The Giant Wall Street Rescue: Unraveling the US subprime crisis

30 | 10 | 2008

The subprime mortgage crisis in the US has a continuing impact on financial markets around the world, and in no way is it possible to say the crisis is ‘fading’, as claimed too early a few weeks ago by some financial circles. This is particularly evidenced this past weekend of September 19-21, 2008 with the giant “rescue plan” of $700 billion proposed by the US Treasury to US Congress, after relentless efforts to “save” Bear and Stearns, the two large mortgage lenders Fannie Mae and Freddie Mac, then Lehman Brothers, Merrill Lynch, AIG.

The list is still long if we count Washington Mutual and the boiling situation of Morgan Stanley and even Goldman Sachs. The full accounting of losses will take a long time and the impact on the US real estate market will continue to be felt for years. It may take another year or more to unload the large number of foreclosure properties in the US housing market.
The sheer size of the rescue is massive, but is only one-third of the two trillion estimate of bad mortgages, and in the background of $600 billions of losses already written off by the investment banking industry worldwide.

Furthermore, it will be necessary to reform mortgage lending and related investment banking regulations, and bond ratings agencies like Moody’s - who now play a critical role in the industry - may see their exalted position change substantially in the near future.
This short paper will attempt to unravel the mortgage backed securities business that is at the heart of the crisis, and look at the reaction to the crisis by the Fed, ratings agencies, banks and other institutions.

Large numbers of subprime mortgages lent to risky customers was only the start of the crisis. The particular and complicated manner in which these mortgages were packaged, tranched, leveraged and resold from mortgage lenders to investment banks and on to other financial institutions and hedge funds is where the scale of the problem went from large to gross.
The two Bear Stearns hedge funds that collapsed, leading to the collapse and sale of Bear Stearns, a well-known investment bank, were leveraged five and 15-times their original capital, a degree of risk that left absolutely no margin for error. It’s as if the 2000-01 dot.com bust never happened, and yet we’re still less than 10 years removed from that catastrophe - similar in the basic premise that investors acted as if downside risk just did not exist. Ignorance or greed? More likely the latter.

Reviewing a timeline of the subprime mortgage crisis will reveal in pieces the various layers of culpability.

First, the Fed began to lower interest rates after the hi-tech bust, as a means of jump starting the economy. This worked, so they continued to lower rates to their lowest levels in decades. The intention was to get more money out into the economy, particularly at the consumer level. People took cheap loans to buy the biggest consumer item of all - their houses. This reflects a psychological bias by ex-Fed chairman Greenspan toward the housing sector as an engine for US economic revival after the 2001 recession.

Home buyers initially acted in a rational manner - lower interest rates meant it was a good time to buy and many did. But when the cheap money meant the everybody was buying, sending prices higher, buyers got greedy and overextended themselves by trying to flip homes rapidly, or buy expensive properties they could not afford unless prices continued to rise indefinitely. Enter the mortgage companies. Mortgage lenders, including for the first time many non-bank lenders, could profit greatly by collecting huge commissions in this scenario. Interest rates were low, however, so to increase profits it was necessary to find more home buyers and extend the cycle of house flipping and ever-rising prices. In normal circumstances, mortgage lenders would not be able to raise huge amounts of capital to lend out to home buyers. Since house loans are paid back so slowly, mortgage lenders don’t normally have massive pools of money available to increase their loan portfolios much past their original capital.

Enter the investment banks. Seeing the rising house prices and the need of mortgage companies for more capital to loan out, investment banks smelled an opportunity. They bought packages of mortgages from the mortgage lenders, who then suddenly had a huge pool of capital to go back to the market and lend to home buyers.

Eventually, mortgage lenders ran out of low-risk, credit worthy home buyers, and were left with high-risk, first-time buyers with questionable credit records. But with prices rising so quickly, the lenders mediated their risk only by producing complicated mortgages that started with low ‘teaser’ interest rates that would rise over time. Buyers, greedy to join in the housing euphoria, took out mortgages without reading or understanding the fine print, or perhaps understanding the mortgage but hoping that rising prices would allow them to sell at a profit if they eventually could not afford to make payments on the loan.

