Tuesday 19 January 2016

How Did University Degrees Become Subprime Mortgages? Part II

If you made it to the end of my last post you will have the same question I did.

Why did Finance Companies and our ersatz Mr. Finance Company Guy arrange a mortgage for Michelle, our hypothetical mortgagee,  when he should have known quite well from experience and the numbers that she would likely be unable to pay it off?  To answer this question we have to introduce a bond trader on Wall Street in New York.  We can even give him a real name.  We can call him Howie Huble

because Howie Hubler really exists and he is the most infamous example of what was happening in the bond markets in 2008.  A bond like a mortgage and like money is a kind of IOU.  It’s a piece of paper that says someone owes someone an amount of money.  Bonds have always been considered good, solid, conservative  low-risk forms of investment.  Usually bonds were IOUs from big companies or banks or even countries, but any kind of debt can be incorporated into a bond and resold to investors.  Unless you are an investment banker you have to get used to the idea that one person’s debt is always someone else’s investment. For the most part, debt is what financial markets buy and sell.

Leading up to 2008, bonds were being created by bundling together a lot of subprime mortgages.  Imagine that Michelle’s mortgage and 99 other mortgages just like hers were put together in a bundle.  All together they would create a bond (or what was called an “asset-backed security” or "collateralized default obligation") which, on paper, was worth 17 million dollars.  Howie Hubler and his ilk on Wall Street would turn around and sell that 17-million-dollar bond to pension funds, banks, and other investment companies around the world.  The answer to our question, the reason Mr. Finance Guy gave Michelle the mortgage in the first place was because he could immediately turn around and sell it to a Hublerite on Wall Street, and the Hublerites would sell it inside a bond to investors all over the world.

Pause and take note that, despite what we are constantly told about capitalism, the people who were making the real money were taking no risks, in fact, as the saying goes, they had no skin in the game. Howie and Mr. Finance Company Guy got paid no matter what.  They could remain indifferent to the quality of the mortgages and bonds they were selling.  In fact, being attentive to the quality and viability of the paper they were selling would have been counter to their financial interests.  The only thing that mattered to them was that they move a lot of "paper" from Main Street to Wall Street to Global Markets.  The hypothetical 17-million-dollar bond I mentioned above was peanuts to the Hublerites on Wall Street.  Merrill Lynch, the company Howie worked for, was paying him 25 million a year and he complained of being underpaid.  Even after Howie lost 9 billion dollars on "credit default swaps" and was fired, he still walked away with a 10-million-dollar severance payment in addition to the millions he would have salted away over the years.

Confession of ignorance #2:  I hadn’t heard of Howie Hubler or “collateralized default obligations” nor did I understand how "credit default swaps" worked until I read The Big Short.  My general impression of how subprime mortgages were bundled into bonds and resold was correct but The Big Short gave me the details and explained how Mr. Finance Guy and Howie could make enormous amounts of money, for as long as the bubble lasted, by moving worthless pieces of paper around.  Actually calling these investments “pieces of paper” gives them more substance than they had in reality.  Not only were the transactions digital, but when Main Street Finance Guys couldn't keep up with the demand on Wall Street for more mortgage paper, some Wall Street gurus, as Michael Lewis reports,  figured out a way to create mortgages out of nothing.  When financial analysts went looking to see what was inside CDOs (“collateralized default obligations”); for example, to find "Michelle's mortgage," they came away saying it was impossible to say what was in a CDO.  

Think about it!  People were paying billions of dollars for CDOs but no-one was able to say exactly what was being purchased when you bought  a CDO.  No problem!  As we now know the government of the USA stepped in and purchased hundreds of billions of dollars worth of this bad, toxic, imaginary debt and all the perpetrators were let off the hook, except of course, Michelle and people like her who were evicted from their homes, lost savings and pensions and were forced into debt and bankruptcy. 

Parallel #2:  In both cases, Michelle’s mortgage and Michelle’s BA, a huge system has been constructed, an upside down pyramid, based on the assumption that Michelle is going to do what is expected of her.  Despite Michelle’s good intentions and hard work, the open question remains:  was Michelle being provided with the conditions which would allow her to succeed?  In the case of her mortgage, the evidence is now clear she had little hope of  paying off the mortgage and owning a house.  The whole venture was to be a losing proposition for her.  What about her BA?

