Short Answer: No

The question is whether or not the wonks can save finance from itself.  So long as lobbyists from the financial industry maintain the influence they currently enjoy, it’s not going to happen. Still, I enjoyed the article most because Luigi Zingales addresses a topic that comes up here from time to time:

Does finance benefit society? It’s a question that has become all too relevant in recent years, and one that academic economists need to do a much better job of answering.

Most economists assume that finance is an unmitigated good — the more opportunities people have to diversify and insure against risks, the better off they are. The 2008 financial crisis and the long string of fraud and market-rigging scandals that followed, though, have given the public a different view: The latest wave of the Chicago Booth-Kellogg School Financial Trust Index shows that 48 percent of Americans think finance hurts the U.S. economy, with only 34 percent saying that it helps.

I don’t know how I would go about addressing this in a full-length post, let alone come up with a working definition of “finance” given how broad it is, so let’s make this an open discussion .  Personally, I’d put myself in the 34% camp but can understand why people think otherwise and believe some of those reasons are valid.

Please do be so kind as to share this post.
TwitterFacebookRedditEmailPrintFriendlyMore options

130 thoughts on “Short Answer: No

  1. I’d easily be in the 34% group. Part of the problem with finance is the problems people have with flying: there are inconveniences and problems and some very loud ugly incidents but in general it works really well and offers a lot of benefits we are so used to that we don’t notice. However there is a difference in that if people don’t want to fly ever or rarely or want to pay for first class they can. They have options. It doesn’t matter what any of us think of the finance industry ( however roughly that may be defined). What they do and F up, affects the economy and therefor all of us. Airlines have some pressure to listen to what we want and like, and sometimes try to make things good for us. Finance types seem to feel they are our rulers and we should just be glad they are so nice to us. How dare us for inflicting our petty rules on their supreme eminences. How dare us for not seeing the riches they bring us.

    Report

    • Interesting analogy. I was just this morning reading this book, by Nouriel Roubin, in which he references an analogy used by Larry Summers. Summers likens the modern financial system to the jet engine. Jet planes get us around the world faster than would otherwise be possible, but also result in some very horrific accidents. We could abolish the jet plane and air travel all together and that would rid us of the calamity of air travel accidents, but would it be worth it in the good that we gain from making the world a more accessible place?

      We can ask a similar question when it comes to finance. The ability to buy a house with a mortgage is a boon to homeowners, but it also leads to things like the sub-prime hosing market and poorly understood synthetic derivatives. A retirement savings account allows us to save more money than would a simple demand deposit account, but is much riskier.

      I am in the broad camp of saying that the risks are worth the rewards, but there is likely no one answer to this question.

      Report

  2. Withought knowing what “finance” is, this is like asking if “money” is good for society. Or “credit” or … you get the idea.

    Trite enough to say that modern financial practices have all sorts of complex tools, and like other tools their normative value is not inherent in the tool itself but rather in the manner of use. But that isn’t a particularly adventurous claim, either.

    Report

  3. Well in a narrow, technical sense, of course I’m in the 34%. Without some kind of financial system there’s no way for businesses or consumers to get credit, to save for retirement, etc.. But if we’re asking if our current system, characterized by great complexity, leverage, and accrual of wealth is a good thing for the economy, I feel pretty confident that the answer is no. We’d be much better off with a simple, boring, not terribly profitable financial sector.

    Report

  4. So long as lobbyists from the financial industry maintain the influence they currently enjoy, it’s not going to happen.

    I am curious about what makes you think that this is the limiting factor. It is a pleasing thought to think that if we could just banish all the lobbyists, the government could tame the financial services industry for the unequivocal benefit of humanity, but why would that be the case?

    Report

    • I am curious about what makes you think that this is the limiting factor. It is a pleasing thought to think that if we could just banish all the lobbyists, the government could tame the financial services industry for the unequivocal benefit of humanity, but why would that be the case?

      I’ll answer your question, but I need to clarify two points. First, I don’t believe banishing lobbyists is necessarily a good thing. Second, I neither believe nor aspire for the government “to tame the financial services industry for the unequivocal benefit of humanity”. However, dealing with some of its worst excesses, especially and maybe exclusively those that have systemic consequences, would be a good start.

      If I erred in any way, I focused my statement too much on lobbyists and not on the very well known relationship between Wall Street, the regulatory bodies and the political branches. I’d like to think that the fighting over the implementation of Dodd-Frank, which started the day it was signed, kind of proves my point that Wall Street is not going to simply accept a regulatory structure that cuts into profits.

      Chipping away at the Volcker rule is a good current example. Frankly, I’m skeptical that it will have the impact the banks say it will. Maybe I’m not sure why it requires proprietary trading to structure credit products for clients. The banks can structure the deal, place the risk with the appropriate parties and make some money doing so.

      Personally, I would have no problem with the banks engaging in prop trading if it was structured to limit the losses to the capital invested and not effect the parent company (I’m not sure how this would work), then I don’t think I’d care. I also wouldn’t care if a Wall Street firm took capital and put it with third party managers, subject to certain rules.

      Report

      • Wall Street is not going to simply accept a regulatory structure that cuts into profits.

        It would if the alternative were a just one, How long would the accumulated time in debtors prison be for going 700 billion in the hole?

        Report

      • How long would the accumulated time in debtors prison be for going 700 billion in the hole?

        I guess that’s one way to get the corporate officers thrown in jail. They’ll never be found guilty of criminal fraud.

        Report

      • I think we’ve had this conversation before. Look, if you convicted everyone guilty of a crime, you’d probably have to build new prisons to house them. I don’t disagree with you on the magnitude of the criminal activity that took place. However, it was too far removed from the executive suites to make a case for any kind of fraud, with the exception of Countrywide’s Angelo Mozilo, who settled on civil not criminal fraud.

        I spent three years at one of the investment banks. They’re HUGE companies with plenty of bureaucratic layers, lawyers and a culture of plausible deniability. Mozilo was a different animal because he was running a mortgage company so it was a lot easier to come up with a case that he knew what was going on. The SEC should have gone after him much harder on criminal fraud grounds and taken him to trial, but that would have been the only trophy kill it could have gotten.

        By all means, throw the people that did the forging in jail, but something tells me that’s not going to be good enough for people.

        Report

      • If you would like to make a case that RICO is appropriate, by all means go ahead. In the meantime, I’ll just agree to disagree with you. Not only do I think it’s next to impossible to make RICO charges stick to organizations without links to organized crime, but I’m not sure how well it would go over if systemically significant firms had their assets frozen. Add to the fact that you are trying to find ways to prosecute people that can’t be prosecuted under more appropriate statutes. Do you think that constitutes justice? I don’t.

        Report

      • Your explanation of why the heads of large financial firms can’t be prosecuted successfully is that they’ve immunized themselves via multiple levels of plausible deniability. That’s exactly what RICO was created to counteract, making it a completely appropriate statute.

        Report

      • That may work against organized crime organizations where it’s an almost surefire bet that the people at the top are coordinating the criminal activity, but it won’t work when there’s almost no evidence that a Lloyd Blankfein or a Jamie Dimon has coordinated a damn thing. Do you think the profits from any fraudulent activity at JP Morgan would have registered on Jamie Dimon’s radar screen given how many business lines make money for that firm?

        If prosecutors can’t uncover any crimes and prosecute underlings for those crimes, on what basis do make your RICO statute? Wouldn’t you first have to prove that plausible deniability exists by tying it to a crime and demonstrating how the cover up shielded top officials? I’m no lawyer but making a RICO run at top Wall Street officials simply on the basis of a shitty corporate culture doesn’t sound like something government lawyers would want to do.

        Report

      • Do you think the profits from any fraudulent activity at JP Morgan would have registered on Jamie Dimon’s radar screen given how many business lines make money for that firm?

        That is, in his defense he’s merely oblivious to or tolerant of fraud, not the mastermind behind it? Then clearly the penalties for it aren’t high enough.

        Report

      • as I see it, the banks got away with something most people think of as wrong because there was no law against it; that was Brooksley Born’s warning: an unregulated market, and the money flooded to it and created a distortion we peons experienced as the real estate boom of the naughts, followed by its bust.

        This is, essentially, the problem I have with this whole discussion: unregulated markets are a problem; particularly financial markets. In the same way, over-regulated markets might be a problem or poorly-regulated markets.

        Finance wasn’t the problem here; unregulated finance was the problem. I doubt the people who answered that survey thought their debit cards were the problem; I doubt they think their house mortgage or car loan or their children’s student loans are the problem. But they know the economic collapse of 2007 was a problem of finance; and specifically, it was a problem of an unregulated financial market where there were no laws saying “this is illegal,” so no laws were broken. Unregulated has two sides to the coin; there are no laws to restrict, but there are also no laws to break. No bankers were harmed by being imprisoned for their massive fraud because that particular fraud wasn’t illegal. The only people who did or will do jail time broke some other law, the didn’t just commit the fraud of gambling on housing loans as if all the risk had gone away when you didn’t have proper underwriting standards.

        Report

  5. I’m pretty sure I saw some research indicating that while the finance sector is, of course, a valuable and useful (and unavoidable) segment of the economy, the problem may simply be an over-supply.

    The conclusion was, effectively, once finance was past some percentage of your economy that it became counter-productive.

    It makes a certain intuitive sense (which means little in economics. Or gambling, for that matter) — obviously if the economy was 100% finance sector, it’d just collapse because you’d be pointlessly trading money around and not making anything. It’d just be reshuffling the owners of wealth. And if it was 0 percent, things would be pretty bad too. A world WITH banks and insurance and lending and functioning investment markets is much better than one without.

    So obviously there’s a tipping point somewhere. Whether we’re over-supplied or under-supplied in terms of ‘finance industry’ is the real question.

    I lean towards yes, but that’s because I see it as an inevitable result of wealth accumulation. Unlike feudal nobles, the modern ultra-wealthy won’t stuff their wealth in a vault, removing it from the economy. They want to invest it. And there’s a finite number of good investments, so again — at some point you’ll need to balloon the finance industry to service all the money being waved around. As there are a finite number of good investments, and a lot of money demanding high returns, I’m not sure how you avoid some weird sort of bubble.

    In both investment vehicles AND the financial industry that designs, maintains, and sells them. (And hedges them and insures them and….wait, this sounds like the Great Recession a bit now..)

    Report

    • Well, limited liability (and for that matter bankruptcy) does push finance in the direction of over-supply. But corporate and capital gains taxes push in the opposite direction. I would not say it is a was, only because I don’t know how to measure the size of the effects. Let’s get rid of both types of factors and see how things work out….

      Report

      • Getting rid of limited liability AND corporate taxes AND capital gains? Those ideas strike me as insane for entirely different reasons.

        If it makes you feel better, I find the first and third far crazier than the second, which is more an awful idea than a cray one.

        More on point, I have no idea how exactly how “limited liability” pushes towards ‘over supply’ nor how the capital gains tax pushes towards ‘less supply’.

        In fact, capital gains should push in the OTHER direction — because of the two primary ways to make money (labor or capital), capital gains is taxed far less and thus to be preferred.

        Unless you think someone sitting on 1000 dollars and thinks “We’ll, I’d invest it but I’d have to pay 15% on any profits I make, so I’ll just sit on this cash and make nothing instead”. Insofar as that requires people not to understand that “zero” is less “any positive number at all” that’s a bit weird. (Now if you couldn’t deduct losses or something weird like that…..)

        Report

      • For capital gains, it would be something like this: Well, given the risk in this venture, I’ll only invest if I can double my investment. Pre tax, this happens to be the case. However, if you take out 15% of my capital gains, I don’t get back enough to make the investment worth the risk.

        Limited liability externalises some of the risks of investment. This encourages investment to an extent beyond what would be warranted by the actual riskiness and gains involved. The idea, roughly, is that we have an efficient level of investment when investors fully internalise all costs and benefits. One of the biggests (if not the biggest) costs of investment is the risk of losing everything (or even more than everything you already invested) For example, taking a loan to finance 70% of my startup is worth it only I am sufficiently confident that my returns will be high enough to pay back the loan with interest eventually. If my company goes belly up and I am fully liable, I have to pay off the loan from my personal funds. But if I can be assured that my personal funds are not touched, then certain risky investments look more attractive. Companies can of course re-negotiate with creditors and consumers to limit their liability, but there is no need to make it a default. As long as the coasian transaction costs can be kept down, even if companies buy back the limitations on their liability (via insurance etc), the distribution of wealth should be more equitable.

        Report

      • I’m not sure how much limited liability matters in practice. It’s priced into the loans, so I would expect that corporations end up paying for it anyway. It transfers risk from investors to lenders, but the lenders are paid for it.

        As for torts, how often are large corporations sued into bankruptcy? I suspect that it matters most with very small firms.

        As for that old canard about investment income being privileged with lower taxes, we’ve been over that.

        Report

      • I’m not sure how much limited liability matters in practice. It’s priced into the loans, so I would expect that corporations end up paying for it anyway. It transfers risk from investors to lenders, but the lenders are paid for it.

        As for torts, how often are large corporations sued into bankruptcy? I suspect that it matters most with very small firms.

        Well, if the size of the effect is small (or negligible), then eliminating it and letting people set up insurance companies which would limit the liability for the company while paying off the creditors in full would be better. At the very least it would not be crazy talk. A lot of people think its crazy talk because they suppose that the amount of investment that limited liability encourages is a lot. But if that is the case, then, since that encouragement happens by externalising the risks (i.e. costs) all that additional investment is inefficient (except for the parts that compensate for corporate and capital gains taxes)

        Report

  6. Any opinions on what effect time banks will have? I don’t see where they are gaining much traction yet, but if they do, things could change.

    Report

  7. “Most economists assume that finance is an unmitigated good”

    Really? Somewhere between 50% plus 1 to 80% of economists believe that finance is on an absolute positive moral foundation? One might catch Larry Kudlow saying something like this (and believing it), but I doubt a survey of professional economists would show that most actually believe ‘Finance! Fish Yeah!’ without reservation or equivocation.

    Report

  8. I also want a better definition of finance. Obviously people do benefit from credit and being able to get loans to purchases houses, educations, start businesses. Most law firms operate on lines of credit. Google became Google because of investments, etc.

    That being said, I am skeptical of all the ways Investment Banks and Hedge Funds of ensuring that they make money while their clients might loose everything. Didn’t Goldman Sachs get in trouble for hedging against their own financial advice to clients?

    Report

    • Hedge funds are asset managers; they don’t make money unless their clients do. Rather, they don’t make real money unless their clients do. Funds generally charge a 2% management fee, plus 20% of returns over a certain threshold. These guys aren’t in it for the 2%.

      What GS did was package a bunch of CDOs to sell to clients, so that John Paulson’s hedge fund could bet against those CDOs. Paulson’s clients made money on that deal. The guys that GS sold those CDOs to did not.

      Goldman is an interesting animal in that they have a reputation of being this incredibly efficient money-making operation that has very little regard for anything buy making money; that includes the well-being of their clients and counter-parties. And yet, there are no shortage of people who want to be clients and counter-parties of Goldman. It’s hard to say what’s going on there.

      Report

      • Although the 2% means that even if their clients lose money outright, they still get paid, and the returns that they get a slice of don’t have to be above the market. So you could quite easily have your investors underperform the market dramatically after fees while still making out like bandits.

        Report

      • These guys aren’t in it for the 2%.

        This. The 2% asset management fee paid to the hedge fund covers the cost of running the fund including salaries, rent, expenses, transaction costs, etc. They get paid to try to make money just like the fund managers that work at the public pension funds.

        Are they paid well? Yes. Perhaps too well for a bad year? Ok, that’s fair to a point, but they aren’t making out like bandits. Like said, the hedge fund managers make all the money when the investors do well.

        Report

      • Get paid, but for some reason that money is still taxed as a capital gain and not a salary. If Congress could fix that, it would be a good start.

        That’s because in most partnership situations, like real estate development or private equity, investors receive the benefit of the carried interest when a capital transaction takes place, usually at the exit of an investment. At that point, the value is 100% driven by the value of the asset in the capital markets and has nothing to do with ordinary income.

