Posted on April 8, 2008 by David Laidlaw
Paul McCulley presented a very elegant analysis of the reason for financial meltdowns which appeared in last month’s CFA Institute’s Quarterly. McCulley’s piece borrowed from the work of economist Hyman Minsky and applied Minsky’s paradigm to the problems associated with mortgage backed securities.
Minsky analyzed what causes economic booms and busts. His theory centers around the idea that stability itself produces speculative bubbles as market participants take greater and greater risks since the assumption is that stable conditions will persist. These risks then become insupportable and cause dramatic unwinding.
Minsky describes different types of “units” that contribute to stability or instability. The first unit is a hedge unit that aids stability since it allows market participants to reduce their risk overall. McCulley labels conventional 30-year mortgages as hedge units since they allow home buyers to reduce their risk to house prices fluctuations by paying off interest and principal over extended periods of time.
Hedge Units are then succeeded by “Speculative Units” where investors borrow funds to invest, but the investment cash returns are only sufficient to pay interest on the borrowings, but not principal. An interest-only mortgage loan is an example of a speculative unit since borrowers are only paying interest and not principal. The appearance of speculative units is destabilizing.
The final unit in Minsky’s framework is a “Ponzi Unit.” With Ponzi units, the investor buys an asset, but is unable to pay back principal or interest without the appreciation of the underlying asset. Applied to the mortgage market, a Ponzi Unit would be mortgage loan where payments do not cover interest or principal and then require a balloon payment to settle the accrued interest debt. These types of loans are very destabilizing since the only way the loans can be paid off is if the underlying asset (here the residence) appreciates and somebody buys it at a higher price.
During 2005 through mid-2007, most lending in the housing market was of the destabilizing variety. The decrease in housing prices led to the collapse we have seen in the credit markets.
Wall Street’s compensation structure for firms and individuals has contributed greatly to instability in our financial markets. Wall Street’s banks and brokerages take anything that produces cash flows such as a company or a mortgage and packages it into a security which it sells. The firms that do this get paid on a transactional basis for the sale of that security and the individual brokers and bankers themselves get paid commissions for this sales activity.
This payment mechanism adds to risk within the financial system since armies of brokers and bankers are incentivized to create and market new securities; however, they themselves have very little “skin in the game.” So if a Wall Street banker creates and sells hundreds of millions of dollars worth of mortgage-backed securities and then collects his bonus, what difference does it make to him whether or not the security flames out since he has already been paid.