May 16, 2009

WTF is the subprime crisis ??

Just like every MBA aspirant I too went through a period where I really wanted to know "What the fuck is this sub prime crisis which led to this mess "....After a long search through numerous articles written by famous economists I understood that "an asshole like me would me would never understand the crisis...But nevertheless not wanting to give up I mixed up a few fundas from here and there and present to you the simplest explanation of the subprime crisis hopefully ... Though I dont take credits for this article , its dedicated to all assholes like me who always wondered "WTF is the subprime crisis"


Not only in India even in the US, buying a house is considered to be one of the best investments one can make. This is particularly true because the government, as part of long standing policy, encourages people to own their own homes by allowing tax-deductions on mortgage interest payments. This means if you took a loan to buy a house and are making monthly payments towards the mortgage as well as towards property taxes, the government puts some of that money back into your pocket by allowing you to deduct a percentage of those expenses from your federal taxable income. In other words, a certain portion of your house-ownership cost is written off by the government from your tax bill.

Since the US government does not consider providing any such relief to people who rent , the financial incentive to own a home is that much greater.
And The housing boom was obvious . For the last few years, prices of houses were skyrocketing in the US driven by ever-increasing demand. So much so that people, many many of them in fact, started thinking like Mr. Ramaswamy below:
"Hey this house is worth $500,000. In a year it will be $600,000. So if I can sell it then, I can get a 20% return on investment. "
Of course there is a small problem. Ramaswamy's net worth, in terms of his savings, are $10,000 (2% of the house's cost). And just to make things worse, he has a bad credit history having defaulted on his credit card bills a few times. In order to make the very basic minimum down-payment for the house (usually 20% of the cost), he needs $100,000 i.e. $90,000 more straight away.

He goes to the bank.

Now in normal situations, the loan officer would look at Ramaswamy's bank statement and his credit history and show him the door telling Ramaswamy politely that he just does not have the equity to make such an expensive purchase.
However these are not normal times.
What happens is that on seeing Ramaswamy's loan application, the loan manager smiles, shakes Ramaswamy's hand and provides him the loan on his down-payment. Yes the full $90,000. Plus the loan manager also provides as loan the rest of the house cost (i.e. loans him an additional $400,000) enabling Ramaswamy to take possession of the house right away with zero-down.

So what does Ramaswamy provide as collateral? Nothing.

The only catch is that in exchange for the high (and unreasonable) risk the bank is taking on giving this loan , it expects a very high rate of interest from Ramaswamy. This transaction between Ramaswamy and the banker (let his name be Kanduvaddi kandaswamy) is what is known, as "subprime lending". Kanduvaddi kandaswamy is happy because he is going to get a lot of money as interest for his investment (albeit more than a bit risky), which, in turn, is going to translate to a higher commission for him.
And Ramaswamy is only too glad to get any loan.

As he tells his worried brother Madaswamy "Don't worry about the high rate of interest. In a year, we will recovered our money and quite a bit more. So no problem."
And so this came to pass that thousands of such "sub-prime" loans are written by greedy creditors out to make a fast buck on the high interest rates and then accepted (often many loans at once), with glee, by equally greedy common citizens who think, based on advice given by "pundits", that the housing market would be the golden goose that would keep on giving year after year.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, are special private corporations that have strong government ties. Fannie Mae and Freddie Mac were started by the US government so that they may provide credit to the banks (i.e. the primary lenders who loan money to people to buy houses). This was to enable primary lenders to provide more mortgages to common people and thus promote home ownership.

In short a "periya thalai" ( the godfather )

Let me explain how I think this works (the actual process I guess is a bit more involved). Say I buy a house for $500,000.. The total amount I have to pay back to my bank at the end of thirty years (my mortgage period) is $600,000 distributed over monthly payments. The bank however has to pay the seller of the house $500,000 right away and then wait for 30 years before they have their full principal and interest back. In other words, the money would be "stuck" for that period of time.
This is where Fannie Mae/Freddie Mac come in. They go to the bank and if they believe that the bank has followed sound lending practices, they buy the mortgage from the bank for say $520,000. Which means that the bank gets its $500,000 back immediately along with $20,000 interest without having to wait for years. It has thus not only made a profit but it has recovered its principal leaving it free to re-invest this amount into another mortgage.

Now Fannie Mae/Freddie Mac will be the party responsible for collecting on the $600,000. Since the mortgage was bought for $520,000, at the end of the mortgage period it will have made a $80,000 profit.

