The US Meltdown – “Reality” Strikes!!!

Over the last few weeks, we have seen a huge drop in the world economy due to the financial crisis in the United States Stock Exchange. This entire crisis was put to be blamed on “Sub-prime Crisis”. Since it is a phenomenon that had rocked the Finance of the World, shedding some light on this would probably help doing the root cause analysis. This is a long post, but it covers a lot of burning issues.

The United States Reality Business

The establishment of the US real estate financial system can be traced back to the early twentieth century, around 1938, with the formation of the Federal National Mortgage Association (Fannie Mae). The securitization of real estate mortgage loans was viewed as a new creation in financial history; it made a massive contribution to improving liquidity of real estate capital and resolving Americans' housing problems. At that point of time, since the same bank functioned as both issuer of house mortgages and bearer of the risks, a very strict check on the borrower's repayment capability was done. Though this ensured low bad debt rate, it also restricted the bank's liquidity. People's surging demands for housing and the banks' need to pass on the risks resulted in the United States setting up institutions such as Freddie Mac, specifically to purchase the banks' mortgage loans. These institutions streamed the cash generated from loans into basic issue of bonds and sold them to investors, thus greatly expanding the source of capital for the housing market, reducing the banks' risks and the interest rate on loans, and proceeding to spur the development of the real estate market; this formed a capital cycle centered on real estate, and this financial innovation provided endless massive capital for the US housing market. Moreover, following the US dotcom bubble burst in 2000, the United States underwent a massive recession. The Fed lowered the interest rate in various funds from almost 6.5% to an all-time low of 1%. This low interest policy drove a lot of investment towards the already booming real estate markets.

The United States uses a system wherein they rate the creditors based on their previous track record. The system rates them as “Prime” i.e. people with good track record and “Sub-prime”, which consists of people who do not have a good track record and even defaults. Normally, the banks are reluctant to give loans to such people. But, in the last decade, the U.S. economy has seen a lot of liquidity flow into the various markets. Moreover, the American Real Estate was booming and prices of a lot of properties almost doubled from 1997 till 2006. With stock markets booming and the system flush with liquidity, many big fund investors like hedge funds and mutual funds saw sub-prime loan portfolios as attractive investment opportunities. The American Banks and the Mortgage Houses wanted to tap more benefit of this situation and hence started providing loans to even the “sub-prime” population since 2003.

Masking the Mess – One man’s Trash, another man’s Treasure?

Since giving the loans to sub-prime population directly would have been a huge mess and they would not find people to invest for the same, the financial institutions developed various instruments under the guise of which the capital was raised against the sub-prime loans. Moreover, the subprime loans were made at around 2% higher interest rate to accommodate for the defaults and hence they seemed to look like better investment options with higher returns. In the 1990s, the Wall Street also joined in looking at the lucrative returns. The corporations now repackaged over and over the house mortgage loans and their securitized capital, pushed a great variety of new financial derivatives such as guarantees for debt securities, and provided investment instruments with varying degrees of risk for investors who favored a variety of risk. The institutions created different bonds, which were then rated from AAA to BBB depending on the order in which the people would be paid in case of defaults. Some of these were also insured. Of course, the higher safety would come with a lower rate of return. The banks always believed that though there would be some defaults, there would still be a lot of gain. And again in case of a default, since the real estate was booming, the price of the houses would surely be greater than the loan and so recovering the funds would not be an issue.

The Government also encouraged lenders to lend to sub-prime borrowers, arguing that this would help even the poor and young to buy houses. Being flush with funds and with Government’s approval as well, the institutes were willing to compromise on prudential norms for the subprime loans. In one of the instruments devised for subprime loans, the borrowers had to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years. Incentives like this made a lot of people take up the loans and hence the “Subprime Loan Market” was reaching new highs.

The Chain-reactions of the Crisis Begin

In the year 2007, the US Housing Boom began to slow down. The major reasons included the supply of a huge number of new houses which were constructed looking at the increased demand due to the additional people who were willing to buy houses due to the easy availability of the loans. This additional supply caused the real estate prices to go down. Hence, most of the houses that were over-valued at the time the people took the subprime loans underwent correction and the prices went down. Moreover beginning in 2004, the Fed launched a cycle of rising interest rates, with 17 increases in one and a half years; the return rate on one-year T-bonds rose from 1.25 per cent to 5 per cent. Since previous market expectations regarding interest rate were low and borrowers favored a floating interest rate on loans, after the rate increase the interest burden became much heavier, and in particular, borrowers of subprime mortgage loans were mainly low-income groups with poor risk-resistant capability, and very many people were unable to repay in these circumstances, and the rate of repayment failure rose.

This increased the default rate among subprime borrowers, many of whom were no longer able or willing to pay through their nose to buy a house that was declining in value. The fact that the collateral for these loans was the same property, the real estate prices went further lower because the banks tried to sell those properties for reclaiming their loan principal. This increased the supply of housing far beyond the current demand and according to estimates; the values of some of these properties have reached as low as 50% of their peak values in 2006.

