The current state of affairs feels different from 2008, when the crash was caused by the overexposure of banks to the US housing market, and turbocharged by the widespread use of new financial instruments that were supposed to reduce risk but did the opposite.
Everyone in financial markets knows you cannot reduce risk. You can, however, slice and dice it and spread it. Thereby reducing the risk to any one specific position or market participant. That also means that you can concentrate risk in a position to to a particular market participant which may or may not be one of those grand ideas.
Those mortgage pools with the income streams sliced and diced by risk. Worked exactly as they were supposed to. The risk of non-patyment was concentrated into those C tranches – the “equity” tranches. The AAA tranches were supposed to be credit risk free. Because the C, then B., then A etc tranches would all have to go bust first.
This all worked exactly as planned. The C tranches all did fall over. The AAA tranches kept paying out and some of them are even still doing so – tho’ getting to be pretty small now as repayments/remortgages happen.
Risk was spread – that’s why German banks went bust when American mortgages soured – they’d bought C tranches perhaps. You know, spreading that risk?
There was also concentration. No rational bugger wanted to buy thsoe C tranches but given the risk they paid higher rates than it cost to finance them with wholesale money on a bank balance sheet. So, banks loaded up with them. Vast, vast, piles teetering on tiny capital bases. So, when they all went bust – both dispersion and concentration of risk, see – then the banks were, umm, in serious trouble.
Everyone agrees you cannot reduce risk. But you can allocate it. The error was in who piled in to carry that risk, not the slicing and dicing of it. If those C tranches had been in hedge funds, backed by proper capital bases, no GFC. Of course, hedge funds weren’t stupid enough to take that risk but that’s another matter.
Here’s my general take on what is going on with “ai” tech stocks, and it’s mostly not being driven by Wall Street. There are two things going on which are driving the current US market: ETFs like VOO and QQQ, and cheap app trading.
I think Covid caused it, because once people couldn’t go to Vegas, or to a local Indian casino, they had to find another place to gamble. Which co-incided with the rise of cheap trading on stocks, options, crypto. The USA really don’t like online gambling, as in, roulette apps, so how do you get your fix? Why not trade crypto or stocks. Especially as the casino isn’t taking much of a cut. And once this habit started, lots of people continued with it. You can gamble on anything. Why not dogecoin instead of Red Rum?
So you get this huge influx of new, retail money. And it pushes up things that lots of retail investors are into. And as that’s young men, it’s not Walmart or Estee Lauder, it’s technology, cars. So money piles into the likes of Tesla, and now Nvidia and Oracle.
Then you have the ETFs. Because people got ripped off by financial advisors, because no-one particularly trusts all those banks, because ETFs got created and could be easily traded, people started buying them. Not a half bad idea. But a lot of money is going into 2 particular: funds based on the S&P 500 and Nasdaq, VOO and QQQ. And this has pushed both up a lot. Not just the tech companies, but also, the likes of Walmart and Estee Lauder. But the tech companies are a huge chunk of the market now. The ETFs then feed back into share prices. Blackrock etc have to buy more shares as more money goes into ETFs, shares go up. People see Tesla going up, they buy more Tesla, the ETF rises in price. People are just saying “put your money in VOO and leave it” all over stock forums.
The S&P 500 is generally high. Take the measure of P/E or Graham Number, it’s high. P/E of 28. Dotcom bubble levels. I’m mostly out of there, except a little UNH. I’m sure I’m missing out on gains but something is going to trigger a crash and I’d rather not be around when it happens.
“The USA really don’t like online gambling”
Sure they do. As long as the government gets their cut. The persecution you see is to get the casinos to give them that.
I thought one of the problems was that the rating companies were in effect rating for cash? That the designations A, B or C etc were (to quote The Big Short) dogshit?
I love The Big Short but there is a lot of the thing of people saying things to each other that everyone in the room knows. Like I knew, going back to Enron, that ratings had to be taken with a pinch of salt. People pay to get a rating, the agency isn’t going to totally take the piss, but they’re going to come up with the most favourable version.
I was talking to a mate in 2004, I think, about the UK housing market. And all the list in the “Jenga” scene were in there, like 100% mortgages, no income verification. As the loan-to-income ratio rises, it gets harder to lend to people. Instead of banks sitting back, they ease restrictions so they can keep lending. Line is going up, so why won’t it continue. Except that loan-to-income has hard limits. People can sell off granny’s jewellery to buy a house, but at some point, there’s nothing left. I knew there was a bubble years earlier. When it was going to crash, I didn’t know. I thought sooner than 2008 but there were various things that kept it going longer.
Most of this is really just exuberance. Lots of people think that the line will continue its current trajectory and that’s simply not how markets work. Things get too expensive, or super profits lead to new competition.
The whole AI thing is going to go pop. My guess, OpenAI are going to float, a whole load of hype around them, huge, huge market cap. And it’ll hold up for a while and then people will start asking where the profits are. OpenAI becomes the next Snapchat. And all the companies under them, all the suppliers to all this AI bubble fall too: Oracle, hosting all the Nvidia kit. Nvidia, producing the kit. All the companies people are currently talking about doing warehousing. The best sign that the AI bubble was peak was the government talking up building more data centres. By the time it hits some idiot Labour minister, everyone is on it. If I was into options, I’d go for some sort of put option on Oracle just after OpenAI floats.
In the US the housing bubble was very heavily promoted by the Feds. Home ownership is good, let’s have more of good things…
There’s video of a pol at the time (Barney Frank, I think) saying something like “I’d like to see the gov’t taking more risk here”.
Regarding the “C tranche mortgages”… As a very conservative and reasonably successful investor it always struck me as rather odd that the concept of lending money to people who had previously been considered too poor/risky to pay it back had been considered a sensible idea by the “big brains” of the banking industry.
“it always struck me as rather odd that the concept of lending money to people who had previously been considered too poor/risky to pay it back had been considered a sensible idea by the “big brains” of the banking industry.”
It was very sensible, if you could then sell the high risk mortgages to some other sucker as a CDO…….the trick would be not to be holding any of the crap when the SHTF.
Sorry that’s wrong.
The risk was assessed incorrectly, so mortgages that should have been C were stuffed in AAA and the resulting package sold as such.
Can’t prove bribery to put them in there, but it’s likely. If not, there was certainly incompetence to go around. And government pressure to “get people in homes”.
Everyone in the mortgage rating agencies should have been fired and forcibly rusticated, i.e. not allowed to work anywhere in the financial industry again. Start them again from the ground up.
No, if that were true then the AAAs would have gone under. They didn’t. So, it’s not true.
The whole point was that if you took a whole pile of dodgy – C – mortgages and then sliced and diced you could create a series of bonds. The lowest grade tranche carried the first risk of default. Then the next one up etc. So, C tranche goes bust if 10% (made up number) of the mortgages default. B is 20%, A if 30#% etc. The AAA only goes bust if 50% (again, made up numbers) do.
The entire point is that you *can* put objectively C grade mortgages into this structure and yet still end up with part of the pool, that AAA tranche, righteously rated as AAA.
And it worked too. The C tranches – certainly those late in the game – all did go bust. Near none – if any – of the AAA did.
Everyone agrees you cannot reduce risk.
Yes you can, e.g. by not lending money to people who won’t pay it back.
Are you suggesting that Ms Lewinsky’s felatee introduced the Community Reinvestment Act purely to get votes and not because it was a prudent way to run a banking system?
“Honi soit qui mal y pense.” as the man said.