Journeyman writes:
I suspect my brain will hurt soon.
Journeyman | 09.25.07 - 10:58 am | #

k harris writes:
So this is not a "major Ubernerd" effort. The simple explitive of clipping and pasting to Word demostrates that this is a 6 page text (at 12 pitch). How many pages qualifies as "major", fer Buddha's sake?
k harris | 09.25.07 - 11:02 am | #

k harris writes:
That's "expletive" ... er something. Sorry.
k harris | 09.25.07 - 11:03 am | #

Broward Horne writes:
The subprime debacle doesn't need to be this complicated. The simple matter is that traditional mortgage rates began a long-term rise in 2003. But to maintain the 20-year RE bubble, lenders increasingly switched to short money from 2003-2007 until the sad, sick game played out.

Interest Rate Converging Triangle

The current outcome was predictable in 2005. You don't get to substitute "loans" for "income" without getting "bad effects" in return.

No free ride, no matter how you cut and slice mortgage rules. Free trade has undercut the ability of the middle class to buy stuff and substituting loans won't fix it.
Broward Horne | Homepage | 09.25.07 - 11:06 am | #

Tanta writes:
If this had been a major UberNerd effort, you would be struggling with the negative of the first derivative of the price function and McCauley durations as opposed to simple linear duration. And there would have been at least one attempt to supply you with a graph so that you can understand convexity.

But CR's internet connection went down, and so I heroically decided to publish this unfinished masterpiece. And what do I get?
Tanta | 09.25.07 - 11:07 am | #

Metrics Wonk writes:
Careful CR, a few more headlines like that and the Daily Show might try to hire you.

Classic.
Metrics Wonk | 09.25.07 - 11:08 am | #

F. Frederson writes:
Only economists would be so irrational as to think people would want to waste any part of their short lives thinking about the crap economists like to think about.
F. Frederson | 09.25.07 - 11:20 am | #

calmo writes:
Marvelous critique madam. An English background is moidering these non-English (possibly non-Economics, non-Finance, non-Commerce...) professors.
Hard not to make the shill call on these somewhat dull "tools"...working for their short term interests and no one else's.
calmo | 09.25.07 - 11:22 am | #

Metrics Wonk writes:
How can you not assume a predilection to bad acts for a dangerously high number of lenders? I mean most undergrad econ programs usually make you sit through some economic history courses, no? I think these folks need a refresher.

Thankfully prepayment penalties are illegal in NJ. We seem to get all the mortgages we need. I don't understand why the rest of the country puts up with them.

But a total prepayment ban... just wow.
Metrics Wonk | 09.25.07 - 11:25 am | #

Patrick writes:
Link to the working paper:

http://www1.gsb.columbia.edu/myg...%20design% 2Epdf
Patrick | 09.25.07 - 11:26 am | #

Robert Coté writes:
I think CR & Tanta need to collaborate on a combination UberNerd + UberChart that shows the flow of funds and flow of debt from the borrower to the orginator and through the bundler to the wholesaler into the tranches past the bond securities sellers into the investor portfolios and out the other end. The part I'd like to see it the how much of a cut or pieces of the flow each financial step takes between the reatial borrower and ultimate lender.
Robert Coté | Homepage | 09.25.07 - 11:28 am | #

bacon dreamz writes:
And what do I get?

complaints from nerds who can't bear to live without understanding oas?
bacon dreamz | 09.25.07 - 11:29 am | #

bacon dreamz writes:
i think i have said this before, but one reason investors (used to) like subprime and alt-a arms is because of the better convexity relative to prime. poor people don't exercise their options quite as efficiently as rich people, and they tend to 'cure' and payoff at some sort of 'predictable' speed that is theoretically not rate sensitive.
bacon dreamz | 09.25.07 - 11:32 am | #

Peripheral Visionary writes:
Thanks for the write-up Captain Tanta, very helpful. I was actually fortunate enough to take a graduate-level banking class from a professor who had helped pioneer credit card securitization, so some of the UberNerd material has been familiar, but the additional detail and insights are very good.
Peripheral Visionary | 09.25.07 - 11:34 am | #

Ministry of Truth writes:
Can't we just bring back the old days of slavery to reduce the risk on debt and increase investor profits?
Ministry of Truth | 09.25.07 - 11:35 am | #

Tanta writes:
poor people don't exercise their options quite as efficiently as rich people, and they tend to 'cure' and payoff at some sort of 'predictable' speed that is theoretically not rate sensitive.

Unfortunately, we blew that when we created such "flexible" guidelines and amortization tactics that poor folk could be just as "rate sensitive" as their betters.

So now, the idea is that we put everyone in an Option ARM without the right to prepay, making all borrowers poor borrowers! It's great, because then MBS investors make more money!
Tanta | 09.25.07 - 11:37 am | #

Jim a writes:
I wonder if they ever mention the pricing for the increased risk of default inherrent in ARMs? In a conventional 30yr Fixed Rate Mortgage with 20% down, the lender (or bondholder who is the ultimate lender) pays a premium (could have gotten better returns elsewhere) because the chance of losing principal is miniscule. That USED to be the reason to buy MBS. The risk of principle loss was near to that of treasuries. And it went down as the loan matured. But about mid2003-early 2007 we've been gettig option-teaser-rate-neg-am cr*p that kicked the big default losses 2-3 years into the future. The future is here and it's not pretty.

