The Credit Crunch Explained

Credit Crunch Explained - How subprime mortgages and securitization has led us into recession

Definition of subprime

It takes its name from the off-cuts of prime meat. This can best be described as the cuts of meat a butcher would use to make sausages, as opposed to prime cuts which would perhaps be pieces of steak. Prime mortgages are issued to credit worthy people that have a credit rating, and a history of paying off their debts. The subprime market was aimed at poorer or more riskier customers that had a bad credit rating, or no credit rating and little or no deposit. In the UK we called subprime selfcerts. They were similar products, but aimed not just at poor people but anyone that wanted a mortgage but didn’t want to disclose their true income, hence the name self-certification or selfcert.

An example of how subprime worked in the US

John Smith is on a low wage and is already in debt to the tune of $10,000, (credit cards, bank loans etc). He is currently renting. It is 2004 and he is approached by a mortgage broker (in the US there were about 700,000 brokers) who offers him a $100,000 mortgage to purchase his own home. The deal can also absorb his existing debt of $10,000 and the arrangement fees for the mortgage, $3,000, making his mortgage $113,000. The enticement or carrot if you like is to provide a very low interest rate or waiver the interest rate altogether for the first two years. In reality the interest is clawed back by the end of the mortgage term by increasing the monthly payments gradually over the term.

The waiver was the hook that helped to draw in hundreds of thousands of new home owners specifically from poorer areas of America that wanted the American dream. The interest rate after two years was high at 10%, normally variable and could reach 14%. This is the only opportunity John Smith has of securing a property. The contract is lengthy and detailed, (over 50 pages in some cases), and John doesn’t bother to read the small print. To him this sounds like cheap money, while fulfilling his dream of owning his own home. He signs up. Millions did. In fact by 2006 approximately 35% of mortgages were based on this model in the US. Put it another way, the banks were taking on 1.3 trillion dollars of debt from people that had a bad history of defaults or no history at all.

If the US was leading the way in how not to run a sustainable economy, the UK was only too eager to follow. Before the Credit crunch, 44% of mortgages were selfcert or "tell us what you earn and we'll believe you" mortgages. According to an article in the Financial Times (January 31) it is now down to 33%!

Now the clever bit starts

The broker then sells on the mortgage debt to a bank and receives a commission for doing so. The broker has therefore received two commissions. One from Mr Smith and one from the bank. No wonder there were over 700,000 mortgage advisors in the US by 2007! with an army of MAs in the UK as well. The bank, let's call it Hyper Bank, is actively taking on these subprime mortgages and then bundles them together into a single product. This is what is known as Securitization. Let’s call this product an SMO. Hyper Bank then pays a credit rating company a fee to give the SMO product (can be known as a Mortgage Backed Security MBS) a good quality debt rating. In fact many got a AAA rating even though the product contained high risk debt from subprime mortgage holders. Why would rating agencies rate a product that is essentially high risk?

Rating Agencies - The devil is in the detail

Rating agencies had rated products, securities and even countries with more than a hint of optimism before, knowing full well there may be significant underlying risk. This was nothing new. Also the act of rating agencies being paid by the organisations holding the securities was common practice. So why was this time so different? I argue that the main problem was not that the agencies were being paid by the organisations to rate their products, however bizarre that may sound, but it was the simple fact that these products in their construction were so complex it would have taken a rocket scientist to unravel them.

Well in fact many of them were rocket scientists! Known as quants, the individuals that devised these bundles of financial products were mathematicians and physicists. Arguably these individuals created a real live Frankenstein’s monster.

