CDOs and Financial Scum Are Important, but the Underlying Problem Was Big Sh-tpile

Or, if you prefer, the housing bubble that started well before the onslaught of CDOs. First, let me point out for readers that ScienceBlogling Mark Chu-Carroll’s description of the latest Vampire Squid Goldman Sachs scandal is perhaps the clearest and most concise description of the whole CDO problem. Having said that, CDOs weren’t the fundamental problem. The fundamental problem was a housing bubble that existed before CDOs became rampant–although CDOs probably ran the bubble up further. But as I’ve noted elsewhere, housing prices were already wildly inflated .
Dean Baker lays out the basic problem:

For the 87,865th time, the collapse of the bubble led to a falloff in annual construction (residential and non-residential) spending of more than $600 billion. The loss of $6 trillion in housing wealth led, through the housing wealth effect (this isn’t radical — it is as old an economics doctrine as you’ll find) to a loss of close to $400 billion in consumption demand. That gives a combined loss in demand of more than $1 trillion and hence a really bad recession.

The bubble represents a far larger problem than fraud.

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10 Responses to CDOs and Financial Scum Are Important, but the Underlying Problem Was Big Sh-tpile

  1. Ken says:

    Thats just another diversion. The bubble was created by banks intentionally giving out mortgages that people couldnt afford. Bigger and bigger mortgages to force prices higher … to make it very profitable to foreclose on bad mortgages, effectively stealing houses to resell at higher prices over and over.
    A banker i chatted with while on a vacation a year before the collapse confirmed my theory. He was on his way to a conference where the financier who came up with the scam was going to be honoured.
    The bastards just didnt know when to stop, when it was obvious the system was in trouble they kept going knowing the government would be forced to bail them out.
    … except of course in Canada where banks cant give mortgages to people who cant afford them.
    Canada was hurt pretty bad by the side effects of the crash … thanks America … but we’re in far better shape than most of the affected countries (growing at nearly 6% so far this year) because of our stronger regulations.

  2. Eric Lund says:

    I agree with your underlying point but not your terminology. As I see it, the housing bubble predated Big Shitpile.
    Yes, there was an obvious housing bubble in a lot of places. It was there by 2003, when I realized that I wouldn’t have been able to afford at then-prevailing market prices the house I had bought just five years earlier at only about 3x my much smaller income at the time of purchase. (I live in New Hampshire.) There were bubbles in lots of places: most obviously Florida, the West (in many places people retiring out of California drove up real estate prices in the places they moved to), and the coastal Northeast. Other places, like Cleveland and Detroit, turned out to have steady house prices sustained by what turned out to be purely artificial demand. But other places, like Texas, never really had a price bubble.
    What the CDOs did here was allow the bubble to go on quite a bit longer than would otherwise have been possible. Lots of money was out there chasing yields (interest rates were kept low for a long time), and securitization meant more money available for mortgages. This is where the loosening and eventual abandonment of underwriting standards came in: the demand for investment in mortgages vastly exceeded the supply of creditworthy borrowers. The reason it became known as Big Shitpile is because these toxic loans were securitized and sold off to investors, leaving more capital available for even more of these loans. The point is that most of the really bad loans didn’t happen until the 2004-2005 time frame, after the bubble was well underway.

  3. Russell says:

    Yeah, but keep in mind that the CDOs and related instruments drove housing prices higher, by motivating all the various creative mortgages.

  4. Russell says:

    BTW, I’m not saying there wasn’t a housing bubble anyway. But all the derivatives definitely drove its later growth. Also, while we may have had a recession, without the financial bullshit, government stimulus could have focused elsewhere than collapsed financial firms.

  5. william e emba says:

    Mark Chu-Carroll, unfortunately, does not know what he is talking about here, and his article has been severely criticized for its incompetence.

  6. Art says:

    He is not wrong. The core of the problem was the housing bubble. But the bubble that was on the verge of collapsing in 2005-6 was allowed to grow much larger by being propped up by investors who used CDOs to bet against the housing market. CDOs that multiplied the risk and damage when the balloon burst. The Goldman Sachs scandal is just one of many where people played both sides and rigged the system to pay off big by betting the bubble would burst.
    Timely buying up of sub-prime mortgages was used to prop up the failing bubble and to buy time, several years, to effectively cement profits by over-insuring against the bubble’s collapse. It was the equivalent of seeing a person committing suicide by jumping out a window and buying a stack of life insurance policies on him before he hits the ground. You know his demise is a sure thing. You know you can multiply your money by buying insurance.
    The bubble was going to burst. It was a certainty. So Magnatar, and others, delayed the housing market failure by buying the sub-prime trash and betting against them with CDOs. In fact having the tranches assembled to their specification so the would fail in a timely manner.
    And while the initial bubble was huge dangerous the people investing in CDOs allowed it to get bigger, and made the crater even deeper, by guaranteeing that their CDOs got paid off, at face value no less, before the shit pile of bad mortgages could addressed.
    What would have been a terrible calamity in 2005-6 became the dire straits we see now.

  7. Moopheus says:

    The book Econned by Yves Smith has more detail on the Magnetar trade. Indeed–without the housing bubble, the GS and Magnetar deals wouldn’t have happened; they just made the big shitpile bigger and more unstable. They didn’t create it in the first place. It was the central bankers–Greenspan, the BOJ, the ECB, etc.–who did that.

  8. My understanding is that the really big problem in terms of the near collapse of credit wasn’t CDOs per se–although they did fuel the bubble by drawing large amounts of money into mortgage lending–but rather credit default swaps (CDSs). Credit default swaps are insurance policies on debt instruments so that if the debtor defaults, the CDS pays off to the holder. The issuer of the CDS receives premiums in exchange for insuring the risk.
    The problem with CDSs is that–unlike normal insurance–you don’t need to have any financial or personal interest in the debt instrument being insured. It is basically like buying fire insurance on some fucking random house in Toledo. In other words, it is pure unadulterated gambling, no different than the sports book in Vegas.
    This leads to two big problems that increased the leverage of the entire system and led to a near complete collapse of credit. (1) Multiple CDSs were issued on the same CDOs. (2) (This part I understand only very poorly) Something called synthetic CDOs can be constructed as a counter-instrument to CDSs, which amounts to further betting on crazy shit.
    So, the end point of all this is that for every million dollars of an increasing principal piece-of-shit mortgage that was never gonna be paid back, there were multiple millions of dollars of gambling going on between financial institutions. This created a complex web of indebtedness that amplified the effects of the one million dollar defaulted mortgage into multiple millions of dollars of drag, and this is what nearly collapsed international credit flows.

  9. Canada was hurt pretty bad by the side effects of the crash … thanks America … but we’re in far better shape than most of the affected countries (growing at nearly 6% so far this year) because of our stronger regulations.

  10. Wow says:

    “The bubble was created by banks intentionally giving out mortgages that people couldnt afford.”
    Here’s how you can work out why that’s complete bullshit.
    Look at the total money invested in homes for the underprivileged.
    Look at the total money invested in derivatives (especially naked derivatives).
    The money disappeared because people were betting on stocks going down. Stock they hadn’t even bought.

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