What's up with the economy?

[Mesteryo]

From a Canadian paper:



Whenever markets really tank, I phone my friend Laura. "Help," I said yesterday. "What's happening?"

"The lipstick has come off the pig," she said.

"This is scary," I said. "How could so many smart people be so wrong?"

"Because they were getting rich. They were manufacturing product out of thin air and collecting fees every which way. And greed just overtook them."

"The models said there would be some defaults, but not too many," Laura explained. The models were wrong. Today, around 30 per cent of the people who bought houses between 2001 and 2007 have what's known as "negative equity," and they're walking away.

Meantime, investment bankers like Lehman Brothers got rich by taking more and more risks. "Let's say you have $100 and you can make $10 on that. But what if you have $5 and borrow the other $95? Your returns are way higher. That's essentially what the game was."


http://www.theglobeandmail.com/servlet/story/LAC.20080916.COWENT16/TPStory/National

[Warpy]

1. Laura's a smart lady but she missed a few things

First, the esoteric formulas were designed not by math PhDs but by economics PhDs, a few of whom won Nobel prizes for their efforts, indicating those prizes are handed out by judging a lifetime of research on its level of impenetrability.

Second, while the idea of borrowing $95 to get a $10 return on a $5 real investment covers things like naked shorting, what really happened with home mortgages is a hedge fund looking at the payback over the life of a mortgage (300% of the loan in most cases) and deciding they could market the whole amount as a security. Thus banks are now holding paper that depends on someone having a job for 30 years and paying the mortgage in full. Since 30% of that money has now evaporated, leaving a property worth less than the original amount of the loan, banks are essentially stuck with worthless paper. Add to that the fact that hedge funds clipped those mortgages into little pieces and sold them to several different outfits, nobody knows who owns what any more. That bank you're paying the monthly whack to is only servicing a mortgage. They no longer own it.

Third, Canada is not immune. Bad paper infects every institution worldwide, from governments and central banks down through insurance companies, pensions, and every other institutional investor.

However, the lipstick has finally come off the pig. She's sure right about that one.