        If hedge fund managers make enough to generate compensation due to carried interest and it was because the fund liquidated positions and made a killing doing so, I fail to see why this is ordinary income. I think it’s a little messy because hedge fund carried interest calculations can be based on paper profits, but so long as the cash is not paid out, it’s not taxable.

        Report

      • What GS did was package a bunch of CDOs to sell to clients, so that John Paulson’s hedge fund could bet against those CDOs. Paulson’s clients made money on that deal. The guys that GS sold those CDOs to did not.

        ABACUS was one thing. What Goldman also did was take short positions on one of the subprime indexes in a bet against that market. At the same time it did this, it was trying to sell off some of its long CDO positions, some of the stuff that would end up losing them millions. While I wasn’t concerned with Goldman’s short position, the problem I had with Goldman’s attempt to sell off its position was that Goldman allegedly never disclosed that the securities they were selling were from their own inventory. If I recall, Goldman took the position that it was acting solely as an intermediary and it was up to investors to do the appropriate due diligence. Of course, they excluded a material fact. I believe that they settled on this one too.

        Report

      • Most of us who get paid with equity pay ordinary income taxes on the fair market value of that equity when it’s issued to us. If the hedge fund managers are doing that and then paying capital gains taxes on the appreciation, that sounds about right. But it sounds to me like that’s not at all what’s happening. It sounds like they’re doing work, being compensated with an agreement that has a nonzero fair market value and paying zero taxes on it, and then paying the capital gains rate later when they convert it to cash. Am I wrong about that?

        Report

      • Funds generally charge a 2% management fee, plus 20% of returns over a certain threshold.

        So if they break even, they get a piece from the 50% of clients who did well but pay nothing to the 50% who did badly? No perverse incentives to transfer losses between clients there.

        Report

      • I’m not exactly sure what you mean, but I think that you are misunderstanding how a fund works. The fund managers aren’t managing a bunch of individual portfolios. It’s one big pool of investments. When the value goes up, the investors get positive returns and the managers make money. When the value goes down, the investors get negative returns and the managers don’t make money.

        Beyond that, I’ll just say that people like to throw hedge funds onto the pile of problems with the financial sector, but I’m not sure that is justified. Hedge funds had almost nothing to do with the Global Financial Crisis. And to invest in a hedge fund in the first place you have to be a certified investor, so it’s not like your grandmother is likely to lose her retirement savings because of a hedge fund. Institutional investors, like pension funds and insurance companies, have some exposure to hedge funds, but a small percentage of their total positions.

        Report

      • Most of us who get paid with equity pay ordinary income taxes on the fair market value of that equity when it’s issued to us.

        As part of a compensation package yes. In addition, to the extent that you receive dividends, the dividends are taxed at the ordinary income level. However, if you bought a stock at 100 and sold it at 110, to the extent that you sell after a one-year hold, that $10 profit is taxed at the capital gains tax.

        Which example applies to carried interest? I’ll try to explain this using a very simple example of a real estate partnership, which uses carried interest all the time (in fact, far more than the hedge fund industry).

        Let’s say I develop a major office property for $100 million. I get a construction loan for $70 million. I reach out to Ordinary Times Investors, LLC (“OTLLC”) to raise the equity. OTLLC agrees to provide 90% of the required equity ($27 million out of the $30 million). I kick in the other $3 million.

        We’re 90/10 partners.

        To keep this simple, let’s assume that in two years, we sell the property into a good market and sell it for $150 million and make a $50 million profit. If we split the profits based on our respective ownership interests, OTLLC would receive $45 million and me $5 million.

        Here’s where carried interest kicks in. It is very common in partnerships for the investors as limited partners to reward the manager (general partner) with a disproportionate share of the profits after some return hurdle. This recognizes that the investors would not have received this return without the expertise provided by the partner and it provides further incentive for the general manager to perform. In my corner of the world, we call it a promoted interest.

        Let’s keep it simple and assume that we agreed that I would receive 20% of all profits even though I only hold a 10% ownership interest. That additional 10% represents the carried interest. Therefore, rather than receive $5 million, I receive $10 million and OTLLC receives $40 million.

        That additional $5 million I receive was not “awarded” to me (yes, it’s negotiated). It could only be paid out based on the same capital event that allowed me to get a $5 million gain based on the equity I have invested. If I sold into a bad market, the carried interest could be worthless. It’s no different than selling stock only I get a higher percentage of what’s there.

        The big difference between hedge funds and real estate deals (and even private equity) is that hedge funds can constantly recycle capital through trading in and out of their positions, so much so that the highly successful funds can generate substantial capital returns on a very frequent basis, even every year. From a window dressing perspective, it may look like a run-of-the-mill bonus, and given that it’s the hedge fund industry, the dollar amounts are enormous and the political climate with respect to inequality and taxes, people tend to wonder why the hell it’s not taxed at the ordinary income rate. In my opinion, it’s not ordinary income in the way management fees are ordinary income.

        I can understand the frustration to an extent (personally, I don’t care one bit), but going after carried interest is a cure worse than the disease. The carried interest structure is commonplace in real estate development, and one thing real estate development does is create middle-class construction jobs (lots of them). Make it more expensive for developers to develop and it negatively impacts the business. It also drives values down because tax-oriented investors will have to factor in higher tax rates into their underwriting.

        If what I’m saying sounds like typical vulgar anti-tax talking points, I’ll point out that one of the worst things to ever happen to the commercial real estate business was the Tax Reform Act of 1986***. It was one of the key factors that led to the savings and loans crisis and the real estate downturn that came in the early 90’s.

        *** In the spirit of full disclosure, the TRA reversed a tax loophole created by the Economic Recovery Tax Act of 1981 that put commercial real estate in a position to take a huge hit in the event it was ever reversed – the use of depreciation and tax losses from real estate investment as a tax deduction on real income. Arguably, this disconnected commercial real estate from its cash flow fundamentals, drove investment based on the tax shield, and when there weren’t enough properties, the S&L’s were more than happy to fund the construction of new ones. Oops.

        Report

      • So if they break even, they get a piece from the 50% of clients who did well but pay nothing to the 50% who did badly? No perverse incentives to transfer losses between clients there.

        They can’t transfer losses because all of the “clients” are investors in the same fund. I think you may be confusing this with money managers that invest on behalf of separate account clients.

        Report

      • Institutional investors, like pension funds and insurance companies, have some exposure to hedge funds, but a small percentage of their total positions.

        If I recall, much of the growth in the hedge fund industry is attributed to increased institutional capital from these sources. They’ve also been the ones to push back on the traditional hedge fund compensation structure, especially with respect to the 2% fee.

        Report

      • When the value goes down, the investors get negative returns and the managers don’t make money.

        You mean the managers don’t make as much money. They still get that carried interest. This is the rationale for complaining about the tax treatment of carried interest income. The whole theory behind lower capital gains tax rates is that you need to encourage people to take financial risks in order to spur economic growth. But when it comes to the carried interest income, there was never any significant risk. Win or lose in the market, the manager still gets that money.

        Report

      • Same scenario, but instead of 10% you put in one dollar. You still get 20% of the profits as a reward for running the project. The same logic about your 20% being the result of a capital event and merely a multiplier of the (fifty cent) profit on your investment applies (and in a bad market, you’d have lost the whole dollar.) Capital gain or performance bonus? If the latter, what changed from the original scenario?

        Report

      • Are there no cases where the same people manage multiple funds and can move profits and losses among them?

        Sure, the U.S. government does this all the time with the social security trust fund. Doing that sort of thing with private investment accounts is clearly illegal though. So, yeah someone somewhere has probable done it, but it’s clearly fraud.

        Financial services firms have other ways to accomplish similar aims though. We already mentioned ABACUS. Broker dealers can also front-run their clients’ trades, meaning that they can buy shares ahead of a big order or other event that they know will run up the price.

        Report

      • ,

        It is very common in partnerships for the investors as limited partners to reward the manager (general partner) with a disproportionate share of the profits after some return hurdle. This recognizes that the investors would not have received this return without the expertise provided by the partner and it provides further incentive for the general manager to perform.

        That actually sounds a whole lot like a bonus that’s based on the performance of the company in recognition of work done by an employee of the company. It’s couched in “capital” terms and tied vaguely to the junior partner’s actual investment, but there’s no actual ownership or capital at risk for that portion of it. It looks to me like it’s either a contingency bonus that magically looks like capital investment for tax reasons, or it’s stock compensation that magically doesn’t include any stock to tax. Weirdly, even though the junior partner is being given something of substantial value (the option to participate in massive capital gains under some circumstances) in exchange for work, the Uncle Sam doesn’t see it that way.

        It’s a neat trick, and if I had the option of becoming a “more junior” partner at my company with less stock to pay taxes on but the same upside at acquisition time, I’d likely have taken it. In fact, if I could have taken the whole thing in capital gains upside with no taxes up front and the price I paid was losing my minority voting status, I might well have done it. I’m having a very hard time seeing how hedge funds or real estate partnerships are some sort of real special case and not just a cute loophole. People form and join partnerships and participate in their growth and resale of those partnerships all the time in all sorts of industries.

        The carried interest structure is commonplace in real estate development, and one thing real estate development does is create middle-class construction jobs (lots of them).

        As you imply at the end of your post, if there’s one thing that seems more than adequately incentivized by government handouts, it’s the real estate industry. And if there are two things, they’re the real estate industry and finance. They’re both very generously fueled by government support, and I think the worldwide evidence over the past 30 years or so is that it’s probably not a good thing. I’m definitely not on the, “Kill the investment banking industry!” side, but this type of loophole seems like a crass carve out and a pretty easy kill.

        I’m generally very skeptical of the claim that absent significant government money, we won’t get enough real estate development. Real estate has been one of the big investments since the concept of investment was invented (and probably before), and it’s one of the things that just about everybody else needs in order to live and do business. It’s a little bit like energy. No matter what we say or do, we’re going to be buying the amount we need, and the market will likely supply it. There’s really no getting around it.

        Report

      • Same scenario, but instead of 10% you put in one dollar. You still get 20% of the profits as a reward for running the project. The same logic about your 20% being the result of a capital event and merely a multiplier of the (fifty cent) profit on your investment applies (and in a bad market, you’d have lost the whole dollar.) Capital gain or performance bonus? If the latter, what changed from the original scenario?

        It would still be a capital gain and a completely ridiculous carried interest structure to boot. If you ever find someone to give you that kind of deal, go for it.

        We’ve done JV deals where our client put in no equity and got 40% of the profits, although I should note that neither party put in equity because they were able to get 100% construction financing. That I believe was treated as capital gains.

        Report

      • We’ve done JV deals where our client put in no equity and got 40% of the profits, although I should note that neither party put in equity because they were able to get 100% construction financing. That I believe was treated as capital gains.

        But how was responsibility for the construction loan shared? If I got a mortgage for 0% down and then flipped the house for a profit, that would be a capital gain, even though the financing was all debt-based, and that seems reasonable to me.

        Report

      • Regarding fraud, I forgot to post this last week:

        http://www.nytimes.com/2009/11/11/business/11bear.html

        The government did aggressively pursue criminal fraud charges against the two Bear Stearns hedge fund managers that oversaw the collapse of the funds, an event that ultimately brought down the firm.

        If the government couldn’t make criminal fraud charges stick against two people that directly oversaw investments that failed, on what possible grounds should prosecutors expect to make criminal fraud charges stick against corporate officers?

        It’s no coincidence that there were no high profile prosecutions after the government lost this case. The problem is with the law itself. Beyond a reasonable doubt is a very high standard for the government to meet. I think Dodd Frank would have been better if some changes were made to the laws governing financial fraud but it didn’t happen. Oh well.

        Report

  9. thanks for the explanation, but that’s what’s so annoying about the loophole. The difference in return on a given equity stake is exactly *because* one or more persons are mixing labor with capital – and in our system, labor and capital are taxed at different rates*.

    *and when stated like that, it prompts one to say ‘hey, shouldn’t labor be taxed *less* than capital?’ Maybe. Except if we did that, all of sudden the very rich would claim their income *was* from labor, not from capital.

    Report

    • *and when stated like that, it prompts one to say ‘hey, shouldn’t labor be taxed *less* than capital?’ Maybe. Except if we did that, all of sudden the very rich would claim their income *was* from labor, not from capital.

      I’d like to think that we both know that if we ever found ourselves in a position where this argument could be made that it would fly like a lead balloon.

      However, I’m a firm believer in low capital gains rates if only because higher capital gains rates make the tax consulting industry a boat load of money by developing tax-deferral structures that keep Uncle Sam from getting its due.

      Here’s one: http://www.investopedia.com/terms/u/upreit.asp

      UPREITs were a structure used by people that wanted to capitalize on the value of increased real estate but didn’t want to pay capital gains. Since capital gains rates were lowered, they’ve fallen out of favor.

      Report

    • Let me second that “thanks for the explanation.” There’s a lot of hazy understanding about the carried interest loophole floating around, so a concrete explanation is helpful.

      Report

  10. I’m glad I’m not alone in wondering how the hell 80% of the ‘finance’ sector is actually useful to the economy.

    But unlike the 48% camp, I do understand how *parts* of it are fairly useful.

    Let’s see if I can point to the bad parts:

    1) HFT clearly serves no purpose, but I’ll go farther than that and asset that day trading serves no purpose, either. Seriously, was our problem really that corporate ownership was happening *too slowly*? Trades should execute once an hour, on the hour. (And the first person to complain about ‘liquidity’ gets a slap to the back of the head. Why exactly do stocks need to be more liquid than *any other investment on the planet*?) Or, if the markets don’t want to slow things down…forget a tiny transaction fee. How about a 1% tax on the total value? People need to invest in damn companies and wait for a cut of the profits, not invest to try to flip the stock to someone else in two hours.

    2) Mortgage derivatives. Sorry, if you can’t handle an *entire mortgage* by yourself, you’re not a very good bank. And letting people slice up mortgages has been demonstrated to be a horrible idea, because a) *dealing with* those mortgages becomes a nightmare from the end of the person paying it off, b) trying to figure out how to forclose on it, and c) *everyone who bundles those mortgages lies*. Hell, on top of ‘no slicing them up’, I’d also like to require banks to not resell the mortgage for X years…and if it’s ‘bubble mortgage’ that jumps up in interest rate after a certain amount of time, *that’s* when the clock starts ticking.

    3) And that goes for all sorts of random derivatives that keep getting invented because, uh, who knows. Apparently we have to have them exist for everything. Many of the reasons for certain derivatives are a bit dubious to start with. So here’s my idea: We should have ‘exchange-based derivatives’, actual useful derivatives that are well-understood and safe-ish and traded in a market, and we have ‘OTC derivatives’ that are weird newly-invented things (Which can eventually be moved to exchanges if they make sense)…and we have *very strict* rules about who is allowed to invest in the later type, and how much. And the big banks *aren’t* allowed to have them, period. (Although see below…the big banks shouldn’t be investing, period.)

    And then there are things that are useful, but *not when you put them together in one thing*:

    4) Savings banks and investment banks are not the same thing, and should not be *allowed* to be the same thing. It’s worth pointing out that with the internet, there’s almost no justification *for* them being the same entity. You need a local bank for savings and checking, that can dispense cash and operate ATMs and cash checks. Investment banks…don’t really have anything they need to do locally. People don’t wander down to their local investment bank to buy stock.

    5) Likewise, another bad combination: Businesses that *make* investments, or deal with the process of issuing stock for a company and whatnot…combined with businesses that *recommend* investments. I’m not exactly sure how to divide that out, but it’s become clear recently that such entities have *huge* conflicts of interest, often recommending investors invest in positions that damage the investor but help the *other side* of the business. Maybe a better way to say this would be to say that entities that make recommendations, and entities that are themselves investors, need to be separate? (And,yes, I’m sure there’s supposed to be some sort of wall between the various parts. At this point, I hope we all realize the fictional walls are a bit silly.)

