Bogus Gold

In my continuing and irregular series of posts attempting to understand how our current economic meltdown came to pass (while rejecting attempts to view politicians rather than the world of finance as the main players involved), today we turn to Michael Osinski. He states his claim to relevance to our discussion quite clearly and succinctly: "I wrote the software that turned mortgages into bonds."

But that's only the beginning. How this software came to be so central to the collapse of places like Lehman Brothers, and the insolvency of so many other financial giants is an important part of the overall story of what went wrong in the world of finance.

As you might recall we started looking into this by examining how the bond market became obsessed with quantitative analysis and risk modeling. Then we looked at the mechanics of how and why these models were used to manufacture a dizzying array of new financial products, on the basis that the risk of such things was now well in hand, until the whole system began spinning out of control.

This piece helps link all those pieces, by explaining how mortgage backed securities - the basis for all that came after - got created and spread so far through the financial industry. It starts with a simple demand within the bond market. As Mr. Osinski puts it:

The packaging of heterogeneous home mortgages into uniform securities that can be accurately priced and exchanged has been singled out by many critics as one of the root causes of the mess we’re in. I don’t completely disagree. But in my view, and of course I’m inescapably biased, there’s nothing inherently flawed about securitization. Done correctly and conservatively, it increases the efficiency with which banks can loan money and tailor risks to the needs of investors.

Lost in all the hoopla about exotic financial offerings and "toxic assets" and all the rest is this simple nugget - the motivating factor for all of this was the simple desire to do what they were already doing - matching investors looking to lend with home buyers looking to borrow - more efficiently.

So where did it start to go wrong? Osinski explains...

I never would have thought, in my most extreme paranoid fantasies, that my software, and the others like it, would have enabled Wall Street to decimate the investments of everyone in my family. Not even the most jaded observer saw that coming. I can’t deny that it allowed a privileged few to exploit the unsuspecting many. But catastrophe, depression, busted banks, forced auctions of entire tracts of houses? The fact that my software, over which I would labor for a decade, facilitated these events is numbing. Is capitalism inherently corrupt? I don’t think the free flow of goods in and of itself is the culprit. No, it’s the complexity masked by thousands of unseen whirring widgets that beguiles people into a sense of power, a feeling of dominion over the future.

My emphasis, just to point out a recurring theme we're seeing through all these stories. The guys who really understood the nuts and bolts - the ones making the models and software and all that other technical stuff - put power into the hands of people who simply didn't understand it. But the egos involved shared a common human flaw - power leads to pride. They wielded their new power over the bond market with arrogance approaching hubris and, as the classics teach us, Hubris eventually leads to Nemesis. It's like Jurassic Park, only with runaway mortgage backed securities and their derivatives rather than T-Rex's and Velociraptors.

Osinski's story goes on to describe how he came to develop the software that later became the industry standard for creating mortgage backed securities.

Working with another programmer, I wrote a new mortgage-backed system that enabled investors to choose the specific combinations of yield and risk that they wanted by slicing and dicing bonds to create new bonds. It was endlessly versatile and flexible. It was the proverbial money tree.

So there were formulas for bundling mortgages, slicing and dicing them, assigning risk to the bundles and slices of bundles. But here we get to a key point. You would think "security" was the top goal here. But look at the above description "combinations of yield and risk" was what the software put into the hands of the traders. And where were the biggest profits to be found? In the least risky investments perchance? Oh heck,no...

Up until that point, almost all my securitization work had involved prime mortgages—those mortgages given to people who had an extremely high probability of paying them back. When a client wanted me to enhance my software to include “subprime” debt, well, that was something new, and I have to admit, I was kind of excited. This would greatly enlarge my universe of clients, because the subprime market was then split among many smaller players, each of whom needed my software.

I quickly learned how fishy this world could be. A client I knew who specialized in auto loans invited me up to his desk to show me how to structure subprime debt. Eager to please, I promised I could enhance my software to model his deals in less than a month. But when I glanced at the takeout in the deal, I couldn’t believe my eyes. Normally, in a prime-mortgage deal, an investment bank makes only a tiny margin. But this deal had two whole percentage points of juice! Looking at the underlying loans, I was shocked.

“Who’s paying 16 percent for a car loan?” I asked. The current loan rate was then around 8 percent.

“Oh, people who have defaulted on loans in the past. That’s why they’re called subprime,” he informed me. I had known this guy off and on for years. He was an intelligent, articulate, pleasant fellow. He and his wife came to my house for dinner. He had the comfortable manner of someone who had been to good schools—he was not one of the “dudes” trying to jam bonds into a Palm Beach widow’s account. (Those guys were also my clients.)

“But if they defaulted on loans at 8, how can they ever pay back a loan at 16 percent?” I asked.

“It doesn’t matter,” he confided. “As long as they pay for a while. With all that excess spread, we can make a ton. If they pay for three years, they will cure their credit and re-fi at a lower rate.”

That never happened.

This is something really crucial to understanding the bigger picture here - the modelers weren't stupid, and the software wasn't broken. As the industry got into ever riskier territory it was done with eyes wide open.

The problem wasn't lack of information. The problem was - and if you're a die hard free marketeer you might want to cover your ears for this part - excess greed. The risks were deemed worth taking because the rewards were so great. It turns out the risks were understated and not properly understood, but we did not get into this mess by proceding with anything close to the proper caution considering the dollars at stake. Salaries and bonuses were making very inexperienced people very rich in a very short amount of time. That motivated - not stupidity - but a discarding of the age-old sense of prudence and caution which is supposed to underly our bedrock financial institutions.

Lest this be seen as an attack on capitalism, it's emphatically not. The problem wasn't the profit motive itself. The problem was that absurdly high profits could be made buying and selling products that were increasingly abstracted from underlying reality. The risk of one mortgage is fairly simple to assess. Bundle that together with a hundred others, and it gets more complex. Sell a percentage of the return of that bundled hundred to another party, who then bundles it with something else and then hedges their risk by buying a product from yet another investor... repeat ad infinitum throughout the world's financial institutions... and you suddenly have seemingly all the money in the world invested in things no one really understands. Trust that the software was keeping proper track of it all wasn't just laziness - at some point the complexity made it a necessity.

The furious momentum of the modeling and the bundling and the buying and the selling and the gigantic bonuses kept things going well past the point someone should have applied the brakes. The bond market was suddenly like Wile E. Coyote running off a cliff - everything seemed fine until someone finally looked down.

But eventually someone had to look down. Underlying all of that were real homes with real mortgages. And all the financial products were based on ever more certainty that their repayment was entirely predictable. Which worked just fine until it didn't.

And that's the real disconnect here. Too many people in this story assumed they could know the inherently unknowable. This belief was fed by a constant stream of whiz-bang new technology, mathematics, and product offerings - each one increasing the fallacious assumption of certainty and invulnerability in its own way. It's not the first time in human history people were humbled in the attempt to assert human mastery over areas of chaos and doubt. And it won't be the last.

Michael Orsinski is long removed from Wall Street these days. He farms oysters now.

In many ways, farming oysters is more difficult, demanding, and frustrating than writing software. Errors take seasons and years to emerge, whereas software is instantaneous. Nature does not give you explicit warning messages; her ways are more subtle and take a lifetime to penetrate. I forgot the day of the week but knew instinctively the tide and the phase of the moon.

The irony is the financial markets were really a lot more like his oyster farm - errors taking years to emerge... warning signs to subtle for most to see - than his software could account for. It wasn't the simplicity of the bond market, but the simplicity of designing software that created the illusion of predictability. There's a lesson in that. I'm not sure it's being learned.