up to do hardcore analysis, they tend to just rely on the rating agencies. And again the spread that they’re getting paid is very small, so they don’t really have a lot of spread to play with to hire a lot of analysts to go and dig in the mortgage pools and really understand them, they kind of rely on the rating agencies, and that’s their downfall. It’s kind of an interesting interaction in the sense that a lot of this mortgage project was almost created by the bid for the CDO paper rather than the reverse. I mean, the traditional way to think about financing is “OK, I find an investment opportunity, that on its face, I think, is a good opportunity. I want to deploy capital on that opportunity. Now I go look for funding. So I think that making mortgage loans is a good investment, so I will make mortgage loans. Then I will seek to fund those, to fund that activity, by perhaps issuing CDO paper, issuing the triple-A, double-A, A, and down the chain.” But what happened is, you had the creation of so many vehicles designed to buy that paper, the triple-A, the double-A, all the CDO paper… that the dynamic flipped around. It was almost as if the demand for that paper created the mortgages.

The argument you heard while subprime mortgages were booming was that it represented this great democratization of credit, tapping pent-up demand among the lower classes who had been unfairly denied credit for so long. Never mind all the advertising the mortgage industry took out; that demand was there and latent, it was argued. But as the hedge-fund manager explains here, there were huge incentives for highly leveraged financial players to create demand—they needed something upon which to extend their derivatives business. Knowing how profitable the derivatives would be, they managed to devise a way to let them come into being before the instruments they would be derived from. And this was accomplished mainly by separating competent understand of risk from the investors who were pouring in the money by way of ratings agencies inappropriately certifying the structured vehicles (and collecting their fees). Another thing to remember when you hear that the credit crisis was the fault of the borrowers getting in over their heads.


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