The Tea Party Is Wrong

[caethan]

So, ostensibly, I should be behind the Tea Party movement. I have Republican leanings, I'm strongly conservative, anti-federalist, etc., etc. My general political leanings align with their claimed ideals. So why can't I support them?

It's one issue: TARPThe Tea Party have been systematically driving out TARP supporters from the Republican

Comments

[caethan]

Yes, this is all based around these mortgage-backed securities, but not in the way that you seem to think. Things went bad because those mortgages were mispriced, but just mispriced mortgages alone wouldn't have caused the crisis.

Suppose that we're in an alternative world, where mortgages are bought and sold by themselves. So you go to your local bank, they loan you money to buy a home, and collect payments from you over the course of the mortgage. Or they can sell that mortgage to someone else to get that payment stream. Other banks that don't want to deal with mortgages themselves can buy up bundles of mortgages to hold as assets. These mortgage bundles are relatively liquid: banks are willing to buy and sell them because their value is pretty well defined.

Now, if Bank A systematically misprices its mortgages and gives out loans to people highly likely to default, then eventually everyone holding Bank A's mortgages is going to lose money. As soon as the mispricing becomes apparent, the market price of their mortgages is going to drop to reflect the newly recognized risk. That's bad for those holding the overvalued assets, but the mortgage market is still liquid. No crisis yet.

What happened in our world was that those mispriced mortgages got wrapped up in complex securities that made it hard to tell who was holding the bad mortgages. Say you run a bank. You buy up a couple thousand risky mortgages and want to sell them off to investors, benefiting from your pooling of the risk. The simplest way of then selling off those mortgages is to average them. You bring in all the income streams from the mortgages, total them, and divide them between everybody who buys shares of your new mortgage-based security. But you can do more: divide up the package into tranches. Then say anyone who buys the first tranch of shares gets paid off first from the mortgage income. Then the people owning the second tranch, and so on. Then someone else buys shares of these securitized mortgages and builds their own security on top of them. Etc., etc.

Everybody holds these securities, and they're nicely liquid for the moment. Easy to sell. Then, suddenly, we find out that some of the mortgages all these securities are based on are badly mispriced. In fact, a lot of the mortgages are mispriced. Who's holding them? It's extremely unclear which of the securities are going to be devalued by the news, and so the market freezes up, as everybody stops trading in fear that someone's going to try to unload worthless securities on top of them.

Banks have been holding these securities as liquid assets, because so far, they haven't had any problems trading them and holding securities earns them some income over cash or T-bills. But suddenly their assets aren't liquid anymore. The market volume tanks and the market price tanks, because nobody is willing to buy assets that they can't value.

Again, the problem is not that the assets are worthless! >80% of the mortgages these assets are based on are still perfectly good, so we wouldn't expect the total hold-to-maturity value of all the mortgage-backed securities to drop by more than 20%. But the market value drops because nobody's trading them, nobody knows how to evaluate what any particular security is actually worth. So the feds come in and offer to buy up (i.e., trade for T-bills) all of the distressed assets for market price --- which is way lower than the hold-to-maturity value that the feds can eventually expect to recover from them.

Note that this is only a smart move on the feds' part because they actually can buy up a substantial fraction of the distressed assets. If they didn't buy all or nearly all of the securities, banks could try and selectively sell off the securities they thought were most likely to drop in value.