Perhaps with some irony the complexity of these products had a positive aspect for both the rating agencies and the companies holding them. If a rating agency gave a triple A rating to a product but the product was by its very nature impossible to unravel, examine and assess, it left other rating agencies slightly out of the loop unable to criticize the ratings, in fear of looking..... dare I say, stupid. Ihe firms holding these products benefitted as the very complexity meant rating agencies did not look too deep into the products, and in any case the products would always hold bundles of undisputable good debt. The toxic assets from selfcerts and subprime would be buried very very deep. More on rating agencies can be found at www.voxeu.org

Also read: The origin of bias in credit ratings, by Vasiliki Skreta and Laura Veldkamp, voxeu.org

Back to our SMO

The attraction of this mortgage bundle (our SMO), is that it is gong to pay 10% a year against government Bonds securities at the time (2004, 05, 06 of only 2-3%) and in an environment of ever growing house prices. So if someone did go into arrears the bank could happily re-possess the house and sell it to get their money back. It was a beautiful plan, just as long as house prices kept on rising. However, Hyper Bank is not satisfied with receiving 7% above Bond rates. Remember the infamous Gordon Gekko from Wall Street “Greed is good” So it creates a new company. Let’s call it SMO Investments, and places the highly rated mortgage debt vehicle into this company with the announcement of 10% returns on this “asset”.

By creating a new company, Hyper Bank is able to get the mortgage liability off its balance sheet, while still gaining loans from other banks to purchase new mortgages. This is simply a brilliant move; keeping this debt at arms length while benefiting from the rewards by virtue of increased capital to purchase even more mortgage debt. Securitization is the time bomb that put us where we are today.

There was hardly a bank in the US or UK not involved in loaning money to other banks and institutions to buy mortgage debt or indeed establishing their own mortgage asset vehicle; the returns were simply too good. Investment banks that had traditionally turned their noses up at dealing with such mundane and lowly products as mortgages were becoming seriously involved by investing heavily into these new debt vehicles or banks that were generating income solely from mortgage debt. Even large insurance companies like AIG were getting involved. It was party time, and no-one wanted to be left out.

This is a very important. For the first time investing in Mortgage Backed Securities MBS or as explained earlier our SMO, brings the housing market activity closer to the financial markets like never before. They are now inextricably linked to the tune of billions. Everything was riding on house prices ever increasing in value. It was utter madness.

Perhaps the exception was Goldman Sachs who put their toe in the water but decided it wasn’t for them. Of course, some dived in and swam around to the bitter end, Northern Rock, Bradford & Bingley, Lehman Brothers to name a few. Okay back to the process…………

and now to the very very clever bit

This new company (our SMO Investments) then offers shares and because the rate of return is 7% higher than government bonds are paying and it has a very good rating from the rating agencies and of course it is backed up by the property assets, shares are in demand and the companies valuation rockets.

However, as we know this pack of cards is being held up by people with a history of debt, unemployment and low incomes. This was a financial Titanic that had left harbour already with a gaping hole in it, running full steam ahead into the largest iceberg ever known and definitely not a life boat in sight.

To a lesser extent this is also how the UK market worked. Northern Rock being the prime example of lending gone mad under the control of Adam Applegarth. But every bank; Lloyds, HBOS, RBS, Barclays and even HSBC had more than their toe in this murky pool of what has become known as toxic debt.

The only assumption or bet, was that house prices would keep going up, at least long enough to make a huge profit. These were not stupid people; but human nature dictates greed above common sense sometimes. The bottom line was nobody wanted to be the first to leave the party.

Back in the USA

John Smith gets his first demand letter after two years of no interest on his mortgage. It is now 2006, but he cannot pay such a high demand. Not only has his salary remained the same, he has also taken out another “cheap loan” for a car. His finances are shot to pieces. He cannot pay and soon the collection agency re-possess his home. Unfortunately this is happening to thousands of people, many more than the banks had calculated. In fact by 2007 1.3 million homes were subject to foreclosure in the US. If this wasn’t bad enough the housing bubble has finally burst in the US and house prices are at best flat lining, on top of that interest rates are going up!. The beginning of the end has started. Banks cannot sell the properties to cover the loans because no one is buying, and if they do sell it is at a loss.

Our bank Hyper can no longer pay the loan repayments it has taken out to purchase new mortgages for SMO Investments, and SMO shares plummet. Hyper shares plummet, and the lender (think of any investment bank) who gave the money to Hyper to purchase more mortgages see their share price fall.

To make matters much much worse by early 2007 when there were plenty of warning signs (e.g. Bear Sterns, Fannie Maie) subprime mortgage approvals continued to grow in the US and selfcerts in the UK. 7 million home mortgages were attached to piggyback or teaser rates in the US, which were aimed at people with no or little deposits. House prices were still fizzing in the UK until late 2007, and more or less anyone could get a selfcert mortgage.

