Financial Crisis and Subprime

November 24, 2016 22:50

Oh dear, whatever happened here? After years of over-borrowing and under-saving, the plentiful supply of cheap and easy money, the enthusiastic recklessness of a number of financial managers, and the complaisance of governments, the inevitable happened, and panic ensued.

It has not been edifying to see political leaders – people at one time we might have considered intelligent, cautious and wise human beings, falling over each other, in the courageous rush to identify scapegoats, to nationalise bad debt and to prop up failing companies.

After cursory deliberation, the condemnatory finger pointed at short sellers and Hedge Funds, and this mendacity passed by with little comment. Thankfully, the new blame game does not seek to target a conspicuous group of people, such as Swiss gnomes, which is progress of sorts, but it is still only a marginal improvement.

So, what caused the financial crisis? Superficially, the answer is simple; it has been the collapse of the subprime market and its impact on underwriters of usurious lending.

There was a time when people with bad credit ratings, or no credit ratings, would have found it difficult to obtain a high street loan to purchase a second-hand car, and would have had no chance of obtaining a mortgage. Cheap money, overvaluation and the property boom changed all of that.

Subprime allows people with dodgy credit ratings to acquire mortgages, albeit with inflated interest rates. For years, things worked quite well, as the number of people keeping up with their repayments well-exceeded analyst’s forecasts, which meant that profits from subprime lending surpassed expectations.

This led to two things: further downplaying of risk in the subprime market, and a boom in the number of banks offering subprime loans.

Traditionally, banks lent out money that they held in the form of deposits, in exchange for timely repayments. In many countries, banks were constrained by how much exposure to risk they could assume, in order to ensure solvency and liquidity; so, even when money was at its cheapest, they could not legitimately expand their subprime business beyond certain levels, without getting creative and by passing on risk to third parties.

What happened next? Just as some banks had cashed-in on insurance brokerage, some switched to the role of subprime lending matchmakers. This meant that they were able to take the upfront brokerage fees, and then pass on the loan arrangements to another financial house, and in this way, they increased their fees whilst offloading the risks inherent in holding especially risky arrangements.

Of course, the actual underwriters of these loans also wanted to reduce their risk exposure.

It is a simplistic explanation, but what these companies first did was to create a way to allow for betting on the overall performance of collections of mortgages – the fewer defaults the higher the gains, in order to allow trading in bets.

Additionally, because of the perceived low risk of subprime and the continued overvaluation of real estate, these bets came with an irresistible added value-proposition, an AAA risk rating, just like government bonds.

Then, these companies sold on slices of composite bets to other punters, charging for the betting slips based on a combination of risk, duration and return.

There are various forms of betting on subprime performance, the most common products being Collaterised Debt Obligations, Mortgage Backed Securities and Asset Backed Securities, the riskiest bits of which are toxic waste.

Now, the calculation of the value and the risks in these bets are horribly complex, and frequently inaccurate. So, just to push the envelope, some people came up with a way to take a bunch of already complex pooled bets, and to create a mega pool of pooled bets, which they would then sell on to the market, as another investment product.

So, when economies tanked, it was the subprime market, mainly in the USA, that took the hit for the increase in the defaults on loan repayments. Worse still, because the holders of these bets could not honestly state either their riskiness or actual value, they became as desirable as financial crap, which meant that other banks were no longer prepared to lend them money, and for Prime Brokers to be denied loans, is like turning off their life support?

As attractive as schadenfreundin might be, letting Prime Brokers go to the wall is not a sensible option, as the survival of other companies and many jobs are also at stake.

The subprime downturn led to the current predicament, but that is not where it started, preceded as it was by the follies and frauds of the dot com era, the artificial “good times” brought on by government overinvestment in the military industrial complex and the costs of war and occupation.

We are where we are mainly because of one thing, decades of government, corporate and personal imprudence.

Martyn Richard Jones
Cordoba, 2nd March 2009

November 24, 2016 22:50

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