When the banks try to offload their bonds in the market, they either do not get customers willing to buy them, or buyers are willing to pay only a fraction of the amount. So the market capitalization of the bonds is only on paper and in actual world its value is pretty different. What also happens here is that the valuation is done based on “Mark-to-Model”, wherein variables and values are entered in the computer and the computer decides a price (similar to book value of stocks), but many of the instruments are over-the-counter derivatives, which are struck on a one-to-one basis between two parties. So they do not really have a market. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument or unwinding derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on thousands of securities and multiple portfolios can wipe out the capital of the bank.

To make matters worse, what also occurs is the “Domino Effect”. Since the institution could not raise the expected capital with the bonds that it wanted to offload, it also ends up selling the other good assets or bonds which may have nothing to do with mortgages. This greatly increases the supply of these bonds and the crisis starts spreading from subprime to prime.

The Far Reaching Effects of the Slump of the Dump

The declining value of the collateral (houses of the defaulters) means that lenders are left with less than the value of their loans and hence have to book losses. Now, the Financial Institutes had created a wide range of instruments (CDO, CDS etc.) to market these subprime loans. The fact that Wall Street and Investment Banks had worked upon these loans also meant that the effects would reach not just people who made these mistakes, but a much wider audience which held a share of this pie either directly or indirectly. As per an analyst, this could be inferred as: “They put bad pork into the mincing machine and then sell sausages to the world.”

In the era of Globalization, the global capital cycle is centered on the US financial market. A majority of developing countries which depend on exporting primary commodities and raw materials have become America's creditors; Americans export not only dollars but also the Fed's monetary policy and Wall Street's novel products. And the Wall Street investment bankers fly in their spacious Boeings to all corners of the world to peddle their derivatives. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.

Global banks and brokerages have had to write off an estimated $512 billion in sub-prime losses so far, with the largest hits taken by Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half of these losses, or $260 bn, have been suffered by US-based firms, $227 billion by European firms and a relatively modest $24 bn by Asian ones.

The American Dream – A Nightmare?
The suddenness of the current events have woken up the Fed from its deep slumber. As of now, Freddie Mac and Fannie Mae have been nationalized to ensure that they do not go down. Other institutes are not so lucky and have to either book huge losses, or even file bankruptcy.

Lehman Brothers, the fourth-largest US investment bank, has filed for bankruptcy protection, dealing a blow to the fragile global financial system. Despite efforts by the US Federal Reserve to offer some financial assistance to the beleaguered financial sector, Bear Sterns, one of the world’s largest investment banks and securities trading firm collapsed. Bear Sterns was bought out by JP Morgan Chase with some help from the Fed. Merrill Lynch, also stung by the credit crunch, has agreed to be taken over by Bank of America. There are fears that AIG, once the world's largest insurer, could also face collapse. It is taking steps to raise money amid reports it is seeking a $40bn emergency loan from the Fed. Washington Mutual, once a financial juggernaut, became the biggest failed bank in history of the United States and was taken over by JPMorgan Chase. There are also reports of Federal regulators brokering a deal with Citigroup for buying Wachovia banking operations, but the latest update is that Wells Fargo and Co., one of the biggest banks in the United States.

All in all, a huge amount of litter has blown all of a sudden, and since the mortgage houses, loaners, investors and financial institutes are not directly connected due to the various variants of bonds, and different packaging and further repackaging, only time will tell who will take how much of a hit. As of now, we are just seeing the effects of the dust settling down.

Yet Another Bailout – Is it worth the Money?
The Bush Administration seemingly worked overtime and drafted a Bailout bill to the tune of $ 700 bn to clear the mess that is bleeding United States and the world. There are a lot of speculations on whether the Fed was keeping the things out of focus to get this bill passed or did things really happen that fast that there was no breathing space? Some of the mathematics doesn’t seem to make any sense. Bank of America grabs Merrill Lynch, JP Morgan takes over Bear Stearns and WaMu. That’s a lot of bad debt being gobbled up cheap. Why would companies amass such a horde of toxic debt without the means to dispose of it for a profit?

All in all, whatever the truth is, the latest news is that today the Bailout Bill is has been passed by the United States “House of Representatives” with a 263-171 vote. This is really surprising after a rejection of a similar bill on Monday by a 228 against 205 for vote. The reasons are said to be a lot of sweeteners added to the bill. But a lot of House members said they were reluctant to help an unpopular industry and approve new federal spending but felt they had no choice.

All said and done, I hope the crisis ends and people understand that Bailout money is a Loan from the Government. It is the very money which the “Tax-payers” have given to the Government with trust that it will be used to improve their country. Frankly, the only thing that comes to my mind is the achievement that Lee Iacocca (Chrysler Automobiles) mentioned in his autobiography.

April 1980: After huge layoffs and losses in the millions, Chrysler barely averts bankruptcy by receiving $1.5 billion in government-backed aid.
August 1983: Chairman Lee Iacocca signs over a ceremonial check for $813,487,500 to pay off its last federally guaranteed loans, even before the term of payment is over.