The Federal Reserve noted the warnings but did absolutely nothing to relieve the situation with significant interest rate cuts. The Fed was asleep, pure and simple. In the UK Brown buried his head in the sand and was more concerned about his own position. The general public were living in a gold fish bowl and bought into this fairy tale of ever increasing property prices.

The CEO of Northern Rock, Adam Applegarth put a gloss on the whole affair. Northern Rock of course is significant, because they copied the US subprime model to the letter. Applegarth continued his massive expansion of Northern Rock through selfcert mortgages and complex financial dealings all linked to subprime in the US. He was warned by insiders and financial journalists to back off. He did not. Northern Rock fell. Applegarth received a huge pay off.

The truth was, as far back as August 2007 banks began to worry about what they were holding in terms of debt vehicles and how secure their loans were to other banks. Most importantly they were concerned what their competitors were holding in terms of toxic debt. It should be noted that these debit vehicles or securities were guaranteed by what are known as Credit Default Swaps (CDS). These work like an insurance policy in case a company goes bust. Unfortunately by 2007/2008 banks began to realise that these CDS could be worthless as bank shares began to decline and debt began to climb, who could possibly pay out?

The whole of our economic system is based on banks lending to each other and in turn lending to us. If this does not happen, people can not get mortgages, businesses can not finance their loans, and people stop spending. Ultimately we have unemployment and recession, which is where we are today.

It is perhaps ironic the banks who led us like the pied piper off the cliff are the only institutions that can kick start the economies around the world once again. This is the reason why more heads have not rolled at our leading banks or even apologies given by the CEOs…. In fact it was announced on 14th January 2009 that Mervyn Davies, former chairman of Standard Charter would become a key government advisor and sit in the Lords. A sure sign of the banks importance to our recovery.

I should also state that although the subprime market has been the main villan in the global economic downturn, it was not just the mortgage lending in the US or UK that has put us where we are today. If only it was that simple!

Banks were lending money like never before for student loans, personal loans, credit cards and business loans and this was happening globally. What makes it worse is that it was happening in a very relaxed regulatory environment that spread across the globe and had its modern roots in the 1980s and relaxed even further under the Presidency of Bill Clinton with the repeal of the Glass Seagell act. Bill Clinton also instituted relaxed standards in home loans so that more minorities and lower income individuals could qualify to buy their own homes. See supplement page for more detail on regulation.

As for the rest of us; we should all have known there is no such thing as a free lunch and personal responsibility must come into play. Debt is debt. The idea there is good debt (mortgages) and bad debt (loans) can only apply in the good times, if at all. Governments are now left with little choice but to spend their way out of recession at huge cost to everyone for years ahead.

BoE interest rates have now been cut in the UK to 0.5% and we have begun “quantitative easing" better known as printing money. This doesn’t actually mean running the printing presses for longer of course. QE works by the central bank buying assets from the banks such as mortgage-backed securities, and other bad securities. QE can also involve buying equities. Another key strategy used is for the central bank to buy treasuries in the market. The reason it does this is if the central bank creates more demand for treasuries the yield of these treasuries will go down which means there is less incentive to buy them over the returns it may get from lending to businesses and individuals. In effect the BoE through QE increases the cash for the banks and encourages the banks to lend more to you and me. Of course the down side it that this increases national debt which will eventually need to be reduced with significant tax rises and a massive cut in public spending. The UK is entering an unprecedented era that could see us downgraded as a leading financial country. The good news is that we are not alone!

It is worth pointing out that we should not forget that our eonomic system is cyclical. The idea that we can have a no bust economic system as Gordon Brown hailed is rubbish. Indeed, it would be completely unsustainable. Imagine an ever growing economy, with year on year house price rises, commodity prices and wages. We need a breather and every generation needs to experience at least a mild recession, unfortunately this one has a very dark side which is the colossal debt accumulated by institutions and individuals on a scale unprecedented.