But what did the investment banks do with huge packages of mortgages? To profit from these, great financial creativity was needed.

Investment banks took a package of mortgages - composed of several thousand individual mortgages purchased from one or more lenders - and turned them into mortgage-backed securities. A mortgage-backed security was intended to be an investment product somewhat like a bond, sold to a third party as one unit that will pay out a dividend, called a coupon, derived from the interest and principal payments coming from the house owners paying off the mortgages that are the underlying feature of the security.

The problem with a mortgage-backed security, in its raw form, is that no one will buy it. Professionally managed investment funds - hedge funds, pension funds, sovereign funds - generally only buy products that are rated by a bond-rating agency, the largest of which are Moody’s, Fitch, and Standard and Poors.

Most funds are required to buy a high percentage of “investment grade” rated funds (ie. the least likely to default). For example, an investment fund might be stipulated in its charter to have 80 per cent of its bonds at the investment grade level, 10 per cent at a medium-risk level, and 10 per cent at a high-risk level. The safer the bond, of course, the lower the coupon.
Enter the ratings agencies: To gain investment grade ratings on their mortgage-backed securities, investment banks needed the help of ratings agencies. The solution devised by the ratings agencies was something called a “mortgage collateralised obligation (MCO)”.
To create a coherent rating, the mortgage-backed security was broken into different tranches and each tranche given a rating from the highest triple-A all the way down to a lowly BA or a similar rating denoting high risk. The key is that the highest-rated tranche - now marketed as a bond - would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The low-rated bonds at the bottom of the pile got the highest coupon, but if homeowners defaulted, they would absorb the first losses.
Remember that despite the different ratings, underlying all the different tranches was the same original package of mortgages.

Another, similar product was called a “collateralised debt obligation (CDO)” which had the same tranched structure, but including regular bonds and other types of debt papers in addition to mortgages.

CDOs or MCOs operated like mutual funds - they bought and sold mortgages frequently, so their assets continually shifted.

But the original rating they received stayed the same. The ratings agencies just based their decisions on a set of guidelines that the CDO manager had to follow at the manager’s discretion.

The ratings agencies used statistical models based on the past behaviour of the mortgage market to determine the likelihood of defaults on the loans. They did not consider that the housing market had changed greatly, with rising numbers of poor credit buyers that had subprime ‘adjustable rate mortgages’ (ARMs) that would have increasing payments over time.
The result is now well-known. Investment banks set up hedge funds based on MCOs and CDOs, and sold the fund to all sorts of financial institutions around the world. They had so much success with the new product that they began to leverage the funds extensively, so they could buy more packages of mortgages, securitise them, have them rated and finally sell them on via their hedge funds.

The investment banks kept going back to mortgage lenders with more money to buy mortgages, so the lenders had great impetus to keep lending and to find ever more home buyers with more expensive properties, no matter what credit rating the buyers had.

Home buyers saw easy credit terms, and in the rush to join in the spiraling market they did not stop to read the fine print that explained how high their monthly payments would rise in the future, if interest rates started to rise. They also did not stop to consider what would happen if house prices cooled or started to fall.

Inevitably, this did happen. Defaults rose quickly in 2007 and payments to the lower, high-risk portions of the CDOs and MCOs had to stop. Institutions holding the funds got nervous, and wanted their money back. But the hedge funds had no money to redeem investors with, because they had used it all to buy more mortgages. Defaults continued to rise and the ratings agencies were forced to cut the ratings on all portions of the CDO and MCO tranches, including the triple-A or investment grade tranches.

This is when financial institutions dumped the bonds completely, into a market with no buyers. The hedge funds and the investors lost billions of dollars in short order.!!

Losses and remedial action
The final tally will not be known for some time. Losses of over $600 billion by large investment banks were already written off, the rescue package under consideration by the US Congress is for another $700 billion and other central banks around the world are considering similar packages worth hundreds of billions under the encouragement of the Fed.