Now where did Freddie Mac/Fannie Mae get this $520,000? Why doesn't it worry about the fact that its money will be stuck for 30 years? That is because Freddie Mac/Fannie Mae sell what are known as mortgage-backed securities to investors.
Just like an index fund allows an investor to invest in a bouquet of companies with the spread of companies reducing his risk of betting his money all on one horse, a mortgage-backed security (MBS) allows an investor to own stakes in a large number of different kinds of mortgages.
So when Freddie Mac/Fannie Mae make the $80,000 profit on its $520,000 investment, it can keep a percentage of the $80,000 as its commission and passes on the rest as dividend to the MBS-holders i.e. all those who made an investment in that particular mortgage.
Now as is evident, higher the rates of interest are on the mortgages that form an MBS, more are the payouts to the investors in that MBS. With financial experts betting on the housing market to grow and with the consistently high returns on such securities, the prices of MBSs appreciated greatly with investment banks, institutional investors like pension funds and hedge funds all rushing in for a piece of the action. And added to the fact that securities issued by Freddie Mac/Fannie Mae had an implicit backing of the federal government (i.e it was "expected" that the government would cover the investment in case of financial downturns) and one can understand the craze for Freddie Mac/Fannie Mae MBSs.

Now were Freddie Mac/Fannie Mae head honchos well-aware of the shaky foundations of the MBSs they were peddling? You bet they were. But then why should Ramaswamy and Kanduvaddi kandaswamy be the only greedy ones when Peelamedu pavadai , the big boss of Freddie Mac/Fannie Mae is also in the game? Buoyed by the high returns on MBSs, the management of Freddie Mac/Fannie Mae helped themselves to obscene bonuses and vulgar pay-increases.

Of course, in the midst of all the excesses, they conveniently forgot that they were to use their profits to buying more mortgages, increase capital flow in the housing market and thus push down mortgage interest rates.

Money as they say does strange things to memory.
In the lucrative business of buying mortgages, Freddie Mac/Fannie Mae were not the only players in the town, though they were the largest. Different kind of financial institutions like insurance companies and even normal banks were falling over themselves in order to buy sub-prime mortgages from the primary lenders and sell them as part of their investment products. Yes those very loans that had been given to credit-unworthy people like Ramaswamy who had no assets to cover the huge amounts of money they had taken out.

Something was bound to give. With a financial disaster of a war, rising national debt, falling dollar, job losses and out of control oil prices, those people who had taken multiple mortgages out on their $10,000 bank account no longer had the money to make the high monthly payments.
The buyers they had predicted would buy their houses at a premium—well suddenly they were no where to be found.
So thousands and thousands of home-owners just threw up their hands and declared bankruptcy. Houses were foreclosed and seized. People were evicted.
But then the question remained: who would buy these seized homes?

No one. Cause people had no money—a state technically called "Govinda govinda". Banks, once they realized that the housing bubble had popped, had tightened their lending policies (too late guys) and so loans were no longer easily available. Houses stayed on the market forever. Their prices nose-dived.
And mortgage-owners were left holding non-performing, fast deprecating assets on which they had to pay property tax in order to keep holding onto them till a buyer could be found.

Remember that $600,000 payment Freddie Mac/Fannie Mae needed in order to pay the dividends to the MBS holders and also take their commission, the expectation of which had forced MBSs to stratospheric levels ?
Well the news was that there was no $600,000 coming..

MBSs , once bought at high premiums, had started losing their value rapidly.
Disaster was now at the gates. For banks who had invested in mortgages themselves. For Freddie Mac/Fannie Mae. For people who had bought MBSs. For anyone who had guaranteed a mortgage or bought one. In short, ruin for most of the economy as black suit bankers sat on a mountain of useless MBSs that was often not worth the piece of paper written on.

Was that all?
I made one gross oversimplification in my preceding narrative. (Well more than one. But bear with me.)
When greedy banker Kanduvaddi kandaswamy gave the loan to Ramaswamy, he told him that Ramaswamy will get the loan only if he takes out an insurance on his mortgage so that if in the (unlikely) case that Ramaswamy cannot make good on his financial commitment, the insurance company will pay the remaining amount on the mortgage. Ramaswamy now has to make monthly payments for his mortgage insurance (over and above his mortgage payments) but Ramaswamy doesnt care. Cause he has the pot of gold at the end of the rainbow. The fact that the mortgage is insured is also good for Kanduvaddi Kandaswamy as he has covered his bases, should someone ask him what kind of risk mitigation steps he has taken.