At some level it's always been about having those who can estimate risks better charging those who can't for the privelige. Traditionally, banks charged an interest rate premium so that THEY would make informed decisions about future interest rates, and give fixed rate loans to consumers. Now, we have bonds whose rates are based upon the relatively naive risk assesments of the bond buyers, informed as they are by the rating agencys who are paid by the people selling the bonds. So the mortgage companies, instead of making an extra half a percent because homeowners were unwilling to commit to an ARM, were making several percent from bond buyers who seemed to assume the the nadier in defaults from 2001-2004 was a permanant situation, or at least that THEIR borrowers would refinance by then.
Jim a | 09.25.07 - 11:37 am | #

Peripheral Visionary writes:
Rob, the professor I took the banking class from did a percentage breakdown on the payments from a credit card securitization. Granted, consumer credit is a different animal, especially since principal payments are much more uneven. But the one thing that surprised me was the sheer number of institutions taking a cut--not just the (many) tranches of investors and the servicer(s), but other intermediaries who took a cut to provide the origination or some form of other service, such as insurance.

As long as the money flows, it's a very lucrative game for everyone, but when it dries up . . .
Peripheral Visionary | 09.25.07 - 11:39 am | #

calmo writes:
Ministry of Truth makes an oblique reference to those 12M illegal aliens.
calmo | 09.25.07 - 11:40 am | #

bacon dreamz writes:
Unfortunately, we blew that when we created such "flexible" guidelines and amortization tactics that poor folk could be just as "rate sensitive" as their betters.

teaser surfing...
bacon dreamz | 09.25.07 - 11:42 am | #

Monkey In Chief writes:
Fixed rate mortgages without prepayment penalties would not exist without GSE intervention in the market. In other countries where there is not intervention, like the UK or Germany, no such product exists.

We take the 30 year fixed mortgage as the baseline option in this country but its not a natural creation of the market. Thus, its not at all surprising that lenders in segments of the market not served by GSEs push ARMs instead of 30 fixed loans.
Monkey In Chief | Homepage | 09.25.07 - 11:43 am | #

Journeyman writes:
If not a major uberNerd post then perhaps a major rant? In any case those academics seem to be in elementary school where we got the idea that 12 lbs. of feathers would have the same effect as 12 lbs. of bowling ball. Or maybe they just work for the BLS.
Journeyman | 09.25.07 - 11:44 am | #

seminole writes:
bravissimo!!
seminole | 09.25.07 - 11:46 am | #

Tanta writes:
We take the 30 year fixed mortgage as the baseline option in this country but its not a natural creation of the market.

C'mon, "natural creation of the market"? Why here's a long paper from some economists on how much of $50 billion we'll have to spend on re-education camps for borrowers to get them to do their part in the "natural creation" of a market for Option ARMs.

I entertain myself by wondering just how unspeakably bad customer service would get if you all didn't have the right to prepay. Don't any of these people ever read Dilbert? Gawd . . .
Tanta | 09.25.07 - 11:47 am | #

bacon dreamz writes:
p.s. i would say anthony burgess is a language UberNerd. i once tried to say 'horrorshow' in casual conversation, and was met with blank stares...
bacon dreamz | 09.25.07 - 11:49 am | #

Tanta writes:
Because I'm curious, does anyone know if these two economists are Soviet defectors?
Tanta | 09.25.07 - 11:50 am | #

bacon dreamz writes:
they're secretly trying to bring down america from the inside...with option arms!
bacon dreamz | 09.25.07 - 11:51 am | #

RW writes:
I vote we spend a few billions on educating mortgage brokers and, in exchange for this beneficent service at public expense, their licensing will henceforth legally bind them as fiduciaries of the borrower.

As to the article by the good professors, the conclusion appears perilously close to Orwellian New-Speak: Love is hate, freedom is slavery, and debt is wealth.

It is touching however that they seem to believe borrowers should be more concerned about investors than they presumably are; too focused on their own, selfish needs doubtless. There's just not enough social responsibility and concern for our fellow citizens these days.
RW | 09.25.07 - 11:54 am | #

ftm writes:
Tanta: An off-topic question

I've been reading CR for a while and I haven't seen this issue discussed -- maybe it's not an issue.

In my dealings with banks and mortgages, I always assumed that banks which originate mortgages (say chase) held the better mortgages as investments and made MBS out of the crappier mortgages or the mortgages that met certain securitization criteria and they would appear to be better credits than the originating bank knew they actually were.

Is this a problem? And if it is, will many of the higher rated mbs likely to face problems because the better credits have beeen cherry picked from the mortgage pool?


ftm
ftm | 09.25.07 - 12:04 pm | #

Alex writes:
If it's not troublesome to state, I'm curious as to what "convexity" means in this context.
Alex | 09.25.07 - 12:06 pm | #

John writes:
Anyone else read with amazement the coverage of the hispanic family that got misled by a triple-threat loan for over $600k in california?

Over $600K! his income was 4k a month before tax!

http://www.nytimes.com/2007/09/2...ess& oref=slogin
John | 09.25.07 - 12:14 pm | #

arbogast writes:
It would look to me that my inner child's suspicion that the half point lowering by the Fed was a panic move is playing out.

It seems to me truer and truer every day that the only question in town is whether the housing meltdown can fit through the convexity of the "financial industry" to infect the entire economy.

After all, that's what even Bernanke has been speculating about for months.

