US Subprime: History of the Credit Crunch and Credit Crisis

 

Geneva, 23 Oct 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.

Part 1: INFLATING THE BUBBLE

First bubble element – sub prime mortgages

 

 

Geneva, 23 Oct 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.

Part 1: INFLATING THE BUBBLE

First bubble element – sub prime mortgages

Every great bull market that turns into a bubble has similar characteristics. It starts with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats. These are obvious to anyone who has bought a house; like the need for a substantial down payment, the verification of income, an independent valuation, etc. But human nature is such that, given enough time and the right incentives, any endeavour will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. The problems with the US mortgage market (and to a lesser extent the UK as well) are now well documented. Loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate valuations.

The lending institutions in the USA have always been able to package their loans and sell them to a larger financial institution. The repayments are passed on to the buyer, as is the risk of default. Originally the biggest buyers of this debt were Fanny Mae & Freddy Mac who sold bonds to the public to raise the money to buy the mortgage debt. These companies collapsed recently under the weight of mortgage default and had to be bailed out by the US government.

As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further… into unsafe practices, or worse.

Second bubble element – selling the mortgages to banks

As lenders entered into the sub-prime area, they charged higher interest rates to borrowers to account for their risk. They made a higher profit on these and sold them on. With their newly replenished funds the lenders actively sought more high risk debt, as they made more profit. This was the first part of the problem as it sucked people into debt who obviously had no means of repayment. They even devised schemes with 3 – 6 months interest free period at the start, which gave more time for the loans to be sold on before there was any possibility of default.

The next step that started to make the problem more serious was that the banks became buyers of these debts and they created imaginative financial instruments with them. They created a collateralized debt obligation (CDO) by taking a package of high risk, but high yield debt and adding some low risk debt from “safer mortgages” and persuading the rating agencies to give the CDO a double-A or even triple-A rating on the basis that not everyone defaults on their mortgage payments at the same time. They conveniently forgot about the possibility of serious recession.

The banks then sold these instruments onto other banks to replenish their coffers, enabling them to repeat the process.

Getting carried away – the role of AIG in insuring the sub prime mortgages

Now the whole process starts to get out of hand. The banks that bought the rated instruments used these instruments as security to increase their capital base and borrow more money. This is where AIG comes into the story. Around the world, banks must comply with a set of internationally accepted banking rules known as the Basel II regulations. These regulations determine how much capital a bank must maintain in reserve and are based on the quality of the bank’s loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps (CDS)

To understand how it worked, assume you are a major European bank with a surplus of deposits (Europeans save more than Americans). You are under pressure to maximize the spread between what you pay for deposits and what you can earn by lending. You want something that is safe and reliable, but also pays the highest possible annual interest. You know you could buy a portfolio of high-yielding sub prime mortgages, but doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities (CDOs) in your portfolio, you simply call your friendly AIG broker and ask him to insure this sub prime security against default. The broker agrees to guarantee the sub prime security you’re buying against default for five years for say, 2% of face value. This is on the basis that the historical loss rates on American mortgages are so low as to be close to nothing.

Although AIG’s credit default swaps were really insurance contracts, they weren’t regulated. That meant AIG didn’t have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to “mark-to-market” accounting (which values an asset at the current market price), AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a portfolio of sub prime “toxic loans”. The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in “profit” each year, without having to deposit billions in collateral.

Apparently, AIG did not have the capital to back up the insurance it sold as it did not expect a default and the profits it booked never materialised. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected and they continue to increase. In some cases, the securities the banks claimed were triple-A have ended up being worth less than $0.15 on the dollar.

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (valued in March 2008 at $22 trillion, but has fallen a lot since) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market.

The credit bubble

The CDS market worked for over 10 years. Banks leveraged deposits to the hilt. Wall Street packaged and sold sub-prime mortgages as securities (CDOs). AIG sold credit default swaps without bothering to collateralize the risk and so an enormous amount of capital was created out of thin air. Nobody is really sure how far the contagion spread. Certainly we have seen the European banks write off tens of billions of dollars of this bad debt in the past year and it is by no means all written down even now. There are strong rumours around Geneva (where I am at present) that we have barely seen half the debt declared and written off.

The Middle Eastern banks have declared that they did not become involved in the CDO and CDS markets. It is not clear whether Asian, Russian, Chinese or South American banks were involved, however it does seem to have been more of a USA & European phenomenon.

Part 2: BURSTING THE BUBBLE

Clive Ward, Guest Contributor for EconomyWatch.com

Sources: Financial Times, The Times, Steve Sjuggerud Daily Wealth, International Monetary Fund website, Time Magazine

Clive Ward is a director of Affinity Consulting Group Ltd (ACG) and of Ganoz Asset Managment Ltd (GAM).  ACG provides investment advice, financial planning and portfolio management services and has offices in Singapore, Dubai and Shanghai.  www.affinity-consulting.com

GAM manages a range of high yield, automated, technical trading forex funds, some of which are capital protected with fixed returns.