As mentioned above, the US government took many actions to lessen the impact of the crisis, including two main policy considerations by the Fed:

– One is to allow its discount window to be used by banks in trouble with mortgages brought in as collateral, which would allow home owners to take new soft loans (even interest-free) and refinance their homes based on current reduced market values rather than previous inflated values.

– Also, the Fed has already lent emergency funds to investment banks and new regulation of investment banks by the US authorities in exchange for further emergency credit is under way.
Overall, the world financial situation remains opaque and the crisis is still around the corner if we note the major difficulties ahead:

– The proposed rescue package by the Treasury might run into trouble with US Congress but will be eventually passed because of the urgent situation;

– The lack of easy credit lines between banks and other financial institutions threatens to inflict serious damage on the economy if not addressed immediately;

– The large size of the package may still be insufficient if new losses are identified due to the multiplier effect of the original mortgage defaults, among investment banks who had used unparallel leverage with financial derivatives, an “innovation” of modern finance without risk control.

In sum, the pieces are in place for a substantial reform to the banking and finance environment as a result of the subprime crisis. Will this stop future disasters like the current events for various Wall Street houses from taking place? It should have positive effects; however, the enthusiasm of investors from all walks of life to jump on the bandwagon when a hot sector emerges makes the boom-bust cycle a hallmark of capitalism.

Sadly, just as it took only five or six years for another hot sector to emerge after the hi tech went bust in 2000-01, might it be only a few years before we have to write another crisis story like this one?

How can Vietnam weather the world’s storm?

Despite the global turmoil, Vietnam is currently seeing good signs that indicate the economy is recovering from the two-month “mini-crisis” experienced earlier this year. These signs include:

– a declining month-on-month inflation rate, which stood at 0.2 per cent in September, compared to 1.6 per cent in August; for December yoy rate down to 23 per cent from the peak of 28.3 per cent in August;

– Likewise, the trade deficit was down sharply to $0.5 billion in September, compared to $2-3 billion monthly deficit in early 2008;

– the VND has stabilised against the US dollars and is essentially unchanged from where it was at the beginning of the year (16,500 VND/$); and

– interest rates have fallen over the last few months and more declines are likely to occur given recent moves by State Bank to improve liquidity of the banking system, and as a result of the government-imposed credit growth limit of 30 per cent for 2008.

Impact of global financial crisis?

Although, we expect that there will be a spill-over of the current global economic challenges on Vietnam, we believe that the effects will be much lighter than experienced in other economies. This is because:

– Vietnam’s lack of integration with the global financial world; minimal exposure to subprime investments; and lower leverage ratios, should keep it on the sidelines of the financial storms;

– Vietnam’s fledging financial services industry and eight-year old stock market do not trade derivatives for lack of financial sophistication;

– Domestic consumption will continue to grow as the country modernises;

– Although a worldwide economic slowdown will affect Vietnam’s exports to some extent, the effects are limited when compared with other Asian countries as Vietnam’s relatively cheap exports are often substitutes for more expensive exports from other countries; but most likely

– FDI disbursement will be less for 2008, at some $8 billion rather than $10-12 billion expected earlier for the surge of FDI commitments to some $60 billion forecast.

– This should be a good lesson for Vietnam in preventing a real estate loan crisis for the banking system; bank inspection should be regularly done and measures should be taken to inject liquidity for the banking system when necessary.

Economic outlook
Provided that the current world financial crisis can be contained, the outlook for Vietnam is significantly better with improving domestic conditions:

– GDP growth is expected to recover to 6.5-7 per cent in 2009 from 6 per cent in 2008 with strong support by FDI and domestic demand;

– Inflation is forecast to be halved to 12 per cent in 2009 as a result of the successful stabilisation efforts by the government, as the cost of food declines and the urban real estate market cools, and provided that international oil price does not surge well above the current range of $100/barrel;

The trade deficit is forecast to be cut further in 2009 with sustained exports earnings, and the current account deficit/GDP ratio is projected to decline to below 10 per cent, helping to stabilise the exchange rate around theVND17,000/US $1 level.

Pham Do Chi (Chief Economist, VinaCapital)

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