    Report

    • Re: HFT I think there’s no reason to think the practice has any redeeming social value whatsoever. However, I was disappointed when I learned that somebody had not, in fact, built a device to send Neutrinos through the earth’s crust in order to sell a few microseconds earlier in Chicago than the competition.

      Report

      • I was referring to a story from last year or something where trades were made in Chicago so soon after a Fed announcement came out that the signal couldn’t have gotten there via a fiber optic cable. It eventually turned out to be an elaborate network of microwave transmitters, but I first read speculation that they were shooting Neutrinos through the earth’s crust.

        Report

    • David,
      You’re in over your head here, pally boy. I ought to let Dave school you on why we need mortgage derivatives… in fact, why don’t I just do that.

      But I will say that without being able to sell mortgages on the open market, my credit union couldn’t afford to buy my mortgage. And I’d rather deal with them than PNC or BNY Mellon — you would too.

      As to 4) — tell that to ING. Plenty of banks don’t have a presence near me, and I bank with some of them anyhow. You scan a check and send in the scanned version.

      Report

      • I ought to let Dave school you on why we need mortgage derivatives… in fact, why don’t I just do that.

        Oh, me and Dave have already have some interesting talks about mortgage derivatives, and I’ve specifically asked. Last I checked, he didn’t come up with any particular good purpose they serve, beyond ‘A place for people to invest money’. Maybe he’s got one now.

        But I will say that without being able to sell mortgages on the open market, my credit union couldn’t afford to buy my mortgage.

        Your credit union ‘bought’ your mortgage? What? Do you mean they *issued* your mortgage?

        And I’m forced to wonder what that has to be with *derivatives*, or if you switched from taking issue with me disliking mortgage derivatives, to taking issue to me disliking selling mortgages to other banks.

        And I’d rather deal with them than PNC or BNY Mellon — you would too.

        If your banks sells your mortgage, either in whole or via packaging it into a derivative…you will *not* being dealing with your credit union any more. That’s how that works. (I guess, in theory, they could still service the loan…except that never happens that way.)

        As to 4) — tell that to ING. Plenty of banks don’t have a presence near me, and I bank with some of them anyhow. You scan a check and send in the scanned version.

        I have no idea what you’re taking issue with there. My point was that investment banks *don’t* need a local presence, at all. It doesn’t matter at all if retail banks do need it or not, the fact is that they often *do* have a local presence.

        The reason I made this point was that part of the justification of normal banks offering investment services was that, basically, almost no people have access to a local investment bank. So local retail banks should be allowed to provide that service. Which was a reasonable justification back in late 90s, but a rather stupid one now, when everyone who might want to buy stocks or whatever can just do it online.

        Report

    • (1) I don’t care for HFT.

      (2) Respectfully, you don’t understand mortgage markets. Not one bit.

      (3) Apparently, many corporations use derivatives to hedge certain kinds of risks, and since companies can’t go on exchanges to find ones that are suited to their needs, they seek out the banks to structure products for them.

      You’re going to tell me that banks shouldn’t use interest rate swaps to hedge their risk? Seriously?

      (4) You can try to enforce that in the United States but it won’t help against the major international banks like Deutche, HSBC and BNP Paribas, all of whom have both commercial and investment banking. I can’t say that the big banks give me the warm and fuzzies but the separation between investment banking and commercial banking had nothing to do with the causes of the financial crisis so why are we even bringing this up?

      (5) So investment banking firms can’t wall themselves off from the research/asset management/private wealth management side of the business? Oh, you say they’re silly so they must be so. Silly me.

      This problem was addressed a long time ago after the mess during the dot-com boom

      Well, at least the Elizabeth Warren/lefty populist viewpoint is now well represented.

      Report

      • (2) Respectfully, you don’t understand mortgage markets. Not one bit.

        See, Kimmi?

        Dave can’t quite come up with a justification for why mortgages need to be bundled randomly into securities, instead of just being sold intact. He’s sure there’s a *really good* reason, but not exactly what that reason could be. Likewise, there has to be a good reason to make a bunch of derivatives from those securities. Surely there’s a good reason.

        Apparently, many corporations use derivatives to hedge certain kinds of risks, and since companies can’t go on exchanges to find ones that are suited to their needs, they seek out the banks to structure products for them.

        And I have no problem with banks *producing* any sorts of derivatives that are wanted.

        I said that certain banks shouldn’t be allow to *invest in* derivatives except specific sorts. (Or, at least, a disincentive should exist, so they don’t hold a lot of those types of derivatives.)

        You’re going to tell me that banks shouldn’t use interest rate swaps to hedge their risk? Seriously?

        I’m pretty certain I *didn’t* say that. Is your objection that interest rate swaps are not traded on the exchanges, and yet are safe? If that is indeed the case, I have no problem with those being allowed under ‘safe’.

        The point of what I am saying is to stop huge markets for random, newly-invented derivatives that *no one understands*, and are rated semi-randomly.

        The problem is, and I have no idea if you agree with this or not, but it is actually is a problem, is that banks constantly invent new forms of derivatives to get around regulations and whatnot, often times absurdly complex ones, and the market takes off, and then explodes, leaving a smoking crater of people who didn’t understand it.

        Apparently, we have to let banks keep inventing this stuff, for ‘innovation’, which is bullshit, but I’ll play along. So what we’re going to do is *put a stamp of approval* on derivatives that everyone actually understands and are regulated (I was thinking it would mostly be things on an exchange, but if you want to argue that interest rate swaps are okay, whatever.), and all the *crazy people* and small investment firms and hedge funds and whoever can screw around with the new stuff. But he giant banks and pension funds and whatnot (The stuff that we cannot allow to keep getting blown up) have to stick with the approved stuff.

        And, yes, I know that’s the point of the rating agencies. And they completely fucked it up, didn’t they? In fact, we could actually do this by prohibiting them from rating things they don’t understand. (Seriously, they rated some mortgage securities that banks *failed to put mortgages in*, which in a sane universe would have them *sued into microscopic pieces*. How the hell do they still exist?)

        You can try to enforce that in the United States but it won’t help against the major international banks like Deutche, HSBC and BNP Paribas, all of whom have both commercial and investment banking. I can’t say that the big banks give me the warm and fuzzies but the separation between investment banking and commercial banking had nothing to do with the causes of the financial crisis so why are we even bringing this up?

        Uh…what? Who was talking about the financial crisis?

        And, actually, I have to disagree a bit there. Looking at it one way, the lack of separation didn’t directly cause the financial crisis.

        Looking at it another way, one has to wonder if mortgage derivatives would have been anywhere near as popular if the ‘investment banks’ weren’t *holding mortgages* they wanted to offload. And one has to wonder if ‘commercial banks’ would have started making as many bad loans as they did if the other side of them wasn’t willing to slap them into securities and sell them.

        Now, this could have happened *anyway*, and by the time of the actual financial crisis, a lot of bogus mortgages were being issued by non-banks anyway. So putting the ‘blame’ on the lack of separation is wrong…but at some point, this whole thing sorta started because ‘investment banks’ had a bunch of spare mortgages laying around and people who wanted to invest in things.

        So investment banking firms can’t wall themselves off from the research/asset management/private wealth management side of the business?

        No, they certainly *could* wall themselves off.

        They just *won’t*.

        We can either have firms with incentives to cheat, and try to regulate that via regulation of an industry that craps all over regulations whenever it feels like it…

        Or we can simply say ‘Nope. You can’t exist. The rule is either you’re *in* the market yourself, investing your own and other people’s money…*or* you’re telling people how to invest in the market, but have no stake in it. Can’t do both.’

        Report

  11. For the ordinary non-economist, non-finance oriented person, the political aspect of this seems mysterious.

    On the one hand, we know from experience that banking is different than any other industry, in that it is so central to everything else; if there was a massive widespread collapse of the nail salon industry, I doubt anyone would care very much.

    Yet we do hear quite a bit that whenever there is a proposal to impose public controls on it, such as Dodd-Frank or the Consumer Finance Protection Agency, there are cries that we must leave the banking sector alone, that touching or tampering with it will invite chaos and calamity.

    It all starts to sound like some primitive icon cult, that The Idol must Not Be Touched, lest the sun be blotted out and the crops wither and die.

    Yet the idol IS touched, often and roughly, by those who manage and work with it- all the specialized instruments and practices and agreements and rules are human inventions, creations that affect many, yet are controlled by few.

    I think I would re-phrase the central post to “Does the current structure of the finance and banking sector benefit us all and if not, how can we move towards that?”

    Report

    • “Does the current structure of the finance and banking sector benefit us all

      Has any structure of the finance and banking sector ever benefited us all? No. The poor has always been underbanked.

      and if not, how can we move towards that?”

      The Post Office. Why? Because Elizabeth Warren said it was a good idea. ;)

      You can’t move towards it, because the people you need to make that happen aren’t going to cooperate if there’s no money in it for them. Such is the way of the world.

      Report

  12. Down here:

    That actually sounds a whole lot like a bonus that’s based on the performance of the company in recognition of work done by an employee of the company.

    It may sound that way, but it’s not. I’m going to try to not get too technical, but if I do, I apologize in advance. Please allow me to try to build upon my last post.

    Regarding the performance of the company, the legal ownership entity of a fund or a real estate property is not an operating company, but rather a special purpose entity set up solely for the purpose of the ownership of that vehicle. The entity itself has no employees. The investors don’t own the property/fund directly but rather own interests in the SPE.

    The ownership entity does not perform anything. That task is left to third party (legally speaking) fund managers or developers. Even if developers have ownership interests in properties that their development companies operate, they don’t own interests in properties through their development companies but rather separate investment vehicles (for good reason). The “third party” managers are compensated through management fees, development fees, leasing fees, etc. This is where the labor is covered, through the fees for services rendered, and the taxation of these monies at the ordinary income rate is appropriate.

    It’s couched in “capital” terms and tied vaguely to the junior partner’s actual investment, but there’s no actual ownership or capital at risk for that portion of it. It looks to me like it’s either a contingency bonus that magically looks like capital investment for tax reasons, or it’s stock compensation that magically doesn’t include any stock to tax. Weirdly, even though the junior partner is being given something of substantial value (the option to participate in massive capital gains under some circumstances) in exchange for work, the Uncle Sam doesn’t see it that way.

    Carried interest is couched in capital terms because it is a capital event that triggers it. In the event of a capital transaction, say XYZ Company buys a stock at $100 and sells at $150, I think you’d agree that this triggers a capital gain on the $50. The same logic applies to real estate. If XYZ Company invests $100 in a property and sells it for $150, there is a $50 gain subject to the capital gains rate.

    My understanding of tax law is that with respect to special purpose entities, all income, expenses, capital distributions, tax liabilities, etc. are passed through to the investors in that entity. In the event that there’s operating income, there is no entity level taxation. Rather, the entire amount is taxed at the partner level (operating income at normal income tax rates).

    The same applies here. If we’ve established that an owner that sells an investment earns a capital gain and is thereby subject to the capital gains tax. If that owner is a special purpose entity, the responsibility to pay capital gains taxes gets passed through to the investors.

    I’m going through this step by step process to try to show where the “it’s income” argument breaks down. How does a $50 capital gain at the ownership level magically become ordinary income when it’s passed through to the entities? There’s nothing in tax law that prohibits one of the investors in an entity to receive a disproportionate share of the cash flows.

    It seems to me that people that want to view carried interest as ordinary income are doing so from a risk stand point, and if a manager has no capital at risk for the carried interest component, then it’s equated to performance-based compensation not unlike equity compensation via restricted units, options, etc. based on some work metric.

    To reiterate why I disagree with this:

    1) to the extent any work is done by the general partner, it’s done through a separate operating entity that is paid on a “fee for services rendered” basis. These fees cover the labor aspect of the transaction and are taxed appropriately.

    2) Carried interest is not the same as equity-based compensation. Equity-based is awarded based on periodic profitably as opposed to a capital event where a return of capital takes place.

    3) If it’s a capital gain to an ownership entity, by what mechanism does it become ordinary income, especially if the IRS does not seem to care how those liabilities are distributed among investors?

    It’s a neat trick,

    Actually, it’s pretty straight forward.

    I’m having a very hard time seeing how hedge funds or real estate partnerships are some sort of real special case and not just a cute loophole. People form and join partnerships and participate in their growth and resale of those partnerships all the time in all sorts of industries.

    I didn’t say they were special cases. They just happen to be some of the more prevalent users of the carried interest structure. Rest assured, in any joint venture agreement in any industry, capital sources are more than happy to provide carried interest provisions to operators in the event certain return thresholds are met. I should have been more clear. They are common place in joint venture agreements in any industry and do a wonderful job keeping interests aligned.

    I’m definitely not on the, “Kill the investment banking industry!” side, but this type of loophole seems like a crass carve out and a pretty easy kill.

    I would disagree and say that not only is it perfectly consistent with how capital gains are calculated but also that it’s not such an easy kill given that it’s still standing. Pardon my being blunt – the only reason we’re talking about it today is because it offends the sensibilities of people. Personally, I have no love or hate for private equity or hedge funds so this doesn’t get my dander up one bit.

    I’m generally very skeptical of the claim that absent significant government money, we won’t get enough real estate development. Real estate has been one of the big investments since the concept of investment was invented (and probably before), and it’s one of the things that just about everybody else needs in order to live and do business. It’s a little bit like energy. No matter what we say or do, we’re going to be buying the amount we need, and the market will likely supply it. There’s really no getting around it.

    I’ve been in the real estate business for almost 20 years and my father has been for almost 40 years so it’s kind of a family thing. I don’t share your abstract views and while your generalizations don’t bother me by any means, they overlook the short-to-medium term consequences of market disruptions. As I mentioned, the changes to the tax code per the Tax Reform Act crushed the real estate markets and sent the S&L’s into a tailspin given their exposure to real estate development. It put a lot of developers out of business and on the ropes, and even if there were development deals to be had, they were in no position to take on new deals, as many of them fell into financial difficulty.

    I don’t think you’d see a repeat of the late 80’s early 90’s, but there would be a negative impact on values if investors had to underwrite higher taxes as a cost of the deal. It would impact future development opportunities, current deals that investors are trying to sell or refinance. Lenders may find themselves in a position where the decreases in value put the loan-to-value on deals at uncomfortably high levels. They may choose to not refinance properties or demand that owners put up more equity collateral in order to restore the proper loan-to-value balance.

    These kinds of things happen every time real estate hits a down cycle. These very things were happening in 2008, and since I think any negative changes to tax policy will hit real estate values. It’s happened in the past and it will happen in the future. The only question is the order of magnitude.

    Report

    • It may sound that way, but it’s not. I’m going to try to not get too technical, but if I do, I apologize in advance.

      I appreciate the well thought out response, but I want to start by saying that I’m not arguing with the legal case that carried interest works the way it does. It clearly does. I’m arguing that it’s a legal fiction that maps pretty closely to any number of other arrangements that seem to differ only in tax treatment. It’s a logical problem, not a legal one. To go to your response to @mike-schilling’s hypothetical $1 investment carried interest deal:

      It would still be a capital gain and a completely ridiculous carried interest structure to boot. If you ever find someone to give you that kind of deal, go for it.

      This leads me to think that this really is just a construct that just happens to be legal, not something that’s done for an important economic reason. The argument that capital gains tax rates are lower to encourage people to put their own capital at risk sort of falls apart if you let this sort of thing happen. The above case is literally somebody investing next to nothing, working for a living on somebody else’s investment, and then getting the profits at capital gains rates because somebody, somewhere owned capital and conveniently got to pass the tax savings on to a third party.

      It seems to me that people that want to view carried interest as ordinary income are doing so from a risk stand point, and if a manager has no capital at risk for the carried interest component, then it’s equated to performance-based compensation not unlike equity compensation via restricted units, options, etc. based on some work metric.