Now let's consider the situation from the point of view of the insurance company. Jambulingam , the big chief, suddenly gets all these house-buyers who want mortgage insurance and are ready to pay a nice premium for them. Ibu thinks to himself :" This is good. With the way the housing market is, there is not much chance of the house buyer going bankrupt–he will always be able to sell his house and make a lot of money. So no chance of him defaulting. Let me keep on selling these insurance products."
And so he keeps selling. Because his company is well-known, the insurance-buyers never ask him "Do you have assets to cover all your insurance liabilities?"After all, when we buy car insurance from Geico or Progressive, do we ever stop to ask them if they actually have the money to pay $25,000 for damages, if I total someone else's car? No we do not.
And so insurance companies kept on making out these insurances far beyond their covering capacity. The premiums were like "free money", insuring (as one expert opined) cars in a country where there were no car crashes. Why just housing? Companies started insuring any kind of big loan with the guarantee of coughing up the cash should the loaner default. Just like mortgage-backed securities, these "I shall pay up when you cannot" instruments (technically called credit default swaps) were being bought and sold on the market at high premiums and companies who were dealing in them were raking in the profits.
What that meant was Jambulingam, the insurance guy , would sell the rights to collect premium from Ramaswamy to the others , say muttal mani and loose mohan would in turn sell that credit default swap to someone else. The market for credit default swaps were red hot —AIG, one of the biggest names in insurance had $78 billion worth of swaps !

Again, all this was fine till the day the housing market went boom. Thousands of people began to default on their loans. All the cars in that crash-free world had just run into each other. The insurance companies and the buyers of credit default swaps, needless to say, did not have the cash to cover the claims. With the housing market going down, different other kind of business deals started going sour. Even more debt insurance claims were made. And the more they were made, the deeper the owners of credit default swaps sank into the swamp.
Then of course there were the investment banks—the Bears and Sterns and the Lehmans of the world. They had their proverbial finger in each of these superhigh yield pies be it the mortgage-backed securities or the credit default swap markets. As a result of years of high-paying lobbying initiatives, the investment banks had made sure that they operated under the minimum of controls and oversight, freeing them to take unreasonable risks while investing.
Initially it all went according to plan. Even better than the plan as a matter of fact. The more they raised the stakes and the more outrageous the risks they took, more money they got.
Income forecasts were manipulated by taking into account the so-called "value" of the credit default swaps whereas in reality it was nothing but "funny money" that existed only in an optimistic future, a tomorrow that would ultimately never come. And with such rosy forecasts and on the back of its great current "performance", Wall Street paid out record performance bonuses across the board.

Till of course disaster struck. The MBSs sunk to junk and people started calling in the credit default swaps. The banks did not have enough assets to cover even a fraction of its liability.
When angry Rajnikantha says with this one rupee I will become a millionare in sivaji it sounds macho and cool. Now when investment banks are shown to have followed that same principle, it's quite horrifying. To put it mildly. No wonder then that investor confidence and their overall credit-worthiness suffered.
The only way for the Lehman’s and the Bears and Sterns to be able to survive would have been to raise money from the market and use it to discharge their obligations. But the credit market had frozen up. No financial entity in Wall Street was trusting anyone else with their resources. Starved of its cash flows, an investment bank like Lehman Brothers that had survived the Great Depression and two World Wars went belly-up. So did Bear Sterns before it was acquired.
AIG and Freddie Mac/Fannie Mae were in danger of coming to their knees but since they were considered too critical to fail , they were given federal life-lines through infusion of tax money to keep them afloat.
Two of the biggest banks–Washington Mutual and Wachovia were not so lucky and was taken over by other corporations.
And most importantly, the High End Girlfriend Index, the true indicator of the value of Wall Street fat cats, collapsed spectacularly.

The face of the financial world had changed within a few weeks.

4 comments:

  1. honestly, never read anything so informative and yet not so boring...wow!!!sooper da...

    now ppl will get to know the REALLL meaning of "crisis" ...
    evn tho you don deserve the entire credit, the lil bits clipped here and there are streamlined and makes the entire post lively...really good approach...

    keep writing :)...waiting to read more about such boring topics in an interesting way..

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  2. hmm future economist .. nice 1 .. right in essentials .. i tot of writin 1 on this .. but u saved me the trouble :)

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  3. thanks ppl ...more to come on the WTF series ...keep visiting...

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  4. KoratturKarizmaFellowDecember 30, 2009 at 8:17 PM

    machi why attack ramaswamy in all your posts? poor guy

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