The paper I will be analyzing is “Systemic Risk and the Refinancing Ratchet Effect”, written by Amir E. Khandani, Andrew W. Lo , and Robert C. Merton. You may recognize one of the authors, Robert C. Merton, who is a Nobel laureate, though even the other professor, Andrew W.Lo, is a heavy-weight in the financial academic industry.
At 75 pages, it is a bit on the lengthy side, but I would consider this a must read for anyone interested in the real-estate finance or the recent financial crisis. It is a draft paper that I will be reviewing, so there are some omissions such as table figure numbers, but at least it is freely available and I would highly recommend to read it at:
The main premise of the paper is that three separate and positive economic effects were (most-likely) the main factors responsible for the subprime mortgage crisis: rising housing prices, declining interest rates and easy very-low cost mortgage refinancing. These normally-looked-at-as positive economics effects lead to higher levels of housing leverage when housing prices increase, but there was no subsequent deleverage when housing prices dropped because of the easy refinancing available. This effect is what the paper calls the refinancing ratchet effect – a ratchet effect is essentially any mechanism that will increase something with time, with no way of reversing that trend – think of cars with more and more features, or textbooks with more and more content.
Mortgages are considered leveraged financial instruments since most of the mortgage is taken out as a loan by the homeowner, and the actual investment by the homeowner is a small 10-20% down payment. And the refinancing that is the cause of the high leverage is not a change of rate/length of term re-financing, but rather a cash-out refinancing, where the homeowner takes out in cash any home equity that has been build up (i.e. any increase in the house value after the mortgage has been signed and/or mortgage payments that payed down part of the principal) – and apparently there was a lot of that going in the years leading to the crisis. This essentially meant that a lot of the risk was transferred from the borrower (homeowner) to the lender (mortgage-lending institutions). On the other hand, if easy cash-out re-financing was not available, borrowers would have smaller mortgages and would be less over-levered, and in the case of defaults, lenders would be less impacted due to the home equity that was build up and could sell the house at a premium. The total simulated impact of the cash-out refinancing is estimated to be $1.6 trillion over a two and a half year span, and this was a figure too high for U.S. banks to absorb, and thus the financial crisis ensued.
Here is an example on how a homeowner can become over-leveraged through cash-out refinancing. If you purchase a house for 400,000$ with a 100,000$ downpayment, the loan-to-value is 300,000$/400,000$ = 0.75
If the value of the house went up to 500,000$, the home-owner can take out 75% of the 100,000$ increase in cash-out refinancing (typical scenario). But if the price of the house drops to the original cost, the loan to value has jumped from 0.75 to a staggering 0.95 (380,000$/400,000$). And from the report, most people do not invest it or pay down debt, but rather use it for such things such as home improvement which does not help in improving house value when the house has already been devalued.
A good amount of the paper goes over the methodology of the simulation and the derivative pricing model used to simulate the mortgage markets, along with details on how the input data was constructed. Having a background in financial engineering will be helpful in understanding some of that material.
The main recommendation given was to create an independent organization solely devoted to track and warn about systemic risk in the system created by the three factors outlined previously.
I have my doubts on the usefulness of creating yet another ineffective government or governmental-type agency, especially when you look at the track record of other financial governmental agencies such as the SEC and their lack of finding any fraud when there was many formal complaints about Bernie Madoff’s funds, and this was many years before he finally got exposed. Or even the U.S. Commodity Futures Trading Commission and its lack of power, oversight and capability to prevent the mortgage crisis, there could have been better rules on regulating the securitization of mortgage securities and diminishing the amount of leverage used by banks.
A solution would be to curb any of the three effects, especially easy cash-out refinancing, but it is not as easy as that since curtailing any of these ‘positive’ effects can lead to negative economic impact – which is precisely the situation we are trying to avoid in the first place.
Alas, I don’t have the solutions, but one thing is clear to me, no matter how much the aftermath of a crisis will be analyzed by academics, economists and governments, it will do little to prevent the next, albeit slightly different, crisis.
Other useful tidbits to note from the paper:
-Just like the term “Black Monday” is used to describe the stock market crash of October 19th, 1987, the recent financial crisis also has a term with capitalized letters to describe it: “Financial Crisis of 2007-2008”
-Matlab and the Financial Derivatives Toolbox plugin was used to price options – if you have access to it, I would highly recommend to learn it
-A pretty good mortgage crisis literature overview is provided, which can lead the reader to get more in-depth knowledge on the other papers written about the mortgage crisis and U.S. mortgage market
1. Systemic Risk and the Refinancing Ratchet Effect can be found at:
2. Racthet Dollars photo courtsey of http://pronlinenews.com/?p=4203
Feel free to leave suggestions on any improvements / factual errors,
and some of my other business writings can be found on my site: ThePostMBA.com
Tuesday, January 10, 2012
Monday, January 2, 2012
A lot of people have ideas, you may be one of few with a truly great idea and to protect that idea you need to patent it. A patent gives you the right to essentially have a monopoly on an idea, process or invention on a per country or jurisdiction basis. The usual protection length is 20 years from filing the patent. The most popular countries to get patent protection are United States, Europe and Japan with the United States usually considered the primary area that you need to get an idea patented and protected.
But you need to be really careful if you go that route.
For one thing, patents can cost in the thousands of dollars if you hire a patent lawyer to draft the patent application. A survey among small Canadian law firms in Canadian Lawyer Magazine discloses the average patent application cost at a staggering $4,3001.
It's a lot cheaper if you don't hire a lawyer, yet it usually recommended to go the lawyer route because you won’t have the expertise to:
-Avoid making the patent too narrow and giving away important rights (non-use and assignment clauses)
-Avoid making the patent application too broad and getting it rejected
And much more importantly, 97% of all patents never make any money2. And you will have to wait three years to get a patent examiner to review your application. The odds are highly stacked against you.
There is a very simple solution to this problem that is often ignored and unfortunately not recommended enough by patent lawyers, and that is to apply for a provisional patent instead - and hence the reason for my chosen title of this post.
This essentially allows you to protect your idea and iron out the details whether you want to file a full fledge patent application, for a small entity (i.e. small business/individual), it will only cost you $125 and should protect you for a year3. The complete fee schedule is available here, albeit a bit complicated on what items get charged:
If you are starting to line up potential customers and can clearly demonstrate real business value and sales revenues, then it is time to exercise the option of turning the provisional patent into a patent application.
A few good places to start the patent search to see if the idea is unique and novel:
- The World Intellectual Property database - http://www.wipo.int/portal/index.html.en
3. I am not a lawyer, so even though this is legal advice, this is not officially legal advice.