Tuesday, September 16, 2008

Roulette, AIG and the Subprime Crisis, pt. 1

I have a buddy, one of my best friends in the whole wide world, who is absolutely convinced that he has a system to beat roulette. This is, of course, pure BS. To those of you who might not know the game, roulette involves making bets on a randomly generated number between 1 and 36. You can bet on, for example, the exact number generated, whether it's odd or even, whether it's 1-18 or 19-36, etc. The house gains its advantage via two spots on the roulette wheel which are 0 and 00, which cause all the bets (except bets on 0 or 00) to lose. Long story short, the house has an expected profit of 2/38, and a player can expect that out of every $38 placed on the board in any arrangement or under any "system" you want, the player can expect to get back. I wrote an Excel spreadsheet to prove it, if anyone wants it. It's obvious to even the most casual observer that a single bet has an expected payout of 36/38, but my friend has come up with a system that, at the very least, is complex enough to obscure the fact that his expected payout is still 36/38. By putting some chips here, some chips there and then changing the bets on the next spin of the wheel, my friend's disadvantage became less obvious, but was always still there, unchanged.

The subprime crisis which once again reared its ugly head this week shares much with my friend's roulette delusion. Here's my attempt to briefly summarize the problem:

It used to be that, in order to get a mortgage, you'd have to demonstrate that you had some amount of income and credit history to allow the bank to be reasonably confident that you'd be able to repay it. As people who were actually qualified for a mortgage became more and more rare, banks began giving loans to people who weren't as likely to be able to repay their loans. Eventually, as this process continued, banks began loaning money to people who were so unlikely to be able to repay their loans that, even while charging those who do pay some calculated interest rate, that banks' expected payoff for a given loan was less than the value of the loan. For example, banks stopped requiring proof of your income to get a loan. So a guy who makes $25,000 could get a $600,000 mortgage, which of course he would be incredibly unlikely to be able to repay.

So why were banks making these loans? A market developed whereby they were able to bundle up a bunch of these loans into one package and sell them to banks/hedge funds/etc. They could sell shares in these bundles of mortgages. Some high-paying shareholders would be more likely to be paid each month, while cheaper stocks would be the first to not be paid as more mortgages go into default.

But few mortgages went into default, because, with more and more new mortgages being given out, homeowners could always refinance, getting more money to make their payments. So everyone made money.

Eventually, even people willing to take ask banks for such absurdly large loans became scarce, and fewer people were looking to buy homes. With this decrease in demand, home prices fell significantly. Existing homeowners became unable to refinance at sufficient house values to be able to pay off their original loans, so they defaulted. Banks were left with, instead of say a loan worth $250,000, they had a house now worth only $200,000. It is these losses of value that ruined Bear Stearns and Lehman Bros., and is ruining AIG, the world's largest insurer and a vital piece of Western finance.

I've had about enough typing for now, so I'll stop here. More tomorrow!

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