I have to hold back the vitriol in launching accusations against Mr. Finance Company Guy who sold Michelle her mortgage, because in terms of education I am his homologue. I never consciously deceived or mislead a student, and remained convinced throughout my career that I was doing something beneficial for my students.  However, I suspect that the average Mr. Finance Guy could make the same claims about his mortgage customers.  

Like Mr. Finance Guy, I felt pressure to attract students and get them through the program.  I know lots of individuals who were conscientious and diligent, working to ensure that Michelle got the best education possible--and I count myself among them.  Overall, anecdotal evidence I’ve gleaned suggests that my undergraduates have done better than average in finding employment. Nonetheless it seems clear to me that just as the problem with the financial markets was that no-one was playing careful attention to the details of Michelle’s mortgage, no-one  is paying careful attention to the details of her BA.   As the system currently stands there is no incentive for anyone to be particularly attentive to the make-up and quality of the education that Michelle is receiving.  

For university professors interested in advancing their careers, far from "no incentive,"as I have pointed out in earlier posts, there is significant disincentive for any professor getting too fussy about the quality of their courses or teaching, or becoming preoccupied with the overall quality of education their students are receiving.  In universities there are only two roads to advancement: research or administration.  The cliché of "publish or perish" has more purchase than ever.  The number and salaries of university administrators has ballooned, while most of the teaching is left to lowly adjuncts and part-time lecturers who are destined to remain at the bottom of the ladder in terms of salary, job security and status.  

Are administrators and tenured professors concerned about the level of pedagogy in their universities?  The most interesting and telling aspect of this question is that we can't know the answer because the question never gets asked.  Lots of lip service gets passed around as part of every university's sales pitch but it is simply not something that professors ever discuss.

In keeping with a typical business model, universities are concerned with enrolment and completion rates.  The system offers no incentive for anyone to be preoccupied by what happens between registration and graduation.  The system is driven by ideology, narcissism, petty politics, turf wars and the obsessive compulsions of fastidious low-level administrators, but because there is little to no consensus about what students should be taught, there is no tracking or sharing of information about what students are supposed to have learned.  

My recent posts might create the false impressions in readers' minds 1) that I view university education as somehow comparable to the financial markets, and 2) that I have some silver-bullet solution in mind for how to fix university education for all times.  This comparison of universities and the financial markets is a demonstration of how disastrous the business model is for education.  I have seen numerous panaceas proposed to cure all that ills university education and invariably come away with the impression that there is no one solution to fit all situations.  The solutions that seem clear and viable to me are the ones who's outcomes are least predictable.  We need to empower those who teach, those who can facilitate effective teaching, and those who want to learn, and then, to quote Death of a Salesman, "attention must be paid" to what is happening to students every step of the way from pre-registration to career.

Friday 15 January 2016

How Did University Degrees Become Subprime Mortgages?

In the wake of the Wall Street collapse and bailout in 2008, I was repeatedly tempted to present my students with a lecture on subprime mortgages.  I kept imagining the lecture I wanted to deliver but finance and economics were not my fields or a relevant subject for any of my literature classes.  Reading the prologue to Michael Lewis’s The Big Short about the nerdy outsiders who foresaw and actually made money from the collapse and learning that Meredith Whitney with her B.A. in English from Brown University was one of the first whistleblowers to accurately assess the mismanagement that was going on, I am once again feeling inspired to offer my two cents (for those of you who still know what “two cents” means).  

What follows is the lecture that I almost but never quite gave and a comparison of university degrees and subprime mortgages punctuated with confessions of ignorance which will demonstrate that you don’t need to know very much in order to understand what was going on even though the people who were supposed to know everything about big finance still claim they had no understanding of what was going on.

Confession of ignorance #1:  Until recently I misunderstood what the word “subprime” meant in the expression “subprime mortgage.” I knew that the “prime rate” meant the best possible rate at which a bank would lend money.  Since the prefix “sub” means “under,” “beneath,” or “lower,” I assumed that a "subprime mortgage" must be a special low-interest kind of mortgage designed to help poorer people. Based on the words, that’s what the expression should mean but I and the people who took out those mortgages could not have been more wrong; it means exactly the opposite.  To keep it simple the expression “subprime mortgage” is a lie, a sales-pitch expression to convince people that they were getting a deal when in fact they were being tricked into signing mortgage contracts with high-interest rates that ultimately they would be unable to pay. 