      This is an accurate statement of the position. I has nothing to do with how the law is written and everything to do with how capital gains rates are justified to the masses. “I get a lower rate because I have capital at risk and that’s good for the economy,” loses its punch when other people get to say, “I also get a lower rate because he has capital at risk ad it’s good for the economy.” It all starts to sound like, “People with substantial assets and political sway get a lower rate.”

      to the extent any work is done by the general partner, it’s done through a separate operating entity that is paid on a “fee for services rendered” basis. These fees cover the labor aspect of the transaction and are taxed appropriately.

      To use your example, if you as the junior partner were paid for your expertise and services rendered as, what is the purpose of you receiving more than 10% of the capital gains at the end of the project? Smart business people pay other people in exchange for something and in this case, it clearly wasn’t for your initial investment. So if it also wasn’t for your work, what was it? What foolish partner would pay you the full value of your work and then on top of that give you an outsized share of the profits for nothing?

      This is the part that sounds suspiciously like taking what should have been payment for the value of your labor to make the development deal happen and shifting a large chunk of it over into the capital gains territory as a tax dodge.

      I don’t share your abstract views and while your generalizations don’t bother me by any means, they overlook the short-to-medium term consequences of market disruptions.

      But that could be said of any number of pieces of bad tax policy that industries become dependent upon. To take a related example, the mortgage interest tax deduction is a silly policy that doesn’t do what it’s supposed to do and amounts to a ridiculous amount of money, but cutting it off abruptly would cause economic chaos. But that doesn’t make it a good policy. Just one that should be phased out slowly instead of eliminated all at once.

      Report

      • Great comments. To respond:

        It’s a logical problem, not a legal one.

        There are at least five problems interwoven into this debate: a problem with definitions (the conflation of labor value and market-based asset pricing and what is and what is not capital for example), tax policy, economic policy the political problem with inequality as well as logical. I tend to rank that one as the lowest

        To go to your response to @mike-schilling’s hypothetical $1 investment carried interest deal…This leads me to think that this really is just a construct that just happens to be legal, not something that’s done for an important economic reason. The argument that capital gains tax rates are lower to encourage people to put their own capital at risk sort of falls apart if you let this sort of thing happen.

        I would caution against using hypothetical examples because the scenario Mike came up with is a very unlikely one to happen in the real world. I wouldn’t even call it an exception to the rule. I know for a fact that in the deals I’ve done, major institutions, who are also players in the hedge fund and private equity space (big ones) won’t invest capital unless the partner is co-investing with them. Otherwise, the $1 partner can take all the risks in the world to shoot for that carried interest and not give a crap what happens if everything falls apart.

        The above case is literally somebody investing next to nothing, working for a living on somebody else’s investment, and then getting the profits at capital gains rates because somebody, somewhere owned capital and conveniently got to pass the tax savings on to a third party.

        Basically a third party money manager or an advisor. That income is and should be taxed at ordinary rates; however, this is not the dynamic in partnerships.

        It all starts to sound like, “People with substantial assets and political sway get a lower rate.”

        This is what’s happening but not for the reasons you suggest. The people making boatloads of money on carried interest and are taxed at capital gains rates have skin in the game.

        To use your example, if you as the junior partner were paid for your expertise and services rendered as, what is the purpose of you receiving more than 10% of the capital gains at the end of the project? Smart business people pay other people in exchange for something and in this case, it clearly wasn’t for your initial investment. So if it also wasn’t for your work, what was it? What foolish partner would pay you the full value of your work and then on top of that give you an outsized share of the profits for nothing?

        This is an awesome set of questions. I’ll answer them.

        If I bring an institutional capital source a deal, they are going to underwrite it themselves. Chances are they are going to use underwriting that’s far more conservative than mine in order to come up with their own valuation and assumptions.

        If they choose to move forward with the deal, rest assured that the proposal they put on the table is going to represent with they think the full value of the deal is as underwritten and that under no circumstances will the developer be entitled to a carried interest payment unless those parameters are met. Financial partners are smart, protect their capital and tend to be conservative. They’re not giving anything away. Carried interest is the gravy they don’t underwrite into the deal.

        To the extent they accept the carried interest, there are a few reasons. First, by the time this happens, the deal is a home run from the underwriting perspective of investors. They will have made more money than anticipated. Second, it further aligns the interests of the developer and money partner. Developers love promotes and partners love developers that chase them. Everybody wins. Third, it is a way of rewarding the developer on the basis that the money partner would not have gotten access to the deal had the developer not brought it to them.

        I think is where the red flags come up with respect to the logical arguments and people cry “performance-based fee”. Yes, sort of. In essence, it’s a finders fee paid on a contingency basis. However, the legal issues with respect to capital apply, and furthermore, under no circumstances was the increased value of a deal when it’s sold (vs. the underwriting) a function of someone’s labor. Capital markets conditions created that additional value, not the developer’s labor. If I buy a stock at 100 and sell it for 150, how did my labor create the $50 difference? We’re back to the same problem.

        This is the part that sounds suspiciously like taking what should have been payment for the value of your labor to make the development deal happen and shifting a large chunk of it over into the capital gains territory as a tax dodge.

        I have a sinking feeling that it’s going to look like a tax dodge to some people no matter how many ways I try to approach this issue. I would concede that there is some value to the labor that goes into the value of the property, but the way these deals are structured, the promoted interests kick in beyond that.

        Hedge funds may be a different animal in that respect though.

        Report

      • Thanks!

        The people making boatloads of money on carried interest and are taxed at capital gains rates have skin in the game.

        To the extent that they have skin in the game, I’m all for them getting the capital gains rate. But that’s clearly not true for 100% of the money. That extra amount is what I’m talking about.

        To the extent they accept the carried interest, there are a few reasons.

        Two of the three seem like good reasons to pay you, but do any of those reasons amount to a capital investment on your part? The first is simply that the investors have more money than they anticipated, but they still need a reason to give it to you and not just keep it. And those reasons seem relate to something you did.

        The second reason, alignment of interests, makes good sense (assuming we ignore the later claim that value of those capital gains is unrelated to your efforts as a partner, which makes your subsequent behavior and interests moot), but this still looks like a special way of doing that from a tax perspective. Other ways of aligning interests it like cash bonuses contingent on market performance, stock options, and actual shares of the company don’t get capital gains treatment.

        The third reason makes a lot of sense as well. It’s something like a finder’s fee. Which is typically taxed as income. I’d be happy to say that when you put together the deal, you get some paper that gives you access to excess capital gains and pay ordinary income taxes on the fair market value of that paper and then it’s capital gains from there on out. That paper still look like an option to me, but I’ll ignore that. In any case, the immaculate transfer of that asset still seems like a very special case. You’re being given something of value for $0 and paying capital gains tax on that value.

        I guess I have a couple of questions:

        1) If all of the tax treatment was the same, would there be a reason to structure the deal this way as opposed to using one of the other methods I mentioned?

        2) Is there a reason that this partnership structure is beneficial to anybody but the partners? That is, do we as a society have a reason to encourage its use that would justify a tax incentive for this structure over the others I mentioned?

        Capital markets conditions created that additional value, not the developer’s labor. If I buy a stock at 100 and sell it for 150, how did my labor create the $50 difference? We’re back to the same problem.

        Hold on. If you buy a stock at $100 and sell it for $150, that’s certainly a plain vanilla capital gain. But that’s not the case we’re talking about. We’re talking about you buying $50 worth of that $100 stock and then getting capital gains treatment for the investment as if you had bought the full $100. That extra $25 came out of your partner’s pocket, and he agreed to let it happen for a reason.

        So it’s not from your initial investment, and it’s not for the value of your labor, and it’s not because you’re a nice guy. But it’s a transfer from them to you for something of value. And that thing of value (labor, dealmaking, middleman-ism, reduction of transaction costs, having a big name to add to the partnership, whatever), are all jobs that other people do at ordinary income rates.

        I have a sinking feeling that it’s going to look like a tax dodge to some people no matter how many ways I try to approach this issue.

        That could be because our minds are made up, or it could be because it really is a tax dodge. I’m not 100% convinced of either for the moment, but the more I hear the rationale broken down, the more it looks like there is a substantial tax dodge component to the transaction.

        Report

  13. Better late than never:

    I’ll start with your questions.

    1) If all of the tax treatment was the same, would there be a reason to structure the deal this way as opposed to using one of the other methods I mentioned?

    The other methods you mentioned are largely unworkable in the context of a joint venture. If the owner is a single purpose entity, then stock compensation is out of the question since the owner has no stock to issue (nor is it practical for the partner to issue more capital in the form of stock compensation). Cash bonuses based on market performance encounter three significant difficulties. First, where does the cash come from? In a typical real estate development joint venture, once the assets are stabilized and producing cash flow, that’s the time that a capital transaction usually (not always) takes place. Prior to that, there are no profits. Second, to the extent there are profits who pays the bonus? A partner seeking an annual rate of return is going to want as much of the cash flow as it can to meet its current yield requirements. Any payment of bonuses out of cash flows cuts into that yield. Investors won’t do it for that reason. Third, what market performance benchmark do you use for illiquid assets like real estate properties?

    The reason why the methods you mention aren’t treated as capital gains is because the cash or stock compensation in those scenarios are generated through operating profitability. You don’t get a stock award at your company when it liquidates. You get it when the company has a good year. Carried interest is typically triggered as a result of a capital transaction and the cash proceeds paid as part of a return of capital.

    2) Is there a reason that this partnership structure is beneficial to anybody but the partners? That is, do we as a society have a reason to encourage its use that would justify a tax incentive for this structure over the others I mentioned?

    I’ll take this into a different direction to show you why I think it’s almost impossible for me to answer this question the way you phrased it. I’ll ask it this way –

    Do we as a society have a reason to discourage its use? According to some, yes, and that reason is that it’s ridiculously unfair for people to pay a lower tax rate on payouts that appear to be very similar to bonus compensation. When those payouts go into the hundreds of millions or more and can take place with a frequency that makes them appear to be more like annual bonuses (irregardless of whether it’s based on labor or capital), what answer can I possibly provide?

    If fairness is the primary motivation (and it’s the only motivation I see that makes any sense), then why split hairs this way:

    So it’s not from your initial investment, and it’s not for the value of your labor, and it’s not because you’re a nice guy. But it’s a transfer from them to you for something of value. And that thing of value (labor, dealmaking, middleman-ism, reduction of transaction costs, having a big name to add to the partnership, whatever), are all jobs that other people do at ordinary income rates.

    You assume that it is a transfer of something of value, a correct assumption. However, you immediately fall back into trying to treat the creation of value as something having to do with someone’s labor. Why is this not a simple profit sharing arrangement between two entities based on a capital transaction? The jobs you mention above (except adding a big name to a partnership, i don’t know what kind of job that is) are jobs that are done at the ordinary income rates and done as part of these transactions (the developers will want to do as much of that as possible on a fee basis because even at higher tax rates, they come out making more money).

    It seems to me that you’re trying to ascertain the intention of providing the carried interest in the first place and that since it may have something to do with the partner itself, there’s a labor component. It’s an interesting claim but I can also tell you that capital sources offer carried interest in order to be able to gain access to deals and they don’t want to lose the business. Therefore, the motivations for offering carried interests may have nothing at all to do with the reasons you mentioned.

    Again, at the end of the day, if it’s about fairness, why go through the hair splitting? Argue against the carried interest on fairness grounds and either propose either carving out hedge funds and private equity (or no carve out at all) or making a case for increasing the capital gains rate.

    Report

  14. But how was responsibility for the construction loan shared? If I got a mortgage for 0% down and then flipped the house for a profit, that would be a capital gain, even though the financing was all debt-based, and that seems reasonable to me.

    The responsibility wasn’t shared. While the developer was responsible for cost and completion guarantees, the construction loan was guaranteed by the investor’s parent company, a major life insurance company (one of the very big ones). Neither put money down. The developer got 40% and the investor 60%.

    It was a great idea at the time until 2008 hit and the insurance company had to make good on quite a few of those obligations. I should also note that the bank that was originating the construction loans ended up getting bought out by PNC because the bank’s construction lending business ended up threatening the solvency of the financial institution.

    Report

    • The responsibility wasn’t shared. While the developer was responsible for cost and completion guarantees, the construction loan was guaranteed by the investor’s parent company, a major life insurance company (one of the very big ones). Neither put money down. The developer got 40% and the investor 60%.

      In that case, the developer paying capital gains on his profit from operations is purely a tax dodge, just as if I paid capital gains on a profit-sharing bonus.

      Report

      • In that case, the developer paying capital gains on his profit from operations is purely a tax dodge, just as if I paid capital gains on a profit-sharing bonus.

        To the extent that cash flows were generated prior to the sale and distributed 60/40 to the partners, those were taxed at the ordinary income. However, the profit on the sale of the asset was treated as a capital gain. I fail to see any dodging going on.

        Report

  15. Can I pick both camps?

    Yes, finance benefits.

    And yes, finance can cause massive problems, too, and be highly destructive.

    I do not see any reason to posit logic that says these two things are mutually exclusive.

    Report

  16. Dave can’t quite come up with a justification for why mortgages need to be bundled randomly into securities, instead of just being sold intact. He’s sure there’s a *really good* reason, but not exactly what that reason could be. Likewise, there has to be a good reason to make a bunch of derivatives from those securities. Surely there’s a good reason.

    Start with the remedial version:

    http://fanniemae.com/portal/funding-the-market/mbs/single-family/

    Did you really think that Fannie Mae can purchase unlimited quantities of mortgages without a need to recycle capital through securitization and sale? How do you think the GSE’s help to keep the residential mortgage markets liquid? Again, you don’t know the first fishing thing about the mortgage markets.

    After you realize why the government sponsored enterprises, the largest issuers of residential mortgage backed securities, choose to “randomly bundle securities” as opposed to sell them intact, then we can get to the more complicated topic of tranches. I’ll use small words so you can understand.

    And I have no problem with banks *producing* any sorts of derivatives that are wanted.

    I said that certain banks shouldn’t be allow to *invest in* derivatives except specific sorts. (Or, at least, a disincentive should exist, so they don’t hold a lot of those types of derivatives.)

    Again, your stunning ignorance of finance rears its ugly head. By your logic, you have no problem with investment banks PRODUCING mortgage derivatives so long as they don’t INVEST in mortgage derivatives but how the fish can the banks do this without INVESTING in the underlying mortgages themselves?

    A lot of structured products are created using the capital of the investment bank so your production vs. investment dynamic makes absolutely no sense in the real world. Shifting away from derivatives for a moment, you realize that the investment banks typically buy the stock from the issuer for an IPO, right? They then sell the stock into the market. You know. Alignment of interests, etc.

    The point of what I am saying is to stop huge markets for random, newly-invented derivatives that *no one understands*, and are rated semi-randomly.

    This has already happened and the conditions that could allow something like this to happen aren’t going to happen for quite some time.

    The problem is, and I have no idea if you agree with this or not, but it is actually is a problem, is that banks constantly invent new forms of derivatives to get around regulations and whatnot, often times absurdly complex ones, and the market takes off, and then explodes, leaving a smoking crater of people who didn’t understand it.

    No, the problem is systemic risk so to the extent that derivatives can contribute to that, I”m concerned. For what it’s worth, if you’ve read your history on the financial crisis, you’d realize that it wasn’t new forms of derivatives that caused most of the problems.

    Apparently, we have to let banks keep inventing this stuff, for ‘innovation’, which is bullshit, but I’ll play along.

    The finance industry thanks you.

    So what we’re going to do is *put a stamp of approval* on derivatives that everyone actually understands and are regulated (I was thinking it would mostly be things on an exchange, but if you want to argue that interest rate swaps are okay, whatever.), and all the *crazy people* and small investment firms and hedge funds and whoever can screw around with the new stuff.

    A hedge fund nearly caused a market meltdown in 1998 so I’d be careful with that. Also, most derivatives are over the counter.

    But he giant banks and pension funds and whatnot (The stuff that we cannot allow to keep getting blown up) have to stick with the approved stuff.

    Like AAA-rated mortgage-backed securities, which they still buy.

