An Introduction to the Sub-Prime Crisis
David Brooks wrote in the New York Times, “Financial instruments like adjustable-rate and subprime mortgages have allowed millions of people to get homes they could not otherwise purchase, and research shows that most of these tools have been used intelligently.”
Banks have, for thousands of years, had the problem of convincing depositors to give the bank their money, promising security, as evidenced by a vault and guards, and profit; they also have the problem of investing all those deposits in instruments that pay enough profit to provide the depositors with everything promised, plus a profit for the owners of the bank. In the 19th century, if the bank invested badly and could not pay depositors, the owner was hanged. People may soon think of the 19thcentury as a halcyon time, with excellent laws that have, most unfortunately, been allowed to lapse.
Investment banks always offered large depositors more of a choice: risky investments that paid a greater profit, or safe investments that paid a much smaller profit. This created an industry of evaluating financial investments for risk. Most people have heard of ‘AAA’ securities and ‘C’ securities, the former being considered quite safe, and the latter quite risky.
The building society was a kind of bank that once specialized in taking small deposits and loaning individual members of the middle and working classes the money to acquire their own homes. Traditionally, such societies were like those depicted in the movie “It’s a Wonderful Life.”
The officers of the traditional building society were supposed to know their borrowers, and to be sure the borrower was a good worker with a secure job who would repay the loan. Typically, the borrower was expected to save up 20% of the purchase price as a down-payment. The officers were also supposed to have a very accurate appraisal of what the home would be worth. The building society could be severely damaged by a default, since foreclosure seldom recovered the full amount of the loan.
Then there is the sub-prime loan. I first heard of these loans more than 30 years ago: In exchange for paying a higher profit rate, the borrower need not put up a down-payment nor provide any proof of ability to make the payments. The people originating and selling these loans were also known in the investment community for accepting unrealistically high appraisals for the underlying properties. Most investors avoided these loans, and those who invested usually lost money.
Now, however, the institutions originating these sub-prime loans sold them to funds that pooled the loans. The funds then sold shares in the pools. Neither the loan originators nor the funds incurred any risk, though these financial instruments remained, as they always had been, very risky instruments.
Here’s the new part to the story: the ratings agencies all agreed that, should the borrower default, the mortgage could be foreclosed and all the money collected from the sale of the house, so these instruments were given the highest possible rating for safety.
Given that the instruments appeared to have high profit rates and complete safety, the loan originators and the funds selling shares in the pools were able to sell these instruments for a very good profit, and these instruments eventually ended up as a significant fraction of the portfolios of the largest financial institutions in the world.
As one final fillip, sub-prime borrowers were offered ‘teaser rates’ that increased substantially after a few years. The borrowers’ incomes were sufficient to pay the teaser rates, but once the teaser rates ended, many sub-prime borrowers were unable to make the higher payments, and the terms of the loan prohibited re-financing at a lower rate.
It remains unclear to me to what intelligent use Mr. Brooks thinks these loans could be put, other than enriching the loan originators and the funds that sold shares in the pools.
The first anyone realized that this was a problem occurred when the first of the teaser rates expired, many of the borrowers defaulted, and the foreclosures only recovered a small fraction of the loan.
The immediate result was that the ratings of these pooled instruments fell from ‘utterly safe’ to ‘highly risky’ and their value collapsed.
The solution proposed by President Bush was that the loans retain the teaser rates indefinitely. Of course, a loan instrument that promises to return the loan after 30 years with 2% profit is worth far less than an instrument that will return the loan with 12% profit, so much less that institutions that invested in such instruments will have a hard time re-paying their depositors.
All this leaves the question: How big is the real problem?
According to one news report, only a small fraction of mortgage loans were sub-prime, so more than 90% of all the mortgage loans in the pools should be repaid in full at the agreed profit rate, as well as some fraction of the value of the sub-prime loans after the property is foreclosed and sold by the loan servicing agency.
Obviously, if this is the case, the world is looking at a needless panic that will, in hindsight, be nothing more than a joke at how frightened everyone became for absolutely no reason.
However, as of current date, all the financial experts are saying that there is no way of knowing the extent of the problem, giving as their excuse the incredibly complicated nature of the sub-prime financial instruments.
By this time, this should not be a valid excuse. Most sub-prime loans were made with initial teaser rates followed by payments in excess of the borrowers’ incomes. Few of these loans will be repaid in full, and the over-appraised houses will be foreclosed and sold at a loss, a loss further exacerbated by the legal fees involved in a foreclosure. The total amount of all these loans should be clear by now, and that should be the total world exposure.
For an individual financial institution that purchased an instrument based on a pool of regular and sub-prime mortgages, the situation may remain murky for some time, but not the overall threat to the world economy.
But no one who might know will give any indication of how big the threat really is.
Which usually means it’s time to panic.