Well, to mix my metaphors and parables into a veritable chaos of syllables, rich men are now pouring through the needle's eye, but...the envelope please...NOT into heaven. Somewhere farther south with a warmer climate.
arbogast | Homepage | 09.25.07 - 12:14 pm | #

sidd writes:
Alexei Tchistyi joined New York University Stern School of Business as an Assistant Professor of Finance in July 2005.
PhD, Business Administration, 2005 Stanford Graduate School of Business
MA, Economics, 1999 New Economic School, Moscow, Russia
MS, Applied Mathematics and Physics, 1998 Moscow Institute of Physics and Technology, Russia
BS, Applied Mathematics and Physics, 1996 Moscow Institute of Physics and Technology, Russia
----------
TOMASZ PISKORSKI

Personal Information: Citizenship: Poland (F-1)
Education:Ph.D. in Economics, Stern School of Business, New York University
2003 to present
Graduation Date: September 2007
M.S. in Mathematics, Courant Institute of Mathematical Sciences, New York University
2006
M.S. in Economics, Catholic University of Leuven
2000
B.A. in Economics, Warsaw University
sidd | 09.25.07 - 12:14 pm | #

Tanta writes:
In my dealings with banks and mortgages, I always assumed that banks which originate mortgages (say chase) held the better mortgages as investments and made MBS out of the crappier mortgages

Well, it would take a long UberNerd post to really address that.

Short version: depository lenders have always been more sensitive to interest rate risk than credit risk when it comes to selling loans. That's because "historically" there just wasn't this kind of range of credit quality: we used to have rather more absolute standards that every loan pretty much met. So the problem was whether you could fund fixed rate loans with variable-rate deposits or not. Thrifts and banks sold FRMs to get out of the rate risk.

Now, that meant that when they did want to do what we used to call "accommodation loans" or the riskier ones from a credit perspective, they did them as ARMs, because they would have to hold them in portfolio (MBS investors in those days not wanting junky credits). But since ARMs add even more risk to the loan, portfolio lenders were quite pissy about LTV limits. You can structure an ARM for a riskier borrower in such a way that the risk profile is comparable to a fixed, if you demand a big enough down payment.

The environment of the last several years has scrambled these assumptions. Part of the problem is that the media insists on seeing loan sales as primarily about getting out from under credit risk, not about getting out from under rate risk. It's hard to see the mechanisms, of course, when we started securitizing ARMs so much. In any case, I think you have depositories out there who kept the best loans and depositories who kept the worst loans, and that we'll find out for sure which is which in a little bit.

I need not mention, I'm sure, that Option ARM is a very popular portfolio product--at least as many of those were held as securitized.
Tanta | 09.25.07 - 12:17 pm | #

arbogast writes:
In addition, the euro has resumed its ascent.

The US is [rhymes with plucked].

The Saudis are dropping the dollar peg. As if it wasn't enough to destroy the World Trade Center.

No conspiracy theory there. It was Saudi's who flew the planes into the World Trade Center. I guess they were "bad" Saudi's as opposed to the "good" Saudi's who are now abandoning the dollar peg.

[rhymes with nun-chucked]
arbogast | Homepage | 09.25.07 - 12:19 pm | #

Tanta writes:
If it's not troublesome to state, I'm curious as to what "convexity" means in this context.

I'll do a follow-up post on that, I promise.

It has to do with the shape of the curve you get when you plot the duration of a mortgage-backed bond with price on the vertical axis and market interest rates on the horizontal axis. A "vanilla" bond (not mortgage-backed) will display "positive convexity," or a slightly convex curve wherein the price of the bond increases as prevailing rates drop, and it decreases when prevailing rates rise.

Mortgages, because of that prepayment option stuff, display an odd-looking curve that is described as "negative convexity." The price of a mortgage bond rises relatively slightly, and then flattens out, in a falling rate environment (because of all the prepayments). It also drops more slowly than vanilla bonds do when rates rise. All of that is relative to the original spread on the loans, or how far above or below "market" the loans were when they were originated.
Tanta | 09.25.07 - 12:24 pm | #

gm writes:
c'mon

they are simply being set up. they don't realize how irrational 'political' real estate (mortgage) finance is. so, in the realm of mathematical models their theory is probably very strict and has a chance versus other academicians, but to tear them apart in a public forum is just unfair. i think they didn't expect the uproar. remember there were no mortgages in the Soviet bloc, the state regime owned everything and at some point they were dreaming of eliminating money from economy altogether, so don't blame them for their zeal.
gm | 09.25.07 - 12:24 pm | #

JKB writes:
"maybe it makes sense to get people to behave rationally through extensive, even expensive, consumer education."

Isn't this what we are doing right now. The "market crisis" is providing extensive and even expensive education. Only it is educating both borrowers, lenders, and investors.

Also, if you be have rationally, you don't pay $600k for a POS tract house. In this bubble, people have made a lot of money off irrationality of buyers and borrowers, if were start behaving rationally, owners will have to really cut their prices and lenders will find their churning fees never return.
JKB | 09.25.07 - 12:26 pm | #

we are all screwed writes:
Wow, nice post. Have you read Smartest Guys in the Room, about Enron. The language Pisoroski (sp) uses sounds eerily familiar to the language that Lay used to lobby for deregulation in the energy business.

When you have a group with specific interests (the banks, IB's, etc...) arguing these programs are in the best interest of consumers, they just don't know it yet, but there are obvious huge advantages to the people creating the products, disaster seems to follow.

It seems to me that our society salivates over anything that gets us things now while at the same time ignoring the future. This thinking has to stop, because guess what, there is a tomorrow.
we are all screwed | 09.25.07 - 12:26 pm | #

Julia writes:
Tanta and all,

http://www0.gsb.columbia.edu/who...io.cfm? id=56899

for full text (I'm not sure anybody wants to check it up). This guy just joined Columbia's Business School as a fresh PhD graduate, he's fresh from the oven. Chances are he will become more and more detached from reality with time.