    And, yes, I know that’s the point of the rating agencies. And they completely fucked it up, didn’t they?

    In fact, we could actually do this by prohibiting them from rating things they don’t understand. (Seriously, they rated some mortgage securities that banks *failed to put mortgages in*, which in a sane universe would have them *sued into microscopic pieces*. How the hell do they still exist?)

    Believe it or not, they are quite competent in just about everything else. Still a big screw up though.

    management side of the business?

    No, they certainly *could* wall themselves off.

    They just *won’t*.

    They do.

    Or we can simply say ‘Nope. You can’t exist. The rule is either you’re *in* the market yourself, investing your own and other people’s money…*or* you’re telling people how to invest in the market, but have no stake in it. Can’t do both.’

    Not.
    Gonna.
    Happen.

    Keep on trucking. You amuse me as always.

    Report

    • Just to be clear here:

      Did you really think that Fannie Mae can purchase unlimited quantities of mortgages without a need to recycle capital through securitization and sale?

      This is not what busted the economy, no matter how many times it get’s repeated.

      The derivatives that broke the economy were not recycling capital, they were bets on the recycling of capital, and not directly related to the capital so being recycled any more than your bet on a horse at the track or a football team suggest you own an underlying portion of said horse or team. The portfolios in question weren’t the actual mortgages, they were hedges on how the actual mortgages would perform; those bets were insured, and the insurer-of-most, AIG, had the short side of too many of those bets called in at the same time and couldn’t cover the spread. The demand for ever more of said mortgages to bet upon led to a housing bubble and discarding underwriting standards.

      Report

      • This is not what busted the economy, no matter how many times it get’s repeated

        Feel free to be clear. Hell, I even agree with this and have since 2008 so I have no idea why you’re bringing this up this way. I’ve also been saying that derivatives were a part of the crisis but not the entire thing. AIG was but one part.

        Report

      • The demand for ever more of said mortgages to bet upon led to a housing bubble and discarding underwriting standards

        Right, reduced standards were purely market driven, no policy involvement in that at all.

        {JH bangs head on desk}

        Report

      • James,

        What policy change did you have in mind? The only vaguely relevant ones I can think of were the removal of the wall between investment and commercial banks, and I suppose — if you squint — when Fannie and Freddie went begging to Congress to be allowed to reduce their standards in order to keep competing with, well, the people issuing NINJA loans to anyone who could fake a pulse. That was so late in the game though that it was more useful as a method for part of the bailout than an actual cause of the meltdown. (Fannie and Freddie could and were used to ‘sop up’ some of the mess).

        Report

      • Morat,

        There were political pressures to reduce standards because they had a de facto discriminatory affect. The goal was to make it easier for poor people, particularly minorities, to get into home ownership.

        That’s not a bad goal, imo, and I want to emphasize that it wasn’t the poor who were really the problem in the mortgage crisis. It was the adjustable-rate mortgage holders, most of whom were middle class. But the general relaxing of standards also made it easier for the middle class to get those ARMs.

        So note that I’m not arguing gov’t policy was the whole cause. I’m only arguing that anyone who thinks this was purely a market driven problem, and that markets weren’t at least in part responding to changes in public policy,* does not really understand what went on.
        ________________
        *Seriously, now, we pass particular policies because we expect businesses to respond to them in a desired way. So we cannot, with any logical consistency, assume that a different change in policy did not cause businesses to respond in any way. And businesses having responded in a way we don’t like, we can’t, with any intellectual honesty, claim that the policy change wasn’t part of the problem.

        Report

      • typically, when I hear this, it’s the rules on lending in minority neighborhoods and the programs to support lower-income borrowers; but none of those rules suggested not doing proper underwriting; that came with pressure for mortgages via Countrywide-style lending. This fails to consider that at the time of the collapse, for every $1 lent in a home mortgage, there were $50 bet on synthetic derivatives. AIG (whose imminent failure was the single business event that made collapse a tangible reality) could have covered the banks losses on all those mortgages and not have had the capital shortage it incurred from insuring the bets on those mortgages. (It could probably have paid off not only the mortgages in default, but all the mortgages lent at the peak of the bubble.) But the derivatives were so much bigger than the lending they were based upon. . . boom goes the economy, and millions of jobs vanish and people begin losing their homes simply because they’re worth less than they paid for them and . . .

        Report

      • Zic,

        I think we can all agree that the financial markets were regulated poorly. Markets require rules and enforcement mechanisms — exogenous or endogenous — to work properly.

        Market mechanisms, market players, and the rules and regulations together form a complex system which is subject to dynamic change. To try to isolate the problem as being the rules, or the regulators or the players or whatever is a fools errand. The systems properties are determined by all parts of the system. The system broke. The system needs fixin’.

        Complex systems of this nature cannot be either controlled or fully understood, but they can be influenced.

        I think way too much ink is wasted on regulation or deregulation. I am a big fan of parsimonious regulation. Exactly enough to allow the system to work, no more, no less. Easier said than done in a dynamic world where we can never be sure if the rules and regs are optimally effective.

        Not trying to solve it here, and I am not qualified to do so on this topic in the slightest. But if we agree to the fundamentals, the direction toward solving the problem becomes clearer.

        Report

      • Mike–congrats on implying that I was saying something I explicitly disavowed. Your mother must be so proud.

        Zic–your pretense that the rules of the game have nothing to do with how the players play it may be gratifying to your own sense of how the world works, but nothing about that necessitates that your sense of how the world works has much correspondence to how the world actually works.

        Particularly, you focus solely on how much money was where, but ignore the fact that money was where it was precisely because of the rules of the games. If the government had not only not encouraged lowered lending standards, but had worked to keep standards high, there could not have been such a plethora of ARMs, or a housing bubble at all (and this is setting aside the Fed’s role in creating the bubble).

        Absent the large number of ARMs, mortgages would have been fewer and more stable, so there would have been less money in derivatives and those derivatives would not have gone south because the mortgages in them would have been collectively sounder.

        Your brilliant analysis begins at the ass end of the dog, sees the shit, and assumes the ass is the primary cause of the shit.

        Report

      • The federal government does not have the power to force a lender to give a loan without verifying the borrowers income. They simply cannot do that; it’s the lender’s choice. And the federal government did not decide to offer minorities ARMs, lenders did that.

        The Federal government did set up a program that encouraged more lending (and less red lining,) and when the demand for mortgages grew exponentially, yes; lenders used that as an excuse for any mortgage; the big bad government made us do it. It said we couldn’t discriminate against people living in certain neighborhoods, so we had to give everyone who asked from those neighborhoods a loan.

        Right.

        This reeks of the stuff Coates wrote about in his Reparations article; blame the minorities so that the bankers don’t need to take responsibility. Hope you’re proud of your deep and thoughful analysis.

        Report

      • Also, it was the illegality of keeping complete records that forced them into forgery.

        And don’t forget that some institutions are required to invest only in AAA instruments. Which, of course, forced the banks into packaging trash into securities and the rating agencies into rubber stamping them as AAA. C’mon — it’s just logic. You gotta look at the incentives government creates.

        Report

      • Right, reduced standards were purely market driven, no policy involvement in that at all.

        As applied to the market for subprime mortgages originated by nonbank lenders and bundled into private label mortgage backed securities, I would say this is almost 100% correct. The only reason that I don’t say that it’s 100% correct is that this may have never happened if fixed income investors were able to find traditional fixed income investments at appropriate yields. However, that vanished when Greenspan took interest rates to historical lows in 2003 and let them stay there for a year.

        Otherwise, I’m at a loss to find which government policies triggered demand in that market, especially since nonbank lenders operated with few if any regulatory constraints. The demand for the bonds was huge and the only way to keep churning them out was to find more product and the only way to do that was to source more loans. It wouldn’t be long before the banks were structuring and selling synthetic collateralized debt obligations with values based on other securities. It was leverage built on more leverage, a housing bubble built on a credit bubble.

        It was the adjustable-rate mortgage holders, most of whom were middle class. But the general relaxing of standards also made it easier for the middle class to get those ARMs.

        Yes, but I’d argue that what happened in the subprime wasn’t a relaxation of standards. The Community Reinvestment Act encourages banks to relax lending standards when making certain kinds of loans in lower income communities, but it doesn’t force banks to abandon their standards to make loans they believe are too risky.

        Lending standards in the subprime space were completely abandoned. The very definition of a NINJA loan, in addition to screaming fraud, doesn’t require three pieces of information that any sane lender would use to evaluate the creditworthiness of a borrower.

        The Fannie and Freddie situation was messy. These were two entities that were created to serve specific functions within the mortgage markets that morphed into giants that were horrifically set up as public-private entities. On one hand, because the market viewed the GSEs as government entities, there was an expectation that the government was effectively guaranteeing them so they enjoyed a lower cost of borrowing than their competitors. They were also ridiculously leveraged – something to the effect of 60 to 1 or higher (by comparison, Bear Stearns was 40 to 1).

        In my opinion, it wasn’t Fannie’s public purpose that got them into trouble, but rather its pursuit of profits:

        when Fannie and Freddie went begging to Congress to be allowed to reduce their standards in order to keep competing with, well, the people issuing NINJA loans to anyone who could fake a pulse.

        This gets us into the ballpark. What I remember happening was that Fannie and Freddie were losing market share to the private label securities market and that Countrywide was threatening to not sell Fannie anything, even traditional loans. The decision to substantially increase subprime holdings was made to boost profitability and market share. They were the biggest or one of the biggest buyers of subprime paper in 2005-2007 (although it wasn’t a large percentage of the total market). Lending standards were already in the toilet by that time.

        Report

      • Folks, there really is no reason to argue about the root causes of the housing bubble and subsequent collapse. There is enough blame to go around.

        Blame the homeowners who bought too much house on not enough income, because they assumed that they could always refinance once the value appreciated. Blame the mortgage brokers who originated the loans on fraudulent or non-existent paperwork, because they knew that they were just going to take their origination fees and pass the loans on to a bank. Blame the commercial bank who took the loans without doing due diligence, because all they are doing is making some points on servicing, while selling the underlying loan to an investment bank. Blame the investment banks who packaged those loans into structured products without really bothering to to do due diligence on the underlying assets, because those guys were booking their profits and locking in their bonuses at the front end before selling the products onto the next guy. Blame the ratings agencies who decided that by bundling a bunch of loans, you could turn crap loans into AAA-rated securities. Blame the asset managers who decided to buy those crap securities. Blame government regulators for making asset managers hold those crap securities without bothering to think too much about just what a AAA credit rating means. And blame the rest of the government for incentivizing some of the worst behavior at all levels up and down food chain.

        There really is more than enough blame to go around. Catastrophes like this rarely have one cause. It was a perfect storm of ill-advised behavior.

        Report

      • So just to get this straight…

        The CRA, a 40+ year old act designed to prevent red-lining, somehow morphed into a giant destructive beast 40 years after passing, because of ‘political pressures’ under George Bush?

        WHAT political pressures? Who, what, where and why? Did Bush declare war on redlining? Was the CRA amended? Did the CRA demand validating NINJA loans? How did this work, exactly?

        If it happened, you can surely give details. The only thing I can think of was Greenspan pimping ARM’s, which had nothing to do with redlining, the CRA, and didn’t even really qualify as ‘political pressure’ coming from the head of the Fed, whose power over the home mortgage market is exactly zero.

        I mean, I can talk at length about NINJA loans, the market pressures behind them and how it all went off the rails (basically faux triple-A rated bundles driving the selling of mortgages to feed the beast, which itself was being driven by demand for amazingly profitable triple-A bundles!), and even when and how Fannie and Freddie got into the mix — surely you can document some of these ‘political pressures’ or explain how a 40+ year old act suddenly went critical out of the blue.

        Report

      • I feel I should quote the settlement agreement signed by Bank of America/Merrill Lynch:

        Through the due diligence process in 2005 and 2006, Merrill Lynch also learned that certain originators were loosening their underwriting guidelines, resulting in Merrill Lynch’s identifying, for example, an increasing number of loans with unreasonable stated incomes. Merrill Lynch’s due diligence manager brought this to the attention of Merrill Lynch’s head of whole loan trading in a memorandum written in November 2005. Merrill Lynch, however, continued to acquire and securitize loans from some of these originators without substantially altering its disclosures to investors. A year later, in December 2006, Merrill Lynch’s due diligence manager again brought the loosening of originator guidelines to the attention of the head of whole loan trading in another memorandum. Merrill Lynch still continued to acquire and securitize loans from some of those originators without substantially altering its disclosures to investors.

        I’m sure there was some sort of ‘government policy’ that made Merrill Lynch acquire and securitize those shitty loans without warning investors, in violation of actual law. Some sort of ‘The big banks must help out smaller banks and other mortgage originators that issued very bad mortgages by buying those bad mortgages, packaging them up, and selling them to unsuspecting investors.’ government policy.

        This is opposed to, well, the theory that the entire industry was high on hookers and blow as money rained from the sky, buying shit loans because they knew they could put them in securities, get rating’s people to rate them as just fine, and then they could lie and sell the securities and derivatives for giant boatloads of money…and they constantly needed more mortgages, so, all you mortgage brokers, sell sell SELL! No, we don’t care about if they can pay them back, we’ll buy them anyone. Keep selling, dammit, we need more LOANS!

        That is what actually happened. (Except not quite said aloud, usually, although some of the internal emails are startlingly blunt.) It didn’t have anything to do with ‘government policy’. And as has been pointed out repeatedly, the problem was not really the shitty loans. The problem was putting them in securities, rating them higher than they should be, and building *entire goddamn castles in the sky*, via derivatives and insurance, on each individual security…securities that were, at heart, complete shit.

        Not because of any government policy, but because that made them a lot of money, and was legal. (Ironically, said market existed because it was mimicking Fannie and Freddie, which were government inventions…but those two had rather strict rules on the mortgages they accepted, and they really only got in trouble *after* the housing market crashed…and it’s worth mentioning the government is suing some of the banks for lying to those two about loans conforming to the guidelines.)

        Hey, ? Care to comment on this? I know you somewhat disagree with what I say we should *do* to stop it happening again, but I rather suspect you agree with both mine and zic’s description of what actually happened.

        Report

      • Hey, Dave? Care to comment on this? I know you somewhat disagree with what I say we should *do* to stop it happening again, but I rather suspect you agree with both mine and zic’s description of what actually happened.

        And I see you have commented and said, at least, you disagree with the idea it was a government policy, so nevermind.

        I hate this forum software.

        Report

      • Morat–You mean like all the concrete evidence you provided? I’m pretty sure I’ve already done that much.

        @zic–

        This reeks of the stuff Coates wrote about in his Reparations article; blame the minorities so that the bankers don’t need to take responsibility.

        Once again you accuse me of something that I did not say, both in the blaming minorities part and the bankers not taking responsibility part. Your continuing commitment to dishonesty is noted.

        Report

      • JR, James and I all said basically the same thing in three different ways and all the response are diversionary. LOOK SQUIRREL!

        If the players were acting bad, then the system including the rules were fucked up. Players shouldn’t be allowed to or encouraged to fuck up in ways which bring the entire economy down. If the blame is the players, then this leads to the rules which allow/encourage this play to occur.

        The system was broken. Not only is there plenty of blame to go around, but every action was connected in endless feedback loops to every other rule and player.

        If a player cheats at football, you have a problem with the player. If players regularly play and cheat in such a way that all the fans are killed in the process, you have a problem with the entire game. New rules and ideas are necessary.

        Report

      • I’ve argued before that the Fed’s efforts to boost the economy through low interest rates fed the housing bubble. I don’t think that’s controversial. I’ve also argued that the Clinton era reduction of capital gains taxes on homes held for at least two years helped make housing more attractive as a short-term investment. Finally, the Federal Reserve did pressure lenders to use relaxed standards.They critiqued “arbitrary and outdated criteria that may disqualify many urban or lower income minority applicants,” and emphasized that “Failure to comply with
        the Equal Credit Opportunity Act or Regulation B* can subject your financial institution to civil liability for actual and punitive damages in individual or class actions.”