(In my case, I discovered from CitiBank that my CitiBank travellers’ cheques now good only as monopoly money.)
Banks have, for thousands of years, had the problem of convincing depositors to give the bank their money, promising security, as evidenced by a vault and guards, and profit; they also have the problem of investing all those deposits in instruments that pay enough profit to provide the depositors with everything promised, plus a profit for the owners of the bank. In the 19th century, if the bank invested badly and could not pay depositors, the owner was hanged. People may soon think of the 19thcentury as a halcyon time, with excellent laws that have, most unfortunately, been allowed to lapse.
Investment banks always offered large depositors more of a choice: risky investments that paid a greater profit, or safe investments that paid a much smaller profit. This created an industry of evaluating financial investments for risk. Most people have heard of ‘AAA’ securities and ‘C’ securities, the former being considered quite safe, and the latter quite risky.
The building society was a kind of bank that once specialized in taking small deposits and loaning individual members of the middle and working classes the money to acquire their own homes. Traditionally, such societies were like those depicted in the movie “It’s a Wonderful Life.”
The officers of the traditional building society were supposed to know their borrowers, and to be sure the borrower was a good worker with a secure job who would repay the loan. Typically, the borrower was expected to save up 20% of the purchase price as a down-payment. The officers were also supposed to have a very accurate appraisal of what the home would be worth. The building society could be severely damaged by a default, since foreclosure seldom recovered the full amount of the loan.
Then there is the sub-prime loan. I first heard of these loans more than 30 years ago: In exchange for paying a higher profit rate, the borrower need not put up a down-payment nor provide any proof of ability to make the payments. The people originating and selling these loans were also known in the investment community for accepting unrealistically high appraisals for the underlying properties. Most investors avoided these loans, and those who invested usually lost money.
Now, however, the institutions originating these sub-prime loans sold them to funds that pooled the loans. The funds then sold shares in the pools. Neither the loan originators nor the funds incurred any risk, though these financial instruments remained, as they always had been, very risky instruments.
Here’s the new part to the story: the ratings agencies all agreed that, should the borrower default, the mortgage could be foreclosed and all the money collected from the sale of the house, so these instruments were given the highest possible rating for safety.
Given that the instruments appeared to have high profit rates and complete safety, the loan originators and the funds selling shares in the pools were able to sell these instruments for a very good profit, and these instruments eventually ended up as a significant fraction of the portfolios of the largest financial institutions in the world.
As one final fillip, sub-prime borrowers were offered ‘teaser rates’ that increased substantially after a few years. The borrowers’ incomes were sufficient to pay the teaser rates, but once the teaser rates ended, many sub-prime borrowers were unable to make the higher payments, and the terms of the loan prohibited re-financing at a lower rate.
It remains unclear to me to what intelligent use Mr. Brooks thinks these loans could be put, other than enriching the loan originators and the funds that sold shares in the pools.
The first anyone realized that this was a problem occurred when the first of the teaser rates expired, many of the borrowers defaulted, and the foreclosures only recovered a small fraction of the loan.
The immediate result was that the ratings of these pooled instruments fell from ‘utterly safe’ to ‘highly risky’ and their value collapsed.
The solution proposed by President Bush was that the loans retain the teaser rates indefinitely. Of course, a loan instrument that promises to return the loan after 30 years with 2% profit is worth far less than an instrument that will return the loan with 12% profit, so much less that institutions that invested in such instruments will have a hard time re-paying their depositors.
All this leaves the question: How big is the real problem?
According to one news report, only a small fraction of mortgage loans were sub-prime, so more than 90% of all the mortgage loans in the pools should be repaid in full at the agreed profit rate, as well as some fraction of the value of the sub-prime loans after the property is foreclosed and sold by the loan servicing agency.
Obviously, if this is the case, the world is looking at a needless panic that will, in hindsight, be nothing more than a joke at how frightened everyone became for absolutely no reason.
However, as of current date, all the financial experts are saying that there is no way of knowing the extent of the problem, giving as their excuse the incredibly complicated nature of the sub-prime financial instruments.
By this time, this should not be a valid excuse. Most sub-prime loans were made with initial teaser rates followed by payments in excess of the borrowers’ incomes. Few of these loans will be repaid in full, and the over-appraised houses will be foreclosed and sold at a loss, a loss further exacerbated by the legal fees involved in a foreclosure. The total amount of all these loans should be clear by now, and that should be the total world exposure.
For an individual financial institution that purchased an instrument based on a pool of regular and sub-prime mortgages, the situation may remain murky for some time, but not the overall threat to the world economy.
But no one who might know will give any indication of how big the threat really is.
Which usually means it’s time to panic.
(In my case, I discovered from CitiBank that my CitiBank travellers’ cheques now good only as monopoly money.)
posted by Dubai@Random at 1:07 am
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