Finance – VI. The Financial Crisis of 2008 (1 of 3)
Date Posted: March 14th, 2009
Between the period of July to December 2008, the roof caved
in on the global financial system. Should we have anticipated
such a calamity? By “we,” I do not mean you and me. We are but
mere mortals. The reference is to the experts who get paid fat
salaries to protect us from such misfortune. What happened? Who
was at fault? I will present you with an overview; brief and
general as it will be, use it to come to your own conclusion.
Keep a box of tissues close by, you will need it! If you want to
know more, and find the subject absolutely fascinating, there are
many books out there on this sad saga.
The subprime mortgage meltdown
The subprime mortgage crisis was due to the fact that one of
the cardinal rules of extending credit was broken. Subprime
borrowers were given a loan, even though their ability to repay
was questionable The result was a dramatic rise in mortgage
delinquencies and foreclosures in the U.S. A chain reaction
followed that affected first the homeowners, then the banks, then
the numerous investors who got caught in that scheme, and finally
the financial markets around the world.
It all started towards the end of the ’90s, and became
apparent in 2007. The problem is still very much with us, many
accounts are still delinquent, and many more houses will be
repossessed.
Who is a subprime borrower, and how could a family be
tempted to overextend itself?
Some red flags which indicate that a family will not be a
prime borrower are:
* Low family income.
* The absence of any assets (car, securities, etc.);
* Overdue loan repayments to previous loan(s);
* Repossession (example a car), or non-payment of a loan in the past;
* Bankruptcy in the last 5 years;
* Relatively high default probability as indicated by the credit score;
* Accuracy of the credit data as reported by the underwriter.
The matter is clear: you’re prime if you have a good income, some assets, and a good credit rating as evidenced by your past credit history. You’re subprime if you have some of
the aforementioned issues, and under no circumstances should you
get a mortgage. But how did you get one anyway? How where you
tempted? Let me answer the second question first.
The Jones are struggling financially. Mr. Jones is a part-
time messenger by day, and a security guard in the evening. Mrs.
Jones is a waitress. Their only son study and works a few hours
a week. Their only asset is a 10-year-old car. They used to own
a better car, but it was repossessed when they couldn’t keep up
with the payments. They are consistently late paying their rent.
They owe sizable amounts to their credit card companies. Would
you loan a substantial amount of money to the Jones? Of course
not. And yet …
One day, the Jones get a flier in the mail. They apparently
can own their own home. Call this number and somebody will come
and explain to you how you can realize your dream. The gentleman
who meets them is very reassuring. Down-payment? We don’t need
any. Our income is low, we can hardly make the rent? Don’t
worry about that, I’ll show you how it works.
So how does it works? The interest rate at the beginning is
low, but then, after two years it increases substantially because
they are a high credit risk. That, however, shouldn’t present a
problem; the price of homes is continually rising, they can
refinance (i.e. get another loan based on the increased value of
their house). The amortization period is 35 years, instead of
the traditional 25 years. (I read that amortization periods of
50 years were offered by some banks!) It’s a bedtime story! But
the Jones do not have the necessary education to properly
evaluate this foolish offer, and they accept it.
In time, interest rate, as promised, increases; the value of
their home, as promised, go up too; all is well so far. However,
the day comes when the price of their home decreases and keeps on
going down. It doesn’t take long before they find themselves
facing a painful financial situation. By 2007, they can longer
make their mortgage payments and they lose their home. The dream
has turned into grief. The Jones are a fictional family,
countless other American families are real flesh and blood
people, and their pain is just as touching. But what is the
interest of the lenders?
Put in a simple way, the loan given is rolled up and
amalgamated with all other subprime mortgages. The whole thing
is in turn sold out to the big boys on Wall Street. But that
requires phenomenal amounts of money; as well, why should Wall
Street institutions be willing to assume such an enormous risk?
The simple answer is that they are getting the funds from
numerous investors, both average Joes, and big institutions, and,
yes, they (the investors) are the ones who assume the risk. But
how and why should people invest in such risky mortgages?
There is something called Assets-Backed Commercial Papers
(ABCP). They were born in the ’90s, the return is somewhat
better than a bond, and they are backed by solid (or so we
thought at the time) assets. Security and good income, who can
ask for more? I never invested a penny in ABCP even though they
were touted as granny’s investments. Why was I suspicious? No
logical reasons, except that I detected a faint bad smell around
them, the smell of it’s too good to be true.
When in time many of the ABCP proved worthless (because they
were largely backed by subprime mortgages), many ordinary
investors and institutions lost substantial amounts of money.
For instance, many big banks had their capital and cash reserve
sharply reduced when their ABCP proved valueless. Many
corporations had their near-cash (called this way because it’s
considered almost as good and as liquid as cash) reserve greatly
reduced when their ABCP lost their value. This lack of
confidence, needless to say affected markets around the world.
But you might say that the so-called investor banks on Wall
Street fared well since the whole scheme was meant to benefit
them. Well, not exactly. When the house of cards came tumbling
down, they were gravely wounded. Why? For that we need to
understand the principle of leveraging, the weapon these storied
firms used to make enormous profits.