        Now that can be read as “of course institutions have to comply with the law” and “those outdated and arbitrary criteria” weren’t the lending standards we’re talking about. But the focus, keep in mind, was on outcomes, not specific practices. And important barriers to outcomes for lending were down payments, interest rates, etc. To comply with outcomes, lenders had to reduce standards.

        This is not, contra the claims of a dishonest or functionally illiterate commenter, blaming minorities. In fact some subprime lenders were not even subject to that law. My contention is that the Fed’s defacto threat played a part–only a part–in creating a changed lending culture that placed small emphasis on borrow ability to pay.

        And that changed culture was only a part of the story, too. Actually, only part of a part of the story. This part of the story is the part that has to do with government policy, and the Fed’s pressure was only part of that–their easy money policy and the reduction in the capital gains tax were also part of it. And that was only part of the story, because the investment banks were remiss in being so gung ho about portfolios that were so opaque, and ratings agencies were likewise remiss.

        Now, it’s possible I could be wrong about the specific role of the Fed in playing a part–a part, I emphasize–in changing the culture of lending that was a part–a part, I emphasize–in an outcome that had many parts and many roles. But in no way am I solely blaming the government, or blaming minorities, or letting bankers off the hook for responsibility, regardless of what any particularly dishonest commenter might want to believe.

        And even if I’m wrong about that, I am confident that I am not wrong that there were multiple factors causing this, that it was a combination of policy and opportunistic behavior. Only a fool would blame solely public policy or solely the market, as though the interaction between the two could be so easily severed.

        Report

      • I didn’t accuse you of anything; I said I thought your grasp of things felt similar to the ongoing stream of events Coates laid out in his argument for reparations (and he dealt extensively with lending, remember?) use a gov. program to take advantage of minorities and then blame them for the results instead of looking at a larger picture.

        You can squeal, “zic called me racist” and “zic’s a liar” if you want; you have a propensity for pointing out other’s perceived faults. But I don’t care what you think. It’s ever so much easier for you to natter on about zic’s a liar then to actually do the hard work of considering what zic said, and ponder if there’s some insight there of value; so there’s no reason for me to care.

        Report

      • So I spent part of my day tracing down the phrase “arbitrary and outdated criteria that may disqualify many urban or lower income minority applicants”.

        What I got to was John Lott, which made me think “Screw it, obvious BS” but I persisted. After all, just because Lott is a lying liar with a history of lies and hilarious sock-puppertry, doesn’t mean he’s ALWAYS wrong. (Also, I had to wade through like 40 articles that boiled down to ‘THE CRA DID IT THE CRA DID IT” so you’re WELCOME)

        So I traced back HIS sources, and I got to Jame’s “government pressure” and policies.

        Where? The Boston Fed. Which, apparently, is the entire Fed. And also government. But let’s assume the Boston Fed, for some reason, carries outsized weight. So what those crazy coots at the Boston Fed did was issue a guide (not ‘regulations’ but an actual, you know, guide).

        So in the Forward, the Fed says:
        The Federal Reserve Bank of Boston wants to be helpful to lenders as they work to close the mortgage gap. For this publication, we have gathered recommendations on “best practice” from lending institutions and consumer groups. With their help, we have developed a comprehensive program for lenders who seek to ensure that all loan applicants are treated fairly and to expand their markets to reach a more diverse customer base..

        Then goes on later to mention:
        The recommendations that follow were gathered from a variety of sources, including mortgage lenders, bankers’ associations, credit counseling agencies, fair housing organizations, and social research groups. All of these organizations agree that an effective strategy for equal opportunity in lending must be driven by economic, social, and legal incentives. They also believe that each institution must develop its own strategy, based on local market dynamics, and that this strategy must be comprehensive, flexible, and integrated into daily business operations.

        and finishes up by discussing how the purpose of the manual is to work to eliminate bias and most specifically “As part of this policy, management should be directed to review existing underwriting standards and practices to ensure that they are valid predictors of risk.“.

        Seriously, that’s “governmental pressure”. Jesus, I’m pretty sure I’m more to blame for the mortgage crises than that.

        So there you go. All this boils down to selectively quoting a manual issued by the Boston Fed, with all the power and authority of — a manual issued by the Boston Fed, which DID actually mention the relevant laws, but itself changed nothing, issued no penalties, and was presented not as a new rule but as a helpful guide to lenders.

        It’s amazing how that little quote was deliberately stripped of all context and passed around, until it became some accepted fact, twisted from it’s original purpose. In short, the CRA did it and if I have to cherry-pick a helpful FAQ from the Boston Fed to prove it, I will! I’ll just claim it was ‘government policy’ since ‘Boston Fed information packet built from feedback from actual lenders given the recent boom in mortgages” lacks that jack-booted government thugs all over my free market punch.

        Report

      • Can’t claim too much credit, as I stole most of it from blog posts by others. I started by googling the phrase, but what I got was a ton of op-eds and John Lott and Ann Coulter stuff. Finally tracked it down to the Boston Fed and googled another phrase (the only link I could find to to the actual manual, off a Forbes piece, was dead).

        I still can’t find a pdf of “Closing the Gap – A Guide to Equal Opportunity Lending” which those quotes originate from.

        I can tell you that it’s from 1993.

        Apparently it took 7 or 8 years for that political pressure to even begin percolating. :)

        Report

      • Hey,@Dave? Care to comment on this? I know you somewhat disagree with what I say we should *do* to stop it happening again, but I rather suspect you agree with both mine and zic’s description of what actually happened.

        I think that’s a fair assessment.

        What it sounds like to me reading what you posted was what the due diligence managers were uncovering when Merrill Lynch bought one of the big subprime lenders, First Franklin, at the end of 2006 although I’m sure the problems were raised much sooner.

        Like hell if Merrill was going to not make money when everyone else on the street was. They were the ugly duckling of the street, and as crazy as it sounds today, subprime was a way for that firm to make shitloads of money and outshine the street.

        There, you had all the problems associated with subprime plus a corporate culture with an inferiority complex and an almost pathological need to beat the rest of the street.

        Report

      • Morat,

        That’s a good response. I’ll only say that it really undermines the CRA argument, but does not rebut the argument that government policies play a role. And I emphasize, again, that I am in no way saying government was the sole cause.

        I’m stepping out of this argument now, though, because I will not spend anymore time getting involved in a conversation with zic.

        Report

      • That’s a good response. I’ll only say that it really undermines the CRA argument, but does not rebut the argument that government policies play a role. And I emphasize, again, that I am in no way saying government was the sole cause.
        Sure, it’s possible.

        However…the problem with the ‘government played a role’ argument is not just that no plausible cause has been illustrated (that is, so far it’s been variants of the CRA — a high bar to clear, given the law is old enough to have children able to drink legally. Or occasionally ‘low interest rates’ which is certainly government policy, however the independence of the Fed and the fact that housing policy is not in their remit other than the fact that the Fed deals with banks) but that government policy is unnecessary to explain the situation.

        The simple fact is that the entire SNAFU can be completely explained without government input at all. (As noted: Investors demanded property investments, CDOs were created, each CDO required more mortgages, companies sprang up to create mortgages, and a nice spiral was built that drove up housing prices, which drove up the returns on the investments, which drove up the number of investors, etc…).

        It’s a bog-standard bubble, of interest only in how it eluded the regulatory controls that normally prevent such things from getting so bad. (Moving mortgages off books, the mathematically opaque methods used to turn trash into triple-A bonds, the signing off on this by ratings agencies, and the entire shadow derivatives market). Property bubbles are, frankly, common enough. Government policy or action has never been necessary to cause bubbles, much less a property one. This one just went national thanks to whole derivatives and bundling stuff.

        The fact that basic market dynamics can explain the entire bubble and bust makes ‘government policy’ seem superfluous, which makes it suspect as a reason. The fact that the argument used for it generally boils down to a 4 decade old law doesn’t help. (Seriously, ‘low interest rates from the Fed’ is the first non-CRA argument I’ve ever heard. And that’s a fun question there, but unless you felt the Fed was manipulating interest rates to keep the bubble afloat – -and with Greenspan pimping ARM’s and generally flabbergasted when the whole thing exploded, I’m game to chat about that one).

        Report

      • It’s not that simple, Morat, because there’s a question you’re not addressing: why then, and not before? Greed is a constant, not a variable, so greed doesn’t explain why those actions happened at time X and not time X-. And absent Fed policy you don’t have a clear explanation of the source of money to fund the bubble.

        And not to direct this at you, be ause I don’t think you’ve do e this, but I do find it amusing that some have transitioned from “repeal of Glass-Steagal caused it,” to “how dare you say govt policy had anything to to with it!” Of course those same folks still blame insufficient regulation or regulatory attention, so they contradict themselves in claiming govt policy had no role. Soil really don’t get the anger some people express at the suggestion that policy played a role.

        Seriously, this was not a monocausal fuckup. Anyone blaming solely government or solely the mortgage investors is not looking to really understand, but just looking for villians, and in a shocking turn of events, each is finding villians that meet their ideological predispositions.

        Report

      • Re: the Fed. If you’ve not heard then mentioned before as playing a role, I wonder if you read outside your comfort zone on this issue. Simply put, the Fed was using monetary pict to move the economy out of recession, then keeping interest rates low because they were hoping to spur job growth in the jobless recovery. They weren’t trying to create a bubble, and despite criticisms at the time of their policy, they were doing it for a well-intended reason.

        I still maintain that the easy money policy went into housing in part because the capital gains tax cut, another well intentioned policy, made home ownership a more remunerative short-term investment. ARMs made it even more so.

        The underlying logic here is that policy affects on business decision making aren’t necessarily linear. Business folk looking to make money will respond in ways that connect policies that had nothing to do with each other. Regulation and response is nearly always a complex adaptive system, and to look at it linearly and demand that only direct links matter is to miss the real story of what’s going on. Not just in this case, but in all, or nearly all, cases.

        Report

      • Re: the Fed. If you’ve not heard then mentioned before as playing a role, I wonder if you read outside your comfort zone on this issue. Simply put, the Fed was using monetary pict to move the economy out of recession, then keeping interest rates low because they were hoping to spur job growth in the jobless recovery. They weren’t trying to create a bubble, and despite criticisms at the time of their policy, they were doing it for a well-intended reason.
        I have heard it, but not as ‘government policy’ because most people take ‘government policy’ to be the stuff that Democrats and Republicans do with Congress or the White House.

        The independence of the Fed, and especially it’s rather cozy relationship with bankers (I am aware it has an employment mandate, but that’s generally a distant second to everything else), does not draw to mind ‘government policy’ when most people mention the phrase.

        The Fed is, obviously, a government institution (however independent). But no, my mind rarely leaps to ‘The Fed’ when talking of government policy. Monetary policy, yes. :)

        My primary problem with the “The Fed” theory is this: By 2003 — when interest rates were cut — the housing bubble already existed. In 2000, housing prices were already running high by historical trends. By 2003 they were 25 to 30% higher.

        Low interest rates *might* have accelerated it (raising them certainly triggered the inevitable crash, but, you know, “inevitable”), but a 30% increase in value in three years? The feedback cycle had already started, the bubble was already inflating. Tulip prices, as they saw, were just bonkers.

        I’m leery of arguing the Fed should have noticed in 2003 when they cut rates. I *do* think they were very, very, VERY late on the ball in raising them — but then again, the Fed has more on their plate than overseeing the housing market. Which is not technically on their plate.

        So I’ll happily claim the Fed, especially Greenspan, basically dropped the ball. But a doctor who mis-diagnoses your illness didn’t cause it, and the housing bubble had already started by the time the Fed started treatment. As it were.

        Report

      • The Fed is one of a dozen and a half independent regulatory agencies. I have never heard it suggested that their policies are not government policy. It is uniquely structured, with both private and public elements, but it was created by statute, has a board of governors appointed by the president and approved by Congress, is subject to congressional oversight, and it’s profits, minus a dividend, accrue to the federal treasury. As with any central bank it sets the country’s monetary policy. It is very much a government agency setting government policy.

        By 2003 — when interest rates were cut —

        Say what now? In October 2000 the Fed a Funds Rate was 6.5%. By March 2001 it was down to 5.3%. By October of 2001 it was at 2.49%. In December it was 1.82%. By December 2002 it had been cut to 1.75%. By December 2003 it had declined to 1%. The big cuts were before 2003.

        the housing bubble already existed. In 2000, housing prices were already running high by historical trends. By 2003 they were 25 to 30% higher.

        One thing I’ve learned from reading economists is that we can’t always tell what’s a bubble and what’s not. Simply running ahead of trend is not itself sufficient for claiming a bubble. But that 25-30% higher number you give is set after the Fed Funds Rate had been cut from 6.5% to below 2%.

        The feedback cycle had already started,
        I keep pointing out the change in the capital gains tax, which preceded this. That’s not proof, but it can’t just be hand waved away, especially if the alternative argument is “no variables changed, but the outcome did,” which is essentially what I’m hearing from the “markets the only cause” crowd. (Yes, investors demanded new products, but why? What had changed?)

        I’m leery of arguing the Fed should have noticed in 2003 when they cut rates.
        For the record, I didn’t make any such claim. Others have, but I think that’s speculative. It’s possible, though, that their increases broke the bubble, by increasing interest rates too quickly, which crimped new mortgages, hence crimped price increases, which made ARMs–so dependent on price increases–go kablooey because holders didn’t have the equity to refi them and couldn’t afford the rate increases. Is that really the story? Shrug. Smart folks are still arguing about it, so I’m not going to stake my life on it.

        Report

      • James,

        Sorry, I was talking Fed but thinking 30-year mortgage rates. They went from 8% in 2000 to 5.5% or so in 2003. Not really sufficient to propel a bubble, and ARM’s didn’t become popular until further in. :)

        However, as to: ” (Yes, investors demanded new products, but why? What had changed?)”

        What changed for tulips? What caused any speculative bubble? And it’s not like real estate is some weird new area for bubbles, you know?

        I think it’s more important to figure out what allowed a national bubble, despite a century+ of experience and mechanisms designed to tamp them down. (Fun fact: Texas was spared the worst of it. Why? Texas has some fairly nasty regulations that make it really hard to get a home equity loan. They were put into place after a real estate bubble some time past, and never repealed. Hilarious, given our low-regulation reputation and the whole ‘Texas miracle’ thing. Half the miracle was expensive oil and half was we didn’t have half the state underwater on home loans).

        You can blame low interest rates as one factor. How about stagnant wages and spiraling health care costs? Made that home equity pretty tempting to maintain standards of living.

        Report

      • There’s a good conversation going on here:

        I keep pointing out the change in the capital gains tax, which preceded this. That’s not proof, but it can’t just be hand waved away, especially if the alternative argument is “no variables changed, but the outcome did,” which is essentially what I’m hearing from the “markets the only cause” crowd. (Yes, investors demanded new products, but why? What had changed?)

        First, regarding capital gains taxes, while lower capital gains rates encourage investors to pay the tax and not use tax deferred strategies, in residential real estate, most people don’t pay the capital gains tax because when they sell a house, they buy into a new one at equal or greater value. Capital gains taxes are avoided when these kinds of like-kind exchanges (known as a 1031 exchange) takes place. For people that are downsizing, like retirees and empty nesters, there are exemptions that shield up to $500,000 in profit from the sale of a primary residence.

        http://www.irs.gov/taxtopics/tc701.html

        Personally, what I think drove home speculation was 1) astronomically increasing prices and 2) the rise of the liar loan markets where potential borrowers could and did lie and claim that the loan was for a primary residence.

        This is why I don’t think capital gains were a major contributing factor.

        Second, if you want to know what changed, start with this…

        Simply put, the Fed was using monetary pict to move the economy out of recession, then keeping interest rates low because they were hoping to spur job growth in the jobless recovery.

        The Fed did that, and the capital markets were equally worried about deteriorating conditions in 2003, so much so that the markets experienced a flight to quality (i.e. Treasuries). The effect of investor uncertainty and Fed interest rate policy drove Treasury yields down to historic lows (the 10-year dropped in the low 3s). I remember this because I bought a home around this time.