Something I've noticed about Columbia Business School is that in their eagerness to establish a real estate oriented MBA, professors in the area looked away when asked if there was a bubble.

They became more optimistic than the NRA! Christopher Mayer believes that the 'superstar quality' of few cities could explain most of price increases.

I heard a REIT class prof saying that salaries will need to double, as real estate prices will keep on increasing for sure ... After that, she dropped the typical "that's what people are saying!" so widely used to "support" baseless statements.
Julia | 09.25.07 - 12:26 pm | #

Julia writes:
ups...

i meant NAR, not NRA!
Julia | 09.25.07 - 12:32 pm | #

ftm writes:
Thanks for the extended response.

Sounds like the recent dynamism of the mortgage market has probably interfered many institutions' attempts to beneficially manage mortgages held for investment.

The Ubernerd posts are a great so don't hold back if you feel one coming on.






ftm
ftm | 09.25.07 - 12:38 pm | #

psychodave writes:
"i once tried to say 'horrorshow' in casual conversation, and was met with blank stares..."[bacon dreamz]

Next time try rolling the "r"s, like in Spanish. It'll work most every time, I promise.

moloko bar should've gone quite smoothly, did you try that?

Meantime, regardless of how delightful I find the subtle and delicate pirouette of flirtation in which you and Tanta engage, please tell me

WHAT, in the ever lovin' blue-eyed world,
is "OAS",
when its at home?
psychodave | 09.25.07 - 12:39 pm | #

Southern Rock writes:
You can find the PDF file of this paper in the link below.

This is a highly theoretical paper in which stupidity and irrationality are assumed away from the beginning. The authors are students of Tom Sargent, the rational expectation school.

The focus of this paper is the design of the optimal contract where both interest rate and the borrower's income are volatile. It's not hard to imagine that payment flexibility options turn out to be a good thing in such a simplified world.

An interesting academic exercise, but it has very little relevance to the current subprime debacle. Just that journalists love to poke fun at eggheadedness of academics...
Southern Rock | Homepage | 09.25.07 - 12:44 pm | #

Greg writes:
As for banking/economics skills of ex-USSR types, here's my favourite quote: "Russia's finance players have extraordinary mathematical skills, but not much common sense," said Eric Kraus, managing director of the Nikitsky Fund. "They were beginning to introduce modern financial techniques borrowed from the U.S., and had they had another 18 months, it would have blown a bubble, causing real damage to the sector and the underlying economy."

From an econ perspective, you could easily turn their (fatuous) argument around and say that "you" could ban prepayment penalties, teaser rates, and high LTV loans for floaters. Lenders would have to offer pricing as close to the 'fair' lending rate as possible - if they overpriced, everyone would prepay as soon as the savings were greater than the processing costs. Convexity would not be a problem - loans would only prepay or default when they had a darn good reason.
Greg | 09.25.07 - 12:45 pm | #

Tanta writes:
Meantime, regardless of how delightful I find the subtle and delicate pirouette of flirtation in which you and Tanta engage, please tell me

WHAT, in the ever lovin' blue-eyed world,
is "OAS",
when its at home?

Flirtation? BD keeps dropping jargon and I keep trying to explain it, and this is stooping to conquer?

And which one of us brought up Molly Bloom, buster?

OAS = Option Adjusted Spread. It's the premium you pay over a positively-convex bond in exchange for your right to prepay. It has a lot to do with why fixed mortgage rates track 10-year Treasury prices better than they do the long bond.

The first person who works in a Faulkner allusion gets a definition of BEEM. But bacon dreamz will have to define it, since I'm dropping it.
Tanta | 09.25.07 - 12:49 pm | #

Tanta writes:
Just that journalists love to poke fun at eggheadedness of academics

Do you see the journalist in question poking fun at the eggheads?

I saw an "egghead" paper that quite conveniently extends the shelf-life of the bullshit journalists have spouted for years now about how high home prices and goofy mortgages are really "rational." Why would journalists want to pick on this idea now?

And I am, of course, picking on these eggheads by being rather eggheaded myself. (Unless you think options theory is patently obvious commonsensical stuff, in which case you must be a blast at parties.)
Tanta | 09.25.07 - 12:56 pm | #

Outsider writes:
Tanta - I'm calling your former employer. You are obviously completely recovered.

:)
Outsider | 09.25.07 - 12:56 pm | #

revro writes:
its sad to say it once again but 60% of population is plain naive and unable to handle their finances, so 30y fixed mortgage is the only product that should be alloved to general population unless they have a lot of cash in bank and the bank account says they are conservative spenders. giving arm to someone living paycheck to paycheck is criminal behaviour on side of bank officer

and to those two clowns from east block, either they are unbelievable naive or they are just plain crooks. i am strongly inclined to second, since the language they wrote screams "we want to fool you, we want fool you"
revro | 09.25.07 - 12:58 pm | #

bacon dreamz writes:
psychodave, OAS is 'option-adjusted spread'. this is an endlessly fascinating subject, and requires a very long ubernerd. essentially, though it's a way to value MBS in a dynamic interest rate environment (ie with volatility). so you use a large number of potential interest rate ( with associated mortgage rates) paths and generate the cash flows associated with each path using a prepayment model (this is how you attempt to value the refi option you're short that's embedded in the mortgages). The OAS is the 'spread' that you must add to your discount rates (say the Tsy spot curve) to equate the PV of the cash flows the the current market price of the bond. so essentially it is the spread you can earn over the risk-free rate after taking into account to embedded optionality of the MBS. did any of that make sense?

