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Notes -
Got an economics question:
I was watching 'Margin Call' the other day, and there is a scene where two day traders are lamenting the (then incipient) 2008 financial crisis. The senior of the two gives his justification for existing to the other:
Is there anything to this? if so, how does that work? I always assumed that day traders basically created no value and just shuffled wealth around to nobody's benefit.
Government subsidies for housing are massive:
You get to deduct the interest and property tax (conditional on exceeding the standard deduction today). However many urban homes are going to be close to this so it doesn't take much charitable giving to exceed the standard deductions.
You don't pay capital gains on your homes appreciation. Up to $500,000 fo couples.
Freddie Mac and Fannie Mae will buy most mortgages offering a guaranteed rate for 30 years that can be refinanced without penalty. The government will directly buy riskier mortgages.
The standard mortgage offers 4:1 leverage (or 32:1 for the government options).
These reduce the cost of housing and give strong incentives for people with high incomes and higher marginal tax rates to invest heavily in housing. The system kind of broke when those homeowners figured out they could vote in local governments that would also limit construction.
Deductions for mortgage interest and property taxes increases the price of housing, rather than decreasing it, by increasing demand. They de facto increase the ability of buyers to pay higher prices, by reducing the monthly cost of home ownership. Ditto re Fannie and Freddie, since they have the effect of lowering mortgage rates.
The monthly cost of their lifestyle was how I interpreted the quote's point. "We (society) put our fingers on the scale to make people's lifestyles more affordable" in the context of the 2008 financial crisis it ties into housing, so I view the topic as essentially "how does society put their finger on the scale of monthly housing costs to make normies lifestyles more affordable?"
Oh I was referring specifically to "These reduce the cost of housing"
Ah I should have said carrying cost! Thanks
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A few more subsidies...
When you sell with a capital gain you have a couple years to buy a new house and avoid paying the capital gain
As in investor, you can do a 1031 exchange to sell one property and buy another without paying capital gains
As an investor, you can earn cash-free tax flow. This is because you are allowed to "depreciate" an appreciating asset. This lets you lose money on paper even if you earn money on practice.
Using "cost segregation" you can depreciate these appreciating assets much faster than the official schedule allows
Investors can finance up to 5-10 houses with similar rate advantages given to buyers of one home
A couple where one spouse is a real estate professional and the other has high income (such as doctor) can use the fake real estate "losses" of one spouse to offset the earnings of the other spouse and pay very little tax.
When you die, your heirs get a step-up basis. So if I bought a house for $100k in San Jose in 1973, my heirs won't have to pay capital gains when they sell it for $3.7 million in 2023.
Probably a lot more than I missed. The whole thing is a racket.
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Here's how it works: Most mortgages are 30-year loans. This means that the person giving the loan isn't made whole for thirty years. Nobody wants to wait that long to get their money back, not even banks. The only reason ordinary people can get mortgage loans at palatable interest rates (5-8%) is because of the secondary market for mortgage debt. The bank that gives you a mortgage doesn't hold that loan on their books for 30 years, they sell it almost immediately to a firm like the one in Margin Call, and the only reason firms like that are willing to pay so much for mortgages is that they can do Wall Street Magic™ like chop them up into highly liquid, officially rated, mortgage-backed-securities that can be easily sold to pension funds, other banks, or whoever else wants to buy it.
This whole process dramatically increases the demand for mortgage debt, which drives the price of mortgages up and the interest rate charged to the consumer down. Thus, we arrive at the scene in question. The only reason people are able to afford anything as extravagant as a 30-year mortgage is because of the very bankers and processes that caused the financial crisis.
Firstly, the widespread availability of mortgages for ordinary people predates the boom in MBS issuance by decades. The boom in MBS issuance occurred as a result of the GLB Act in 1999. There was a specific period of a few years when the vast majority of (certainly privately-issued) MBS ever issued were issued (or, from Wikipedia). Certainly, securitization (including of mortgages, although usually commercial mortgages) had a very long history, but the MBS market that exacerbated/caused the financial crisis wasn't responsible for people "being able to afford" a 30-year mortgage, no.
Secondly, while MBS prices certainly affect interest rates on new mortgages, I'm less sure that the existence of the MBS market itself was 'responsible' for rates being lower than they would otherwise have been in the early 2000s. That's an unfalsifiable thesis in any case, but I think the default view should be that the lending environment of the pre-crash age was more dependent upon the government, on the Fed and on the wider macroeconomic landscape than it was on the existence of the MBS market.
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If long-term investing is good, then day trading must also be good but less so. I might hold an investment for years because I think it has unappreciated value, this helps direct investment to good places, or at least places that people think are good. Someone should react to news, analyse whether recent events should have capital reallocated. At minimum they provide some liquidity for transactions.
High frequency trading is a waste of time though, compared to the brainpower that goes into it.
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Margin Call is a great movie but it’s even less realistic than the average Wall Street film, in part because most tend to focus on people more interesting / more on the fringes of finance (like The Wolf of Wall Street) rather than the comparatively more staid PMC culture that exists in bulge bracket investment banking and even increasingly (probably since about 2000) on the trading floor. The bank in Margin Call is based on Goldman Sachs, which partially hedged some of its exposure to the mortgage crisis. But the real life story (and there is some reporting on it) is less exciting than the movie, the events took place over a much longer time, and the drama with the board in the movie was fictionalized. I hope someone makes a similar movie fictionalizing the Credit Suisse collapse though, I think that’s a more fertile ground for storytelling although it would work best as a miniseries that takes place over maybe 3-5 years.