        Keep in mind that fixed income investments are valued at some spread to the corresponding Treasury rates so if you assume that a AAA-rated corporate bond is priced at 65 basis points over Treasuries, yields on fixed income investments will drop because Treasuries drop.

        This was a big problem for yield-oriented fixed income investors. Yields dropped to a point where many of these investors were not able to achieve the yield requirements for their portfolios had they simply bought Treasuries, AA-rated corporates or other fixed income investments. It was a classic situation of a lot of yield-oriented investors chasing too little available product.

        A change in interest rate policy coupled by economic conditions created a situation where fixed income investors seeking yield had fewer and fewer opportunities to invest. Prior to 2003, this wasn’t a problem, but it became one. Private label mortgage-backed securities became the solution to that because they had attractive yields and were given investment grade ratings. Yield plus quality (perceived or real) equals more demand.

        Even after Treasuries went up and hovered in the 4% range, it did nothing to stop demand for the product. In fact, there was so much competition for the stuff that the spreads that investors were willing to pay tightened (which explains why mortgage rates didn’t seem to move much even if Treasuries did).

        And absent Fed policy you don’t have a clear explanation of the source of money to fund the bubble.

        This. The money that drove the bubble came from fixed income investors responding to an interest rate/yield environment that was a function of the interest policy at the time. Had bond investors been able to earn yields on traditional fixed income investments, there would have been no need to look to private label mortgage backed securities.

        Trying to remove the government from the equation (and monetary policy is government policy) screws up the entire narrative.

        My primary problem with the “The Fed” theory is this: By 2003 — when interest rates were cut — the housing bubble already existed. In 2000, housing prices were already running high by historical trends. By 2003 they were 25 to 30% higher.

        By 2006, there were housing markets experiencing appreciation of those amounts every few months or less.

        The best way to look at the Fed theory is to not look at housing prices but rather what happened in the capital markets, but if you want to look at house prices. Look at home price appreciation and compare that to how much subprime/Alt A paper was being sold into the markets. Home prices went through the roof when those markets took off. That’s no coincidence.

        Low interest rates *might* have accelerated it (raising them certainly triggered the inevitable crash, but, you know, “inevitable”), but a 30% increase in value in three years? The feedback cycle had already started, the bubble was already inflating. Tulip prices, as they saw, were just bonkers.

        I’m not sure where you got your appreciation numbers from, but assuming they’re correct, I don’t know if I would call 30% over three years a bubble (abnormally high, yes). Interest rates were dropping as a result of the recession and it drove down mortgage rates so much of the increase in value was attributed to that.

        What feedback cycle do you speak of? The cause of the home price appreciation in 2000 to 2003 (mostly interest rates) was not what drove home price appreciation from 2003 to 2006 (poor underwriting standards, fraud, liar loans, the need to source product to investors consequences be damned).

        Last point: what the Fed didn’t pay attention to in 2003 was an alarming increase in mortgage fraud.

        Report

      • Is mortgage fraud really the Fed’s bailiwick, though?

        In any case, I think we’re all in agreement here that the question wasn’t “What drove a real estate bubble” (speculative bubbles happen, and real estate bubbles are a very, very, very common form of it. Real estate bubbles have happened with high rates and low ones, with good economies and bad) but what transitioned the bubble from a local problem (like California’s in the 1980s) to a national one?

        Now me? Income inequality, basically. That’s when I first really thought about the problem, in the wake of the collapse — the national bubble was driven by (as Dave and everyone else notes) investment money. It wasn’t people flipping houses, it was large scale, nationwide investments.

        Now I came to the belief that what you had here was too much money chasing too few goods. Although in this case I mean ‘capital’ and ‘good investment opportunities’. (As additional data — weren’t there several large investment frauds over that period? One big Ponzi scheme I can recall, and then there were the Enron manipulations and other shenanigans).

        Now the Fed undoubtedly played a role, but they were doing their normal job of monetary policy on the economy as a whole. In a sense they’re partially culpable to everything good and bad that has ever happened to the economy since the inception of the Fed because, you know, banks are sorta important. :)

        Me, like I said — I go back to this: Why was there so much money seeking investments? At the time, the middle class was cashing out equity like there was no tomorrow to maintain their spending patterns and taking on increasing debt — they weren’t investing that money.

        I don’t think it’s the Fed’s job to keep interest rates high so investors have places to find risk-free 5% returns (not that anyone’s claiming it exactly, but they shouldn’t be considering investment opportunities for capital when manipulating the rate, other than the obvious of ‘does it remove money or add money’ stuff).

        Spot-checking the 10-year rates (which I think is more useful proxy for investment), just for fun — hovered around 5% in 2000 and 2001, dropped to low of 3.77 in 2003, then jumped up to 5. They’re less than 3% now.

        Makes me wonder where today’s bubble is. Stock market?

        Report

      • morat20,
        Automobiles (autotitleloans, among other things). AAA+ too. Yay fucking rating agencies.

        This is all Reagan’s doing, you realize? Those big investors? They ain’t banks. It’s Calpers and other people the banks intend to impoverish, so that they get new chimps to work the plantation.

        Dave’s post on PayDay Loans is very relevant here (not the least of which is because it was wall street got the anti-usury laws passed. I’ll leave it as a question to the reader about why they did that, and what they stand to gain.).

        Report

      • Me, like I said — I go back to this: Why was there so much money seeking investments? At the time, the middle class was cashing out equity like there was no tomorrow to maintain their spending patterns and taking on increasing debt — they weren’t investing that money.

        The capital sources were not middle class investors, who are prohibited from purchasing mortgage-backed securities anyway since they are privately placed and only available to qualified institutional buyers. They were endowments, hedge funds, fixed income funds, pension funds, life companies, sovereign wealth funds and other major institutional investors. The investors you speak of represent a tiny portion of the market. This was institutionally driven.

        Report

      • I don’t have time today to get deep back into this, but just a couple comments.

        Morat
        1. What changed for tulips? What caused any speculative bubble?
        You ask that as though you know nothing else changed except speculative demand. Do you know that factually? I’m not an expert in the Tulip bubble, the South Seas bubble, etc., so I don’t know. Are you an expert in any of those bubbles? Can you say with certainty, and demonstrate persuasively, that nothing else changed? Do you actually know that, or are you assuming that just because you’ve never heard of some other factor?

        How about stagnant wages and spiraling health care costs? Made that home equity pretty tempting to maintain standards of living.
        This makes absolutely no sense to me. It requires people deciding that since they have less available income they should spend more on housing. It’s a theory I’ve not previously heard suggested, and probably for good reason.

        Dave
        3. Personally, what I think drove home speculation was 1) astronomically increasing prices
        I think that’s circular.

        4. 2) the rise of the liar loan markets where potential borrowers could and did lie and claim that the loan was for a primary residence.
        Why? What caused this? Possibly it came out of nowhere, but that’s always a bit dubious. What changed that made liar loans develop at time T1 rather than time T? That’s what bothers me about these types of explanations is their incompleteness–they posit a change in behavior without positing a cause of that change.

        5. A change in interest rate policy coupled by economic conditions created a situation where fixed income investors seeking yield had fewer and fewer opportunities to invest. Prior to 2003, this wasn’t a problem, but it became one. Private label mortgage-backed securities became the solution to that because they had attractive yields and were given investment grade ratings.
        Right, this is the kind of thing I mean, in terms of providing an explanation for a change in behavior. What really irritates me are explanations that chalk it up to corporate greed. Of course greed is a factor, but it’s not really an explanatory factor because it’s a constant–they’re always greedy, in time T as well as time T1, so greed can’t explain a change in behavior between those two time periods. A policy change that shifts the focus of greed from certain types of investments to others, that is an explanation.

        Report


    • Did you really think that Fannie Mae can purchase unlimited quantities of mortgages without a need to recycle capital through securitization and sale? How do you think the GSE’s help to keep the residential mortgage markets liquid? Again, you don’t know the first fishing thing about the mortgage markets.

      I am *quite sure* that I’ve had enough discussions with you about the mortgage market for you to know I am aware of how the GSEs work.

      After you realize why the government sponsored enterprises, the largest issuers of residential mortgage backed securities, choose to “randomly bundle securities” as opposed to sell them intact, then we can get to the more complicated topic of tranches. I’ll use small words so you can understand.

      I understand how the mortgage market works. Mortgages are issued by banks or other entities, sold to either the GSEs (If the mortgages meet certain rules) or to other banks if they met laxer rooms that the other banks have, bundled into different securities based on various estimated different levels of risk and maturity time. Then derivatives can be created based on these securities doing something or not doing something or whatever, which is a whole nother bucket of weirdness. Happy?

      What you have always failed to explain is why you think this is optimal, or why the system falls apart if banks are required to hold the mortgage for a certain amount time (Let us say 1/4 the time) before selling them to someone to put into securities.

      Likewise, you have entirely failed to explain why *derivatives* on these mortgage securities need to exist.

      I have no problem with mortgage securities (as long as they aren’t full of shit mortgages, hence my requirement that originator assume the risk for some amount of time). But derivatives? Why?

      Oh, I know. To ‘hedge risk’. I don’t know what this crazy idea came from that we should run around hedging risk in all directions so we can invest in risky things, and that doesn’t particularly make any goddamn sense at all from a logical point of view.

      In the real world, you can’t *actually* make money betting in multiple directions at once, and in the real world, what people do is *bet less* to reduce their exposure. If banks are somehow making more money by betting $10 one way, and $9 the other, vs just betting $1 to start with, it rather implies that banks are somehow ripping people off.

      Or, rather, collecting their vig.

      By your logic, you have no problem with investment banks PRODUCING mortgage derivatives so long as they don’t INVEST in mortgage derivatives but how the fish can the banks do this without INVESTING in the underlying mortgages themselves?

      You’ve managed to read that wrong in two different ways.

      First, I was responding to, and I quote: ‘Apparently, many corporations use derivatives to hedge certain kinds of risks, and since companies can’t go on exchanges to find ones that are suited to their needs, they seek out the banks to structure products for them.’

      If corporations go to their bank to create *mortgage-based security derivatives* to hedge risk, that’s a new one on me. What sort of hedge would that be?

      Second, we were talking about *weird, new derivative that are not well understood*, being held by a large bank. The sorts of custom things that companies do to migrate certain risks are usually well understood…and even if not, I have no objection to any bank creating them. I have an objection to the large banks *holding* poorly understood derivatives, which would mean they’d have to have a buyer for *both sides of the derivative* when they made it. (Or, alternately, like I said, just make a strong disincentive to hold it.)

      This has already happened and the conditions that could allow something like this to happen aren’t going to happen for quite some time.

      It won’t happen until about 2028-ish, by my reckoning. At that point, of course, we’ll have *yet another* disaster. Like clockwork.

      For what it’s worth, if you’ve read your history on the financial crisis, you’d realize that it wasn’t new forms of derivatives that caused most of the problems.

      All forms of derivatives have basically been invented already, a long time back. There are only so many ways you can make triggers and split up money. (Now, there have been new, completely nonsensical, ways of calculating *risk*, but that’s something else.)

      What caused the crash was derivatives and securities created to exist *outside of regulations*.

      ‘You know, no one’s ever tried mortgage backed securities with random mortgages before. Like the GSEs, but with no standards at all, we’ll just take whatever mortgage we can buy. I’m sure we can somehow value those right, and I’m sure we don’t have to *check* the mortgages at all. And then let’s make all sorts of derivatives from them! The market is completely unregulated! Wheee! Now pass the cocaine and hookers!’.

      And the rating companies then randomly rated them, then, as zic pointed out, AIG insured them.

      I say: Don’t let the big boys play with those. Or at least disincentive them. Make a safe list, and I mean *the government* makes a safe list, not the incompetent fuckers at the ratings places.

      I.e., I am flipping the rules around, at least for the huge banks: Only specific stuff is allowed, everything else is disallowed. (Or banks could just choose to not be huge, which, hey, would *also* be a damn victory.)

      Believe it or not, they are quite competent in just about everything else. Still a big screw up though.

      LOL. I will admit, they usually have a very well-maintained lobbies, and their softball teams are very good. ?!

      They didn’t just screw up a little. They did the equivalent of the FDA approving anthrax as a nasal spray, or the Nuclear Regulatory Commission dropping an atomic bomb on Seattle. They lost. It’s over. They are worthless, and cannot be trusted in the slightest.

      Report

      • Then derivatives can be created based on these securities doing something or not doing something or whatever, which is a whole nother bucket of weirdness. Happy?

        I have always argued in favor of the strengths of the securitized mortgage markets. Nothing more nothing less. It sounds like you’re discussing a whole other class of derivatives (CDOs maybe) based on those securities. As far as I know, I’ve never defended derivatives tied to mortgage backed securities, although I could make a good case for credit default swaps (which I’m sure will freak some people out). There is nothing fancy or weird about a credit default swap, as it’s basically a form of insurance.

        I have no problem with mortgage securities (as long as they aren’t full of shit mortgages, hence my requirement that originator assume the risk for some amount of time).

        If this is true, then we have a huge misunderstanding on our hands here because I always thought you had a problem with mortgage securities in of themselves and have addressed everything from that angle (which may explain why we talk past each other).

        To your point about requiring issuers of MBS to hold a piece of the deal, I have two concerns about that. The first is that if the regulations are such that only certain kinds of mortgages can get securitized and the banks are using only those kinds of loans in their loan pools, then there’s no reason to hold a piece. If everything qualifies, they can sell it.

        The second reason is that requiring issuers to hold a piece is going to be costly for both the bank and the borrower. The banks typically fund their securitization business using short-term credit lines so there’s little by way of equity involved. This keeps the bank’s cost of capital for the deals low. If bank equity has to be contributed and a piece held on the books, the banks will need to be compensated for that risk. They will need to charge a higher cost on the loans in order to meet their cost requirements of structuring the deal. Given that equity is much more expensive than debt, that could significantly diminish a bank’s competitive position if not put them out of the business.

        25% of a deal is enormous,especially if some of that 25% can be sold off as an investment-grade rated security. In 2009, I argued for 5%. Today, I think that’s too high.

        They didn’t just screw up a little. They did the equivalent of the FDA approving anthrax as a nasal spray, or the Nuclear Regulatory Commission dropping an atomic bomb on Seattle. They lost. It’s over. They are worthless, and cannot be trusted in the slightest.

        While I will not defend the ratings agencies with respect to their rating mortgage backed securities during the bubble days, I can not and will not dismiss the work that the ratings agencies do elsewhere. They play a critical role in my business and we rely on the work of the ratings agencies to evaluate the financial condition of hospitals and health systems.

        The ratings analysts that rated CDOs screwed up because they had no idea what the hell they were doing. The ratings analysts that rate not-for-profit hospitals understand the business quite well and have done so for decades. Having spoken to a couple of them, I’d say they get what’s going on.

        Likewise, you have entirely failed to explain why *derivatives* on these mortgage securities need to exist.

        To answer this, I’ll try to make something up…

        Let’s say that an investor in an unrated tranche (the highest risk portion) of a residential mortgage backed security that has a substantial amount of collateral loans in market where the shale industry was booming. Based on current conditions in those markets, the investor is concerned that the potential slowdown could cause loan defaults to increase thereby substantially diminishing if not destroying the value of the investment. He/she calls a major hedge fund and asks the hedge fund to structure a credit default swap that protects the investor’s risk in the event that loan defaults exceed a certain level.

        If the hedge fund is sufficiently capitalized to take the risk, why shouldn’t the hedge fund be allowed to enter into that transaction?

        Otherwise, I’m not sure what you mean by derivatives ON mortgage securities. Mortgage securities investors may employ interest rate swaps to hedge against increases in interest rates but that’s not necessarily a derivative created based on the mortgage security. Swaps have been around forever.