OAS = static spread - option cost
bacon dreamz | 09.25.07 - 1:00 pm | #

bacon dreamz writes:
BEEM = Bond Equivalent Effective Margin.

it's a concept used for ARMs, and is essentially the average spread over the underlying index the investors expects to earn over the life of the bond.

i will note that Tanta is paid to do this (tips), while i'm just avoiding what i'm paid to do at the moment.
bacon dreamz | 09.25.07 - 1:07 pm | #

ratefink writes:
Eureka! I've got it!

The Ludavico Mortgage!


(I was cured, all right.)
ratefink | 09.25.07 - 1:07 pm | #

sysadmin writes:
When people move, that is a prepayment on the mortgage on the old house, is it not? How do they model for moves every 7 years or whatever the current average is?
sysadmin | 09.25.07 - 1:11 pm | #

revro writes:
and i forgot the most important part. in my wonderfull country theres no 30y fixed rate. yes we have 40y, 120%, ninja and other exotics created for the secondary market as purchase money since there are too many problems with mbs.

i think i will go to bank just for fun to see the stupid look at the face when i ask them info about 30y fixed mortgage xD could be really funny, well the people in bank have economy school but well schools in east block are not about thinking they are about memorizing. maybe this two gentleman are just too brainwashed :)
revro | 09.25.07 - 1:14 pm | #

psychodave writes:
"did any of that make sense?"

Yes, but if you tell anyone I'll have to kill you.

Seriously, let me know if the two following redactions are erroneous:
1)to equate the PV of the cash flows the the current market price of the bond
to equate the PV of the cash flows to the current market price of the bond

2)after taking into account to embedded optionality of the MBS
after taking into account the embedded optionality of the MBS

Thanks to both of you (bacon dreamz & Tanta) ... (the two of you make a lovely couple)
psychodave | 09.25.07 - 1:16 pm | #

GP writes:
ARM's have never value compared to a comparable 30 year fixed rate loan without offering some form of gimmick to induce the borrower to accept. The fact that the term "teaser rate" can be presented to a borrower without blushing shows how tone deaf the industry is. I mean, come on. what does "teaser" mean?

Tease - V.; To arouse hope, desire, or curiosity in without affording satisfaction.

Teaser rates (called introductory rates by better salesmen) are simply designed to deceive. The implication was that in exchange for giving up the security of a fixed rate a borrower could get a better deal on a loan that allowed the interest rates to fluctuate with the market. Yet, few borrowers understood that at the end of the teaser rate period that their interest rate was guaranteed to increase by usually over 200 basis points even if the market rates remained constant.

Without a teaser rate or some other gimmick, like no down or no underwriting, an offer of a fully indexed ARM has always been a non-starter. Hence, lenders have always tried to fool the borrower and then act surprised when (in times like now) they reap what they sow.
GP | 09.25.07 - 1:18 pm | #

Turbo writes:
I think my disgust threshold with my profession (financial economics) has finally been irretrievably breached. Anyone know of any good natural resource econ grad programs? Maybe there's still time to redeem myself.
Turbo | 09.25.07 - 1:21 pm | #

bacon dreamz writes:
Thanks to both of you (bacon dreamz & Tanta)

hey no problem but Tanta gets to explain POP duration...HAHAHA!!!
bacon dreamz | 09.25.07 - 1:21 pm | #

energyecon writes:
Consumers face record winter heating costs

WASHINGTON (Reuters) - U.S. consumers are expected to pay record prices for heating oil, electricity and propane to warm their homes this winter, and low-income families will need government help to cover those bills, government energy officials said on Tuesday.

Heating fuel expenses this winter will be highest for heating oil, with the average family paying $1,834 for the season, up 28 percent or $402 from last year, according to the National Energy Assistance Directors' Association.

The group expects propane costs to average $1,732, up 30 percent or $384. Consumers that rely on electricity for heat will pay $883 this winter, up 7 percent or $58.

Natural gas expenses will be the cheapest of the major heating fuels, averaging $881, up 5 percent or $50, the group said.

[snip]
energyecon | 09.25.07 - 1:32 pm | #

energyecon writes:
Turbo,

I can recommend the Colorado School of Mines Mineral Economics program...though the out of state freight is triple the resident rate.
energyecon | 09.25.07 - 1:34 pm | #

sdtfs writes:
The first person who works in a Faulkner allusion gets a definition of BEEM. But bacon dreamz will have to define it, since I'm dropping it.

Hmmm, this paper could borrow the title, The sound and the fury.

That's a twofer :)
sdtfs | 09.25.07 - 1:34 pm | #

Tanta writes:
Tanta gets to explain POP duration

Sorry, I only do MOM duration.
Tanta | 09.25.07 - 1:36 pm | #

km4 writes:
Things are getting rough in the housing market. I wonder if this guy had an ARM

Person ditches house on the Hollywood freeway
http://www.boingboing.net/2007/0...ches- house.html

An appropriate quote...

"In the downtown area, the wheels started falling off, California Highway Patrol Officer Jason McCutcheon said".
km4 | 09.25.07 - 1:39 pm | #

Tom Stone writes:
Tomasz is a heckuva salesman,He'll pisorski down your leg and tell you it's raining.
Tom Stone | 09.25.07 - 1:40 pm | #

Alo writes:
How bout a 2nd free subscription to CR to whoever finds out who might have bankrolled this paper? The authors thank an outfit called westernfinance (westernfinance.org) that gets in turn is funded by a few investment outfits - Goldman, Barclays etc....

I know in the world of real science, you have to offer your papers up for peer reveiew, and you have to disclose how your research was funded -- do economists play by the same rules?
Alo | 09.25.07 - 1:42 pm | #

Karl Smith writes:
As a quick note, I think what the economists are glossing over (and this is from an economist) is the massive adjustment costs associated in moving to this type of world.