In financial circles the expression “subprime mortgage” means that the people borrowing the money are considered “subprime” because they have low incomes and/or poor credit ratings.  The loans are considered riskier for the lender and so the borrowers have to pay higher interest rates.  Hypothetically, if a rich person and a poor person wanted to buy exactly the same house, the rich person would pay less for the house and the poor person would have to pay a higher interest rate on the mortgage and therefore much more for the same house.  This is what is known in capitalist economics as a level playing field. (Yes, I am being sarcastic.)

The day I almost gave my lecture on subprime mortgages, I was lecturing on the Age of Reason, that period in English literary history known as the Enlightenment in antithesis to the Dark Ages, the Medieval period dominated by religious dogma.  As a warm-up to my lecture, I began with the thunderingly impertinent question to the class:  “Why are you here?”

With rapid alacrity a hand shot up in the third row and a handsome young man with loads of puppy-dog charm answered earnestly:  “to procreate.”

“Say what?” I asked.

“You know, to make more people.  To procreate.”

I couldn’t resist.  “I think I should warn the young women sitting around  ‘F.’ that he is here today in class at the University in order to procreate.”

(Just in case you might think I did “F.” some harm, I should point out that when the giggles subsided what I witnessed was a half dozen young women gazing at him in newfound dewy-eyed admiration—and “F.” was nothing if not a good sport. ) 

I was introducing the notion that a university education was the continuation of an idea, which became dominant in and perhaps defined the Enlightenment, that it was possible for individuals and societies to improve.  This concept of progress, of getting better, provided a new answer to the question about why we were here, the purpose of our existence, displacing the established Medieval notion that the human species existed to praise, worship and obey God and, in the words of my grade-school Catholic catechism, “to reflect his glory.”

Before the class could get there, we had to get past the other answer to my “why are you here?” question:  “to get a degree,” and the cut-to-the-chase, more cynical echo, “yeah, to get that piece of paper.”

“To get that piece of paper”:  that was my cue to deliver my “subprime mortgage” lecture, but I chickened out. 

In the lecture I daydreamed but never gave I took a bill out of my wallet and asked the class “and what is this?”  I received the funny joke answers with a smile and a laugh, and collected the “right” answers:  “it’s money,” “Canadian currency,” “it’s a five-dollar bill.” 

I would acknowledge and congratulate the correct answers, but at the same time, I would point out how knowing the right answer can sometimes blind us and prevent us from recognizing the most obvious, empirical, irrefutable, down-to-earth answer.  In this case what I was holding for display was, in the first place,  “a piece of paper with printing on it.”  This particular paper was an IOU issued by the Government saying that Canada owed me five dollars.  It is a very strange kind of IOU because everyone understands that it marks a debt which will never be paid.  (If this intrigues you check out When Should You Repay Your Student Loan.)  We typically assess the value of something in terms of money, but this time the valuation needed to be reversed.  The Government designated the value of this bill as “5” but its real value is unpredictable.  Depending on the time and place a Canadian 5-dollar bill could have a value of 3 litres of gas or maybe 5, 2 bottles of beer or maybe 1 or maybe 5, half a hamburger or maybe 2. You never know what five dollars is worth until you try to spend it.

Now I take out a sheet of paper and write on it in large letters:  MORTGAGE, and underneath an amount, say $170,000.  If I was really well prepared I could have copied out something that looked almost like a real mortgage:

FCG Mortgage
Name:  Michelle
Amount:  $170,000
Starting Interest rate:  3% (variable)

Property:  Nice little house on nice little street.

