Friday, October 10, 2008

A to Z of Subprime Crisis

This article was also published in Gulf News, UAE's leading news paper.
Clarence Nathan was a man with three part-time jobs who earned about $45,000 a year, and yet a bank loaned him $540,000. The bank never checked his income.

What happened that diluted the most basic rules of lending? What happened that made the banks open their coffers without bothering to even consider the risks? What were the brokers and bankers that made all this possible thinking while showing their generosity to those least deserving of the loans?

When we first heard about the subprime crisis we would’ve thought it had to do with the housing industry. However, it had less to do with that and more to do with financial services industry – and the people who were financing those houses.

The crisis really starts with what some researchers have started calling ‘The Global Pool of Money.’ This is the entire world’s investments: pension funds investing for people’s retirements, insurance companies investing our premiums, governments’ central banks investing their nation’s wealth. This global pool is estimated to be about 70 trillion dollars. This amount is more than entire money spent by everyone – individuals, companies, governments - all over the world in a year. So, this global pool of money is a huge amount of money.

We also have a group of people called the investment bankers whose job is to watch over that money. They have a twofold task to perform: not to lose a penny from the pool and to also make it grow. For a long time, they made this pool grow by investing in very safe bets like US treasury and municipal bonds. But right before the actual story starts, something happened – something really big. This global pool of money got too big too fast. In fact, it doubled between the year 2000 and 2006. The scale of this proliferation could be gauged by the fact that this global pool took centuries to reach 35 trillion dollars and just six years to double up. The major reason for this humungous growth was the sudden growth in the wealth of many historically poor countries like India, China, Brazil, Gulf countries, etc. These countries banked their profits and looked around the world for ways to invest them. So, suddenly there was twice as much money in the pool waiting for investment. However, the world wasn’t ready, simply because there weren’t twice as many good investment options. Another parallel development was Alan Greenspan’s move to reduce the US Fed interest rate to one percent, thus making US Treasury bonds – the then darling of investors - not so lucrative for the international investors. So this global pool looked around for options and found one in the US housing market and a special bond created by the Wall Street. This bond just couldn’t produce enough profits to keep all the investors happy and the pressure of generating ‘good’ profit figures just kept building up. More and more international investors wanted those bonds than the investment firms like Morgan Stanley, Bear Stearns, Lehman Brothers etc. could actually produce.

This is how the investment banks produced the financial magic of turning mortgages into bonds. They buy up all the housing mortgages – thousands of them – and pool them all together. That way, they had this constant stream of mortgage EMI payments coming to them every month. They would then sell shares in that stream to global investors. That is how you create mortgage backed security or mortgage backed bond. Now, between 2003 and 2006, US housing market was growing so fast that all the global investors were itching to get a piece of that action. But there was a problem. The problem was that to make a mortgage backed security, you need a mortgage – and there weren’t enough mortgages. By 2003, with very low interest rates, all the people with a steady income who could afford mortgages – and were considered safe borrowers - had already taken those bonds. They didn’t want to take any more bonds. But this global pool of money was hungrier than ever for these mortgage backed bonds. So Wall Street started lowering its standards for offering such loans.

It used to be that to get a mortgage, you had to prove that you made enough money, that you had a steady job, that you had some assets in banks. But starting around 2003 onwards, Wall Street started to loosen up a bit every month. One month, banks would say that buyers don’t have to prove how much they make, they can just state how much they make and we’ll trust them. The next one was a No Income Verified asset; so you don’t have to tell the people what you do for a living or how much money you make – all you have to do is state that you have a certain amount of money in the bank and we’ll trust you. Then the next one that came was No Income No Asset (NINO) loan wherein you don’t have to state anything; you just need a credit score and prove that you’re living. Even the latter was optional in some cases like those in Ohio where 23 dead people were issued mortgage loans. This NINO loan is now retrospectively infamous as ‘The Liar’s Loan.’ Within the banks, there were people getting sick to their stomach at giving such loans. They fought tooth and nail with their sales force and bosses to stop offering such loans. But all they got were cold shoulder replies like ‘Others are offering it, we’ve to offer it too. The global investor has some loose cash and if we don’t use it, somebody else will. We’ll get more market share this way. House prices are booming and everything is going to be fine.’ All of this was happening under the assumption that US house prices would always appreciate. So even in the worst case if someone defaulted, the impounded house would be a bigger asset with the bank. That assumption proved very costly.

In the old days, such mortgage companies would’ve held on to these loans for years - until they were sure that the mortgagee would be able to pay - before selling these mortgages to Wall Street. In the new system, they held them for a month or two and then sold it to Wall Street – all that risk was Wall Street’s problem. Even Wall Street wasn’t too concerned because it just passed the risk to the global pool of money – all the global investors. The irony, however, is that Wall Street also wasn’t particularly cheating on these global investors. They had complex computational models that were constantly monitoring the data to assess the risks of the bonds. That data told them not to bother since mortgage foreclosure rate was one or two percent and the models were designed to perform well even on a foreclosure rate of ten to twelve percent. But this conclusion was way off because all the data they were looking at in 2005-06 for the loan repayment was years old –and was positive because the old bonds were issued to qualified people who were duly paying them back. Then there were companies like Dynamic Credit that bought and re-packaged those bonds into a complex financial product called Collateralized Debt Obligations(CDOs) and sold them to these global investors.

This finishes the chain which now looks like “Individuals taking mortgage -> broker -> small bank -> Investment Bank (Wall Street) -> thousands of mortgages in one big pool -> shares of monthly income called mortgage backed security -> repackaged into CDO -> global investors”

When it all came down at once, these pools started showing a foreclosure rate of around 15 to 50%. Therefore, such bonds then started losing money – taking with it, everyone involved. Four million Americans facing the foreclosure, hundreds of mortgage companies are now bankrupt, hundreds of thousands of people have lost their jobs. IMF has estimated that banks and investors could lose around a trillion dollars.

But everyone involved was not exactly foolhardy. Companies like Dynamic Credit refused to buy the bonds that were outright risky. They thought they were being conservative – yet they lost millions, even billions. Almost everyone involved in this knew that something weird was going on. The deals they struck did not feel right. But none of them really questioned things. Why would they? Everyone involved was making an awful lot of money.

The nosediving of all the share markets the world over is just the symptom of a disease. The disease is imprudent financials practice of flouting the basic pragmatic rules. As David Moore, CEO Moore Investment & Holding, Inc, wrote, “Our efforts will all be for naught until two things happen:
1. investment banking and mortgage lending institutions follow strict, conservative and prudent regulations regarding investments and lending and
2. the American people are not allowed to obligate themselves to loans they cannot afford. It would be nice to get people to conduct themselves with their own financial interests in mind, but we must regulate the areas that we can and not give financial access to people who cannot prove a reasonable probability that they can repay loans, and we must regulate business so they don't engage in these unsound lending practices for personal and institutional greed ever again.”