Its not just a matter of "rational" borrowers. Its a matter of clearing markets. If markets are perfectly competitive then eventually we will get to the point where the optimal loan always is offered at a significant discount to the 30 FRM.

However, on the way to eventually many many borrowers will be screwed to high heaven by lenders and brokers who are trying to make the most of a shifting market by stuffing clients into permanent high margin ARMs.

Not to mention there is the very real issue of hyperbolic discounting. That is the emotional interest and financial interest do not accrue according to the same formula. In effect emotional interest rises as time goes forward, causing people to care less about the future than a constant rate of return would imply.
Karl Smith | Homepage | 09.25.07 - 1:44 pm | #

DH writes:
OT-sorry everyone?

does anyone know who the FIG Trader is that posts on Seeking Alpha? I have been following their stock picks
and they have been very good. Seeking Alpha link takes me to Blogsite with no further contact info.

Thanks in advance.
DH | 09.25.07 - 1:46 pm | #

arbogast writes:
TOMASZ PISKORSKI's credentials are really quite impressive. Courant has a storied history of greatness, and Polish mathematicians in general are wizards.
arbogast | Homepage | 09.25.07 - 1:51 pm | #

RayOnTheFarm writes:
Find some way to insert "peer reviewed" into the title of this blog... just to scare the tenure out of certain academics :p
RayOnTheFarm | 09.25.07 - 1:54 pm | #

Tanta writes:
I know in the world of real science, you have to offer your papers up for peer reveiew, and you have to disclose how your research was funded -- do economists play by the same rules?

SUUUURE they do. That's why these brilliant young pups released this paper to a credulous reporter before submitting it to peer review.

Arbogast, I'm sure these two are brilliant mathematicians. My industry has never suffered from a lack of brilliant mathematicians (at least once you get past the loan officers). And look where our lovely math fetish has gotten us!
Tanta | 09.25.07 - 1:56 pm | #

Tanta writes:
But of course I'm trying not to do a "peer" review. I am in no sense these gentlemen's peer.
Tanta | 09.25.07 - 1:59 pm | #

arbogast writes:
If you start talking about fetishes, I shall have to politely decline.

--Sir Norman Fry

Seriously, I smell panic. I think the Fed panicked, and now I think the market is going to panic.

Those who believe as I do might want to pick up some SH.

I don't want panic. But all of this is psychological, non-linear, and exhibits positive feed-back, making it much too frightening to model.

We have a man at the UN who the nation would dearly love to unseat (whatever that means), who is able to thumb his nose at us (a non-sexual gesture to be distinguished from a "wide stance" something that does not exist in Iran). We have a former Chairman of the Federal Reserve who is a serial liar as proven by Professor Krugman. We have a sociopath President. And we have more debt per capita than the owner of a dry-cleaner in Little Italy with broken equipment.

We are screwed. Just plain screwed.

We will have panic.

There will be blood. Oops, wrong movie.
arbogast | Homepage | 09.25.07 - 2:03 pm | #

energyecon writes:
CR,

You led the curve - again!

Heebner, Top Fund Manager, Sells New York Real Estate (Update1)

Sept. 25 (Bloomberg) -- Kenneth Heebner, manager of the top-ranked U.S. real-estate mutual fund, sold stakes in New York property owners because prices will decline as banks, hedge funds and buyout firms fire workers.

[snip]
energyecon | 09.25.07 - 2:06 pm | #

Average Joe writes:
While they are educating their way to rational thinking, can they teach people to stop using drugs, commiting crime, abusing their children, and splitting tens when the dealer has a ten showing!
Average Joe | 09.25.07 - 2:10 pm | #

Shnaps Parlor writes:
Now I have two reasons to hate Columbia Univ.

its sad to say it once again but 60% of population is plain naive and unable to handle their finances....we want fool you"
revro | 09.25.07 - 12:58 pm | #

revro - Is that you, Sen. Clinton?
Shnaps Parlor | Homepage | 09.25.07 - 2:11 pm | #

WaitingInOC writes:
Woohoo! Tanta did a post (and an excellent one at that) on the article I found.

Maybe it's just me, but if these professors are assuming that the borrowers act rationally, wouldn't it seem like a better idea for the borrowers (with fluctuating incomes) to get a 30 year FRM and simply save up enough for a decent down payment plus reserves (enough for 6-12 months, invested in a liquid investment) and use those reserves to get through the lean times and then replenish the reserves during the fat times? This seems to especially be the case (FRM as opposed to ARM) when interest rates are still below the historical average since the professors are assuming that the borrowers will pay the mortgage for the full 30 years; it seems that any premium paid for the fixed rate would be more than made up if interest rates go through a normal fluctuation during the 30 years.

But, what do I know? I only took Econ 101 and 102 at college. And, I'm saving for a down payment and waiting for prices to fall back in line with fundamentals, at which point I'll purchase a house with a FRM. Clearly, I am just irrational and need some of that expensive re-education that they are advocating.
WaitingInOC | 09.25.07 - 2:14 pm | #

DejaVu writes:
arms market has an Apollo 13 moment, but has no duct tape?
DejaVu | 09.25.07 - 2:15 pm | #

Julia writes:
"WASHINGTON (Reuters) - U.S. consumers are expected to pay record prices for heating oil ..."

Don't worry! Venezuela is here to help, did you see the adds?

About borrowers being interest rate neutral when they default (maybe my intuition is very flawed). Very low interest rates correlate with a recessionary environment. They wouldn't prefer to default there if they were rational.