It is impossible to blame one institution for this mess, or one government, but if you want to know my views in the blame game; they are as follows:

• US Government relaxation of regulatory processes dating back to Clinton’s era Glass Seagell act largely repealed. See supplement. (Although to be fair massive de-regulation was born in the 1980s, Securitization in the 1970s, (More on this on the supplement page).
• Hands-off approach by UK Government and believing that boom and bust was over forever and more de-regulation
• A complete lack of understanding how money markets were working by senior staff within investment and retail banks and perhaps more important, their lack of foresight and no contingency plan if something went wrong
• A lack of self regulation by senior management. (CEOs were a law upon themselves. (Applegarth and Goodwin case in point) Little meaningful power given to non-executive Directors. Senior staff muzzled.
• The banks for knowing the levels of toxic debt and risk attached but no one wanted to be the first to get off this roller coaster. They knew that house prices would not go up forever, but when they were making so much money it was difficult to jump off the train. Hedging was poor to say the least. Their faith in CDSs would prove useless
• The Public for really believing that property was a one way bet, so much so that interest only mortgages became the norm and owning more than one property a must. Personal credit card and loan debt spiralled on the back of increasing unrealised profits in their property

What needs to happen now

1. Banks have to start lending to each other at reasonable rates in an aggressive manner and in turn to businesses and on to us. The libor rate is decreasing but lending to individuals and business is simply not happening to the level that will kick start the economy. Unless we want to see 4 million poeple unemployed in the next 12 months, and major companies on their knees, banks need to begin lending aggressively and now even at the risk of over extension.

Yes, our economic system requires us to follow the same model that got us into this mess in the first place. Money needs to flow, pure and simple. The difference this time round is that the genie will only partially be allowed out of the bottle. (People on low incomes will probably be excluded from the party in future, with higher deposits for home owners and more security for business and personal loans required long into the future, or until the next geenration has forgotten all about the Credit Crunch. In order for banks to feel able to loan money something radical has to happen with their current toxic debt portfolios. Their current accounts need to be cleaned by government. This process has begun with the UK government starting to guarantee loans banks have given out. This in effect should give more confidence to the financial system by way of a safety net for banks. It also allows banks to begin lending as they will not have to hold such large reserves for loan defaults. What more can be done? This is the trillion dollar question. One thing is for sure there are no quick fixes.

The truth is we just don't know what's round the corner. As unemployment rises, credit card debt and personal loan issues will become the banks prime concern, which could cut down any green shoots that are seen on the horizon.

However, we cannot stand still and fear the worst, if banks do not extend borrowing you will see many more foreclosures, and much more uemployment.

2. Inflation needs to increase, which means we need to spend money, which means of course the banks need to lend money. We do not want to enter a deflationary period like Japan hit in the 90s. Why, because this will hold the economy down for longer as people will assume prices will fall further so why buy goods and services now? A degree of inflation also indicates a robust economy and helps foster confidence in the financial system. It will also mean we can increase interest rates to normal levels so banks make money, and in turn can lend even more to us.

3. Fiscal stimulus is required in moderation and targeted. I am hesitant about using excessive fiscal policies to drag ourselves out of this mess, so I come back to the banks. The next few months are critical. If bank lending increases and the financial markets begin to recover (not bear bounce, but begin to really recover) then perhaps we can avoid massive Government spending that would only lead to large tax rises in the medium to long term, which will hit people hard.

4. Spend, Spend, Spend. As I have indicated throughout this paper, we need to spend I’m afraid. Yes, you, me, and government (moderately). We need to borrow and we need to spend. We just need to make sure we don’t spend more than we can afford to pay back. Our economic system can only function properly if there is a workable equilibrium between savers and borrowers in the market. It is hopeless if we all put our money in the bank and do nothing with it.

Until some bright spark comes up with an alternative economic model, that doesn’t constrain individual aspirations to make money, recession will come again. Next time though we may be better prepared.

Note from the author

The views in this paper are my own, based on articles and books I have read on the subject and my own thoughts. There may be some minor inaccuracies, (the finance strategies used by banks are extremely complex to grasp), but it has been written in good faith and a great deal of research. John Abbey - 2009