On one hand, the US did and does have an addiction to cheap credit. The housing crisis was spurred in large part by the Bush administration’s relentless push to ‘end the legacy of redlining’ by pressuring banks into lending to just about anybody without much consideration of their long term ability to pay, and many mortgage salesmen and retail banking compliance/KYC deliberately looked the other way as people lied and were coached to lie on application forms to borrow even more money. A movie about mortgage salesmen in Arizona in 2007 could include this line and I think it would be a fun (and accurate) description.
On the other hand, the credit traders in Margin Call aren’t mortgage salesmen. They have little to nothing to do with the provision of credit. The securitization of mortgages was not primarily responsible for the housing boom and collapse, even though that crash subsequently caused the financial crisis in part because of said securitization. You can twist the words into making a point that credit would possibly have been slightly more expensive if the MBS market had been less developed, but the reason for the housing bubble was primarily the fault of governments and retail banks, not investment banks.
So as a statement, it doesn’t make much sense, no. The thing is that traders at big banks aren’t really cowboys, for the most part these are people who make what they believe to be very predictable, very safe moves to hedge clients’ money. They’re not at a hedge fund or a hotshot at a small prop trading firm. They’re not Jordan Belfort type boiler room operators. They’re not Glengarry Glen Ross salesmen. They’re doing what is, almost all the time, a very low risk job where doing very well means making the bank a very small amount of money on the work they do for clients.
Good explanation, thanks. I thing along these lines I've always wondered:
My impression is that a substantial amount of the financial shenanigans that led to the crisis were based on all of the various actors who make up the pipeline of financing mortgages trying to figure out some way to themselves not lose their shirts in the environment of all of these sketchy mortgages the banks were forced to make. Where "forced" is not in the sense of "you will go to jail if you don't do this", but a more subtle indication that "we will audit and regulate your bank out of existence unless you do this". So essentially, deep down everybody knows it's going to collapse somehow eventually, and they're all trying to arrange things such that they're not the ones holding the bag when it does, which involves never acknowledging that to anyone else. Do you think this is accurate, or off-base?
It's hard to say, there's probably a few million pages of congressional testimony in which various people might or might not hint at this obliquely, I actually have no idea. I don't think there was any major effort by the majority of loan originators in middle america to limit their exposure to the subprime mortgage market. There were some smart people who did, especially from 2006 onwards, just like there were some smart hedge funds who made the same play, and just as Goldman eventually realized it themselves (as fictionalized in Margin Call). Obviously there were people who predicted the housing bubble bursting more generally, but we're 400 years on from Tulip Mania and there are always Cassandras preaching about imminent doom. It's very hard to tell who got lucky and was neurotic at the right time (like the hypochondriac who finally catches a terrible disease very early) and who knew the whole thing was really a sham.
I'll say that my impression from old hands in investment banking rather than trading is that most did not expect a crash in 2007. The market had barely recovered to dotcom levels, it had only been 6 years since the last crash and 4 since the trough of the 2001-2003 recession, M&A activity was hot but not shockingly so, the housing market was the only red-light indicator, if it even was.
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Peter Wallison says that (1) Fannie Mae and Freddie Mac misleadingly categorized mortgages as subprime only if they were issued by a small category of "subprime lenders" (rather than the more typical definition of any mortgage made to a person with FICO score worse than 660), so (2) the banks never even knew that the situation was in the toilet.
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Appreciate the post thanks man. So let me see if I've understood this correctly:
Day traders as depicted in Margin Call do/did perform some modest (probably very modest) service to society in that all the jiggery-pokery and complicated financial instruments have the effect of making investments more appealing, which in turn would reduce the downstream cost of credit to borrowers which is good because all other things being equal cheap credit is better than expensive credit.
It's also not completely fair to lay blame for the financial crisis at the feet of traders/investment banks, at least no more than any other bankers, because they weren't fundamentally responsible for the rotten mortgages that were the root cause of the crisis. At worst they simply didnt look too hard at the numbers because they were making money quite handily from the status quo.
But it certainly isn't true that credit traders etc. give 'Joe Everyman' a big advantage over his global competitors.
Day trader typically means private individuals who trade with their own money from home, like on WallStreetBets. The traders depicted in Margin Call are professional sell-side traders working for an investment bank, whose job is to trade on behalf of the bank's large institutional clients (major corporations, pension funds, hedge funds, university endowments, other banks). To limit the bank's risk, they hedge these trades as they make them. If they're good at their jobs, they make a small amount of money for the bank in the process, but on huge volume, this can amount to a large profit for the desk / their team, which is why many top traders are paid very well. Sometimes, as with the MBS the bank itself issued (a consequence of the GLB Act passed in 1999), their job would also be to trade/sell the bank's securities. I actually don't remember whether the MBS the credit traders in Margin Call were selling had been issued by the bank itself; it might not even be mentioned in any detail.
Traders in general had relatively little to do with the 2007 crash. Lehman Brothers, the largest casualty, collapsed because of decisions made by its leadership to directly enter the mortgage market by acquiring mortgage lenders, to keep acquired mortgages (including commercial ones) on its books for longer before packaging and selling them, and even to some extent to directly enter the commercial real estate market in 2006. None of these decisions were made by even senior credit traders, whose only job was to (try to) sell the securities.
Sure. There were huge mistakes made by senior bankers (although even more by regulators) in the run up to 2008, the biggest of which was a total failure to consider the possible catastrophic implications of a liquidity issue / credit crunch caused by a seizing up of the US housing market. There are ethical issues on the trading floor and in investment banking/advisory (ie. M&A, equity and debt issuance and so on), mostly to do with bankers taking advantage of management that doesn't know what it's doing. But the financial crisis is hard to lay at their feet.
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