As usual, for the sake of 'tractability' these guys had assumed risk-neutrality ("solving the model with risk-aversion would require development of a completely new solution method") and that the lenders have access to unlimited source of funding.

From these 2 assumptions you have the BS conclusion, rationality might not be the worse assumption they used.
Julia | 09.25.07 - 2:18 pm | #

son of zinger writes:
I didn't read the article, my bad. Did the profs address risk aversion as a possible reason for (some, perhaps rational) borrowers not liking ARMs? That was one of the more important factors for me; the lower adjusted rates be damned.
son of zinger | 09.25.07 - 2:23 pm | #

Outsider writes:
energyecon -- electric heat is expected to be cheaper than oil/propane next winter? Did I get you right on that?
Outsider | 09.25.07 - 2:25 pm | #

Tanta writes:
When people move, that is a prepayment on the mortgage on the old house, is it not?

Yes, it is.

How do they model for moves every 7 years or whatever the current average is?

The art of modeling prepayment speeds obviously has to involve more than just running interest rate scenarios, since as you note other things drive prepayments, like mobility.

Two observations:

1. Industry prepayment models are notorious for ignoring "non-refi" payoff incentives for the most part.

2. It's hard to separate mobility and mortgage rates. Do people relocate irrespective of the costs of getting a new mortgage on the new home? This "every seven years" thing is, I think, mostly a Realtor urban legend.
Tanta | 09.25.07 - 2:26 pm | #

Julia writes:
No. They blamed it mostly on irrational behavior and predatory lending.

Also they excused themselves for not taking into account inflation (which have to play a role in people's preference towards a fixed rate).

My guess is that the neutrality of the borrower when it comes to "when do I prefer to default" (which should be never in a rational world) comes from the assumption that borrower's income does not change with changes in interest rates. This is a HUGE assumption! especially during recessions. This is justified with a paper that showed that household income shocks are weakly correlated with asset returns.

Under funny assumptions: people live forever and home prices don't change.

All said, according to them, these assumptions shouldn't change the fact that pay-option ARM are optimal.
Julia | 09.25.07 - 2:35 pm | #

son of zinger writes:
Julia | 09.25.07 - 2:18 pm | #

Geez. I gotta refresh HaloScan a bit more often; my comment got stale before I sent it off.
son of zinger | 09.25.07 - 2:39 pm | #

Alo writes:
Tanta you definitely are no peer to these profs (you are a peerless ubernerd, though, and thank you very much for that)
Alo | 09.25.07 - 2:49 pm | #

ertilm writes:
One point of clarification: very few subprime borrowers have option ARMS. The Inter-Agency guidance of 2005 took care of that. So the typical borrowers have a 710 FICO and put doan 25%. Of course there are exceptions (and loans made prior to the middle of 2005) but the option ARM structure is not common in subprime.
ertilm | 09.25.07 - 2:52 pm | #

energyecon writes:
Outsider,

That is a tough one to swallow, no? That is what the article said but you have to wonder - is cost escalation for coal less than that for natural gas? I don't follow that one...though once upon a time I would have the price of a cord of seasoned birch handy (woodburning days in AK lol).
energyecon | 09.25.07 - 2:52 pm | #

daveNYC writes:
The article is like the punchline to that joke, "First, assume a can opener."
daveNYC | 09.25.07 - 2:56 pm | #

Elvis writes:
This "every seven years" thing is, I think, mostly a Realtor urban legend.

Real estate agents are the best at perpetuating myths, because they generally just repeat what they are told.
Elvis | 09.25.07 - 3:03 pm | #

Tanta writes:
So the typical borrowers have a 710 FICO and put doan 25%.

Well, sort of. Yes, the typical LTV might be around 75%. But I believe that less than half of these loans are purchases--so nobody "put down" anything, the 25% is appreciation.

As far as the purchases go, given the FICOs you're probably dealing with move-up borrowers. In other words, that 25% down came from the sale of the previous home (into a hot bubble market).

So we'll see how popular OAs stay when vapor equity entirely vanishes.

Of course, the whole point of the paper we're looking at here is to universalize the mentality of the move-up borrower to everyone. How you keep finding suckers (first-time homebuyers to pay you your handsome downpayment) to fuel it beats me.
Tanta | 09.25.07 - 3:09 pm | #

dc1000 writes:
my income fluctuates wildly month-to-month
dc1000 | 09.25.07 - 3:14 pm | #

Shnaps Parlor writes:
When people move, that is a prepayment on the mortgage on the old house, is it not?

Wait a tic - Not if they got one of those 'portable mortgages' offered by E-trade a few years ago. I actually thought that was a decent innovation. Apparently, not many others did, I think Etrade mortgage called it quits recently.

IGNORING? C'mon Tanta - You know why relocation is hard to model. It doesn't take an ubernerd to understand that. OTOH, that doesn't stop some prepay model vendors from claiming they can deliver this El Dorado.
Shnaps Parlor | Homepage | 09.25.07 - 3:21 pm | #

Tanta writes:
Wait a tic - Not if they got one of those 'portable mortgages' offered by E-trade a few years ago. I actually thought that was a decent innovation. Apparently, not many others did, I think Etrade mortgage called it quits recently.

Well, you know, I happened to be in a meeting a few years ago when someone wanted to get me interested in buying those "portable" mortgages from old E*TRADE.

I went to my first "seminar" on the portable concept (given by Fannie Mae, who had been working pretty hard on it when they decided to go for reverse mortgages instead) back in the early 90s. So it was particularly amusing to hear those brash upstarts at E*TRADE declare that they'd solved all the problems with that product. I took one look at the legal docs they were using to effect the property transfer and suggested that I'd rather stick a pencil in my eye than sign off on a collateral delivery of it.