Lender Signature:  Finance Guy

Borrower Signature:  Michelle

“Again, this is a piece of paper.  Agreed?  If you suspend disbelief a moment, let us imagine that this piece of paper is a real mortgage.  If we compare these two pieces of paper we will discover why people who know about finance consider the mortgage so much better than money.  Ignoring the difference in the amounts (5 versus 170,000), the mortgage is better than money because the value of money is, historically, less certain.  The value of money always goes down over time but the value of mortgages and houses always go up.  Historically, inflation decreases the value of money by around 2% every year, but a typical mortgage increases in value by around 5% every year.  Money used to be backed up by gold, but these days the value of money is based on nothing tangible.  A currency is worth whatever people who trade on money markets decide it is worth for reasons that no-one really knows.  Mortgages on the other hand are backed up by actual buildings.”

[Now I would draw my best grade-school impression of a house on the blackboard.]

[Cut and paste from the net; much better than I could do!]

“So how did mortgages which were less risky and more desirable and solid than cold, hard cash suddenly become 'subprime,' 'toxic,' unreliable and generally worthless?  The answer:  mortgages are only valuable when everyone is following the rules.  When people stop following the rules, mortgages become worthless pieces of paper.  Actually, much worse than worthless because the person who takes out a mortgage is still expected to pay it off or s/he will be punished.”

[Here’s where we can begin to compare university degrees and subprime mortgages.  Spoiler alert:  The moral of both stories is that mortgages and degrees are of value when the people involved in the process are doing what is expected of them, following the rules, and fulfilling their obligations.  Unfortunately, for everything that went wrong with mortgages from 2003 to 2008, it's possible to see a parallel with university degrees.]

“A mortgage has to be taken out by an individual.  In our case, let us imagine that this is Michelle’s mortgage. [There was always at least one Michelle in in my classes and Michelles were invariably nice and smart and would cheerfully accept being my hypothetical.]  Michelle is a student and works part time, so what is she doing taking out a mortgage?  Many people would say that the problem with subprime mortgages is Michelle’s fault.  She just couldn’t afford the house she tried to buy. So why did she?  To answer this question we have to look at the guy from the finance company who arranged her mortgage.”
 “Here’s his sales pitch:  'Michelle, you can buy this house, really nice, huh, for $170,000.  I will give you a mortgage for $170,000 at 3% interest for the first two years.  That means you will be paying $805 a month, which isn’t much more than you are now paying for rent.  Your interest rate might go up after the first two years, but so will the value of your house, so if you're not happy you’ll be able to sell it for a profit.'"
“Sounds like Michelle can’t lose, right.  And how could she resist?  She’s being given $170,000 and a house.  All she has to do is sign the mortgage contract, and supply a few documents like pay cheque stubs, tax form, credit rating.  And if she doesn’t have them, well Mr. Finance Company is a nice guy and wants to be nice to her, so he will approve her mortgage even without the documents.”

“Mr. Finance Company Guy probably knows that eventually Michelle will not be able to afford the house and the mortgage.  She might manage to pay the mortgage, the taxes and the expenses of keeping up a house for the first two years, but after the first two years the 3% interest rate (it’s called the ‘teaser rate') will end.  Suddenly Michelle will have to pay a new variable, non-teaser rate of something like 12%—because students like Michelle who work part time and don’t have high incomes or great credit scores have to pay extremely high mortgage rates.  Assuming Michelle never missed a mortgage payment in the first two years (which isn’t very likely), she will still owe $160,561 on her mortgage.  Her new monthly mortgage payment at 12% will be $1657.00—at least twice as much as she can possibly afford.”

“So what does Michelle do now.  Obviously she has to sell her house.  Maybe she can sell it for $180,000?  Nope.  How about selling it for $170,000?  Still no.  How about if she sells it for just enough to pay what she owes on the mortgage?  Still no buyers.  How about if she sells it for $150,000; she ends up with no house and a debt of $10,000?  For most people in Michelle’s situation in 2008 the answer was still no.  Why?  Because Mr. Finance Company Guy had made the same deal with lots of people that he made with Michelle and they were all in the situation of being unable to pay their mortgages and were trying desperately to sell their houses for less than they paid and less than they owed—so the price of houses was collapsing.”

Parallel #1:  Anyone with a university degree who is unemployed or underemployed and faced with a student loan knows a bit about how Michelle’s situation must feel.  Owning a house, getting a degree--they were both supposed to be no-brainer guarantees of future prosperity but the implied promises have been reneged upon.

To be continued . . .

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