        In the real world, you can’t *actually* make money betting in multiple directions at once, and in the real world, what people do is *bet less* to reduce their exposure. If banks are somehow making more money by betting $10 one way, and $9 the other, vs just betting $1 to start with, it rather implies that banks are somehow ripping people off.

        Or, rather, collecting their vig.

        It sounds like you’re talking about reducing risk exposure. If Goldman Sachs is short a $10 million credit default swap and has to pay that out in the event of a default, it can hedge that risk by taking an opposite long position at the amount of its choosing. If the long position is $11 million, in the event that a default event happens, Goldman receives $11 million on the long and pays out $10 million on the short, netting $1 million less the premiums paid for the long position.

        It’s not about collecting a vig. It’s a simple netting out of two positions.

        And the rating companies then randomly rated them, then, as zic pointed out, AIG insured them.

        AIG wasn’t the only company that insured them, but AIG was the biggest player. AIG also never bothered to take the opposite position and net out its risk exposure.

        I say: Don’t let the big boys play with those. Or at least disincentive them. Make a safe list, and I mean *the government* makes a safe list, not the incompetent fuckers at the ratings places.

        The easiest way to disincentive them is to ban certain forms of proprietary trading and to place stricter limits on their ability to leverage themselves. Those things alone may be far more efficient than trying to get into the nitty gritty of permitting or prohibiting individual types of derivatives.

        Report

      • If this is true, then we have a huge misunderstanding on our hands here because I always thought you had a problem with mortgage securities in of themselves and have addressed everything from that angle (which may explain why we talk past each other).

        Erm, no. That was me explaining how things *do* work, not how I want them to work.

        I do have problems with mortgage in and of themselves. Two problems, specifically.

        The first is that if the regulations are such that only certain kinds of mortgages can get securitized and the banks are using only those kinds of loans in their loan pools, then there’s no reason to hold a piece. If everything qualifies, they can sell it.

        I’m unsure what you mean here.

        Firstly, from what I understand, there are not any regulations about what mortgages *can* be securitized. As far as I understand it, almost *any* asset that hypothetically returns money can be securitized, legally. (With maybe a few specific rules about certain things.)

        There are, of course, some practical limits on what sort of securities can be sold, or at least sold at prices making the entire thing worthwhile. Banks could make things that no one would buy. (And, of course, they did exactly that, except the rating agencies were smoking crack so people did buy them.)

        Secondly, the entire problem here is that the mortgages that were securitized *did* put perfectly acceptable mortgages in them…or so the originator claimed. That, right there, is a good half the problem of the the crash. To explain my way of thinking:

        There are a lot of securities out that have obvious, unquestionable values. Bonds, for an obvious example.

        And there are securities that are indistinguishable from each other. Like share of stock. You know it’s X% of a company. The *price* can be manipulated by various people, but they couldn’t have secretly sold you a piece of stock that only had .9X% of a company. Same with cattle futures, or forward options, or all derivatives I can think of right now. An investor might be wrong about how much it’s worth, but they know exactly what it *is*. (And even then, we outlaw things like insider trading and market manipulate.)

        Those both those sorts of securities are on identical items. The people selling them cannot lie really.

        So, problem number one with mortgage securities: Mortgages are *unique*. Sure, banks assign risks…but it’s the *bank* doing that, or the bank originator the bank bought it from, and you flatly can’t trust them *if they have an incentive to lie*.

        While I am not *completely* opposed to mortgage security, they’re *starting* on fragile ground. And see the end of the post, with my other problem with them.

        The second reason is that requiring issuers to hold a piece is going to be costly for both the bank and the borrower. The banks typically fund their securitization business using short-term credit lines so there’s little by way of equity involved. This keeps the bank’s cost of capital for the deals low. If bank equity has to be contributed and a piece held on the books, the banks will need to be compensated for that risk. They will need to charge a higher cost on the loans in order to meet their cost requirements of structuring the deal.

        What you are saying literally cannot be a problem in the long run. The money *has to* exist to buy mortgages, because it *does* exist, and people *are* buying mortgages with it. They’re just buying them through two layers of resell. (The originator, and then, usually, whoever bought it to put it in a security, and they buy the security.) Two layers of resell…well, it might not make things more expensive, but it probably doesn’t make them *cheaper*.

        All your objection is saying is that, *given the way the market works now*, mortgages would be more costly than they used to be. But there’s no actual reason the market would *continue* to look the way it looks if a major part of it changed!

        It’s amazing, for a market that insists on no regulations so it can ‘innovate’, it’s apparently impossible to structure the mortgage industry so that it has no incentives to create bad mortgages. It’s just flatly impossible to structure the industry in that manner, somehow. (Despite this actually being the way it used to work until very recently.)

        The ratings analysts that rated CDOs screwed up because they had no idea what the hell they were doing. The ratings analysts that rate not-for-profit hospitals understand the business quite well and have done so for decades. Having spoken to a couple of them, I’d say they get what’s going on.

        So, basically, the *next* crash will be with a *different* thing that’s misrated?

        To answer this, I’ll try to make something up…

        Or this investor could, and here’s a completely insane and novel idea: Sell some of the damn securities, buy other things with them!

        Like I said…the market likes to build crazy-ass castles in the clouds. Towering artifices of nonsense, hedging one way and then another and then getting insurance on that and whatever.

        JUST STOP IT. There are *actual things* that, when owned, provide income. How about *owning and trading those*, instead of owning and trading things about things referring to things based on those things. Don’t like the risk of something, sell it. The entire thing is completely insane.

        I’m not saying hedging using derivatives shouldn’t exist at all. I mean, that’s the point of the future’s market.

        I’m saying perhaps the *very first thing* everyone runs to shouldn’t be derivatives. I’m sure it’s completely crazy to suggest this, but perhaps we shouldn’t have an *imaginary* derivative’s market that dwarfs the entire US economy and all money in existence?

        Mortgage securities investors may employ interest rate swaps to hedge against increases in interest rates but that’s not necessarily a derivative created based on the mortgage security.

        I’m not sure what those really have to do with mortgage securities. Interest rate swaps aren’t related to them.

        But this is as good a time as ever to mention the *other* problem with mortgage securities, and why derivatives *specifically* on them are bad: Namely, that mortgage ownership is pretty damn important, and mortgage securities seem *completely unable* to deal with that in a reasonable manner. Securities, while they sorta-kinda are corporations, don’t actually do things. Like foreclose.

        And the situation just gets even more screwed up with derivatives. Derivative owners can end up weird places where they have an *incentive* to make the mortgage fail.

        When *corporations* trade derivatives, they know what they’re doing.

        When a random new homeowner has an agreement with a bank to pay back a mortgage, yes, they have to deal with that loan being sold, but there’s a difference between that loan sold intact to another bank, vs it being stuck in a security and thus being owned by a company that barely exists, and managed by another company, and third- and fourth-parties have weird interests in seeing their mortgage succeed or fail. Banks that own a mortgage have *actual responsibilities to borrowers*.

        Frankly, if you signed a contract with a bank, and tried to do something within that contract (Even if the loan had been sold), and the new owners didn’t do it correctly, you ought to be able to sue *the original bank*, which, after all, had a legal requirement to actually make sure the people they sold their end of the contract to would follow the contract.

        If both my concerns about mortgage securities are addressed, namely, that there is *no incentive* to lie when making them (And that’s different from such lying being illegal) and there is *actual management of these securitized mortgages like if a bank holds the mortgage*, I have no problem with them.

        And I *really* doubt either of those things are possible in today’s climate. And the later issue probably requires a real holding company instead of a security.

        The easiest way to disincentive them is to ban certain forms of proprietary trading and to place stricter limits on their ability to leverage themselves. Those things alone may be far more efficient than trying to get into the nitty gritty of permitting or prohibiting individual types of derivatives.

        Except that ‘stricter limits on their ability to leverage themselves’ doesn’t do anything to solve ‘lying about mortgages’, and, even more worrisome, will almost certainly magically disappear in a few years. Like it always does.

        Report

      • Obviously, I have problems with mortgage *securities* in and of themselves, not mortgages.

        But, anyway, to clarify my confused italics: The part you quoted was me explaining how the mortgage security market *currently* worked, because you seemed to think I didn’t understand it. It was not me recommending or approving of it.

        Report

  17. Firstly, from what I understand, there are not any regulations about what mortgages *can* be securitized. As far as I understand it, almost *any* asset that hypothetically returns money can be securitized, legally. (With maybe a few specific rules about certain things.)

    http://www.nixonpeabody.com/Qualified_mortgages_vs_qualified_residential_mortgages

    While there’s some truth to what you’re saying, the reality is that the rules governing qualified mortgages make it so prohibitive to originate mortgages that don’t fall under these qualifications that in effect it has killed off the problem loans of the past. There is too much legal liability associated with issuing these kinds of loans that no one will do them. Also, I’m not sure that liar loans are even legal under the CFPB.

    It’s almost a moot point anyway because the market for private label mortgage-backed securities is next to non-existent today. The GSEs issue 95% plus of the residential mortgage-backed securities sold today and do so with loans based on their requirements.

    There are, of course, some practical limits on what sort of securities can be sold, or at least sold at prices making the entire thing worthwhile.

    Agreed. Please see above.

    Secondly, the entire problem here is that the mortgages that were securitized *did* put perfectly acceptable mortgages in them…or so the originator claimed.

    I think the qualified mortgage and qualified residential mortgage rules addressed these problems.

    So, problem number one with mortgage securities: Mortgages are *unique*.

    That’s more of a problem with buying whole loans than it is mortgage securities. Mortgages may be “unique” because of the characteristics of each property and borrower, but mortgage securities mitigate the uniqueness through diversification. It’s one reason why mortgage securities are more favorable for financial institutions that want to invest in mortgages but want nothing to do with buying whole loans.

    and you flatly can’t trust them *if they have an incentive to lie*.

    Which they no longer do under the current rules.

    What you are saying literally cannot be a problem in the long run. The money *has to* exist to buy mortgages, because it *does* exist, and people *are* buying mortgages with it.

    It’s not a question of whether or not money exists, it’s the cost of that money that’s the issue. Yes, it can exist in the long run because equity capital will always be more expensive than debt.

    It’s amazing, for a market that insists on no regulations so it can ‘innovate’, it’s apparently impossible to structure the mortgage industry so that it has no incentives to create bad mortgages.

    It’s not impossible at all and it was addressed in Dodd-Frank and quite well IMO. Legal liability for bad mortgages is an incentive not to create them. Furthermore, it’s not likely that any such securities would get rated by the ratings agencies so the market for them would be so limited as to keep the size of the market small.

    So, basically, the *next* crash will be with a *different* thing that’s misrated?

    If I knew that, I wouldn’t tell you anyway. I’d short that market and reap the rewards. Hell, maybe I’d tell you that it’s a good idea to go long in market. FYIGM, right? ;)

    Or this investor could, and here’s a completely insane and novel idea: Sell some of the damn securities, buy other things with them!

    An investor should sell as opposed to using a hedge to manage what may or may not be risk that was existent at the time the investment was made? To your credit, you got the insane part right. That’s about all I have to say on that.

    Like I said…the market likes to build crazy-ass castles in the clouds. Towering artifices of nonsense, hedging one way and then another and then getting insurance on that and whatever.

    Your descriptive language notwithstanding, so long as such things do not cause a systemic crisis, who the hell cares? Heaven forbid people that have forgotten more about finance than you and I know do something that has no bearing on our day to day lives. I say this as someone that’s all in favor for regulations to address systemic issues.

    I’m not saying hedging using derivatives shouldn’t exist at all. I mean, that’s the point of the future’s market.

    They shouldn’t exist if they meet your yet fully worked out definition of “towering artifices of nonsense”. I spent a good deal of my graduate school days dealing with derivatives and financial engineering, and I don’t remember the term “towering artifices of nonsense” being used anywhere. It’s cute in a lefty-know-nothing-economic-populist sort of way, but when the rubber hits the road, you’re going to have a very hard time proposing alternatives that make any sense.

    I’m sure it’s completely crazy to suggest this, but perhaps we shouldn’t have an *imaginary* derivative’s market that dwarfs the entire US economy and all money in existence?

    It’s completely crazy to suggest that the derivatives market is imaginary. It’s also completely crazy to look at the size of a market based on its total notional value. You could have a 50 gajillion dollar market for credit default swaps, but if 50% if the market is betting one way and 50% the other way, each side offsets the other and the net exposure is zero. Keep that in the proper perspective.

    But this is as good a time as ever to mention the *other* problem with mortgage securities, and why derivatives *specifically* on them are bad: Namely, that mortgage ownership is pretty damn important, and mortgage securities seem *completely unable* to deal with that in a reasonable manner. Securities, while they sorta-kinda are corporations, don’t actually do things. Like foreclose.

    I disagree.

    Setting aside the fact that you offer no tangible support for your argument, mortgage-backed securities existed for decades prior to the last crisis. Did the problems you mention arise during those times in such great fashion that it drew national attention? No.

    Your comment ignores the role that loan servicers play in the process. They represent the various classes of the bondholders. They are the ones that receive the principal and interest payments and then distribute them. They are the ones that handle all of the loans that go into special servicing. They are the ones that have the legal authority to initiate foreclosure proceedings.

    The problem in the crisis was more process related than it was a structural defect like the one you mentioned. The biggest problem with the loan servicers was that they weren’t set up to handle the flood of mortgage defaults that would eventually happen nor was there any incentive for loan servicers to beef up their operations. There were problems with the legal ownership of notes because the chain of title got screwed up in a lot of cases and the electronic record keeping system was awful. However, this was driven by process and the sheer volume of work being done to push crap into the market. It was never a historical problem.

    And the situation just gets even more screwed up with derivatives. Derivative owners can end up weird places where they have an *incentive* to make the mortgage fail.

    What incentives to they have? How can a holder of a derivative make a mortgage fail if the mortgagee is paying his/her payments on time and consistently?

    When a random new homeowner has an agreement with a bank to pay back a mortgage, yes, they have to deal with that loan being sold, but there’s a difference between that loan sold intact to another bank, vs it being stuck in a security and thus being owned by a company that barely exists, and managed by another company, and third- and fourth-parties have weird interests in seeing their mortgage succeed or fail. Banks that own a mortgage have *actual responsibilities to borrowers*.

    1. The differences are very few, mainly a point of contact that a borrower may not know. The borrower still writes the monthly checks, only to a different entity.

    2. Bondholder that assume legal ownership of the notes, or some portion thereof, are also bound by the lender obligations in those notes. When loan servicers deal with borrowers, they have to perform the same responsibilities as the banks do, to the extent those responsibilities are in the loan documents. There is little difference there.

    Frankly, if you signed a contract with a bank, and tried to do something within that contract (Even if the loan had been sold), and the new owners didn’t do it correctly, you ought to be able to sue *the original bank*, which, after all, had a legal requirement to actually make sure the people they sold their end of the contract to would follow the contract.

    That will fly like a lead balloon. Banks don’t have a legal requirement to follow through and make sure that the buyers of their loans are meeting their legal obligations. If I recall, loan documents specifically state that the note may be sold to a third party and that the bank itself is not responsible for any claims that arise after the note is sold. Borrowers sign with the language in place.

    That’s insane. The real estate equivalent of that would be me developing a building, leasing it to a tenant, selling it to a third party and having the tenant sue me for a dispute he/she has with a new owner because it’s my job to make sure the owner follows the provisions of all the leases long after I sell and walk away from the investment. I’d never agree to that kind of arrangement.

    If both my concerns about mortgage securities are addressed, namely, that there is *no incentive* to lie when making them (And that’s different from such lying being illegal)

    Done

    and there is *actual management of these securitized mortgages like if a bank holds the mortgage*, I have no problem with them.

    And done. See, that wasn’t so bad now was it?

    And I *really* doubt either of those things are possible in today’s climate. And the later issue probably requires a real holding company instead of a security.

    Since I have so kindly provided you with a lesson on the way the world works, you can evaluate your own statement and tell me where you are in error.

    When *corporations* trade derivatives, they know what they’re doing.

    Really?

    Report

Comments are closed.