They hadn't, of course, solved all the problems, and the servicing was such a nightmare that the product quietly died an ignoble death. Part of the big issue at the consumer level is that a portable mortgage might keep your rate constant, but if home prices keep getting more expensive, each subsequent purchase involves "new money" that gets priced at market (the "portable" part is only the old money, kind of like a CEMA). It's great for down-shifting empty nesters, except you get funny servicing values that way.

I didn't mean to be insulting with "ignoring," I just meant that, well, options models pretty much give up on that problem. As you say, except for the ones that offer to solve it.
Tanta | 09.25.07 - 3:37 pm | #

FFDIC writes:
Absalom, Absalom!
by William Faulkner

"You see, I was that sun, or thought I was who did believe there was that spark, that crumb in madness which is divine, though madness know no word itself for terror or for pity."


http://www.amazon.com/Absalom-Wi...1078500- 6825652
FFDIC | 09.25.07 - 3:49 pm | #

ericblair writes:
they don't realize how irrational 'political' real estate (mortgage) finance is. so, in the realm of mathematical models their theory is probably very strict and has a chance versus other academicians, but to tear them apart in a public forum is just unfair

Big problem in academia. Just like the joke about the drunk looking for his keys under the lamppost instead of where he lost them because the light's better there. You make assumptions because the math works out nicer, not because that's what's more likely to be useful.
ericblair | 09.25.07 - 4:15 pm | #

Stagflationary Mark writes:
Tanta,

However, I am reaffirming an old conviction of mine: there is no fruitcake like academic fruitcake.

I love the sarcastic wit!

I'm sitting in TIPS for the same reason lenders like ARMs. I'd like to transfer some of the risk of higher inflation over to the borrower (in this case the US Government, or ultimately, the taxpayer). That doesn't mean I'll make more money. It simply means I want less risk.

From a risk/reward point of view:

Borrow at a fixed rate. (Borrowers can refinance later if rates fall.)

Lend at a variable rate. (Borrowers won't refinance later if rates rise.)

Well, unless as Piskorski claims, "Obviously people are to some extent irrational."

I'm payin' 5% now, but I'd like to pay 10%! - Irrational borrower attempting to refinance
Stagflationary Mark | Homepage | 09.25.07 - 4:26 pm | #

dr strangemoney writes:
A Clockwork Mortgage

Nice title.
dr strangemoney | Homepage | 09.25.07 - 5:00 pm | #

Jack D writes:
You're all ignoring the real opportunity here: The Training Program. I can do the whole thing for $25 billion and You can keep the other half. I may need some additional pocket change to buy the black binders and some colorful markers for the marketboards. Oh, polo shirts for the trainers. And refreshments. I'll still bring it in under $30 bills and the other twenty goes to You.
Jack D | 09.25.07 - 5:33 pm | #

Producer writes:
OK, guys. What are "more favorable terms" on an ARM?

Lower margin
Producer | 09.25.07 - 8:12 pm | #

Tanta writes:
Lower margin

Lower than what, Producer?

In this "perfect contract" with no ability to prepay, there is no rate sensitivity of the loan, and therefore no option adjustment. Presumably the margin is purely a credit risk premium.

But why should anyone actually worry about how high it is? With no refinanceability, the borrower's not going anywhere. Why do you think lenders would shave that margin down?
Tanta | 09.25.07 - 8:32 pm | #

bacon dreamz writes:
the remittance reports for some of these option arms are out today...prepayments are slowing down, especially for the slightly more seasoned 2006 loans.
bacon dreamz | 09.25.07 - 9:19 pm | #

RowanS writes:
While I think that their assumptions about assuming no risk aversion and complete rationality is a huge problem, it's worth considering that in almost every country in the world ARMs are the standard mortgage. In most places borrowers can only fix rates for a few years, and they have to agree to substantial prepayment penalties during the fixed rate period.

The end result is not as unstable as you'd think because when most of the population has an ARM consumption is quite sensitive to interest rates, so the powers that be don't have to change rates so much.

I don't agree that the US should (or even could) move to such a model, but it is a viable alternative.
RowanS | 09.25.07 - 9:51 pm | #

Alex writes:
Thanks, Tanta.
Alex | 09.25.07 - 9:52 pm | #

Keith writes:
Actually, it looks like Tanta just makes herself look bad, here. I think Tanta does some great things on this blog and really educates lay readers about the institutional ins and outs of the mortgage industry. But on this post she definitely comes off here as the person who can "check the boxes," (a useful and often underrated skill) but who doesn't really like any abstract reasoning that doesn't confirm her prior beliefs.

I think the paper does some useful things.

Certainly, it's useful to point out that option ARMs would exist in a perfect world, and in fact would be a perfect product in that perfect world. Basically, you would give the "rentier class all the options" in exchange for a better deal on your base interest rate. You would then handle all the options yourself. Certainly part (maybe only a small part) of the growth in Option ARM is due to some financially savvy people who face much lower costs for doing financial transactions.

And it's useful to point out that educating buyers and having software that makes complex mortgages and financial decisions far easier could make buyers functionally smarter. Turbo tax certainly makes a complex tax code far easier to deal with (though possibly also more distortionary), does it not?

And requiring mortgage brokers to look out for the customer's fiduciary interest would certainly facilitate this kind of move. So it's not like this paper even eliminates Tanta's favorite regulatory outcome.

So what's her freakin' problem?
Keith | 09.26.07 - 4:48 pm | #