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Written by CH Cheah
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Saturday, 04 October 2008 19:21 |
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 It's ironic that the world's largest economy can be brought to its knees. And it did this all by itself - driven by the inherent greed of its financial experts and bankers. The problem is that it's bringing others down with it. That is what being the world's largest superpower is all about. When you catch a cold others sneeze along with you.
The current economic crisis may have been triggered by the slumping housing market and the defaults of the sub prime loans. But that is not the whole story. The real devil behind it is the derivatives, or what is called toxic waste by some prominent long term, value investors. What exactly are these 'toxic waste' and how did they cause the collapse of US economy?
The story starts with the sub prime loans. Do you wonder why banks even give out these loans? Traditionally banks do not take a lot of risks and as anyone who's has ever taken a loan from a bank knows, the bank will attempt to mitigate its risks by taking your house as collateral as well as checking your financial status out to make sure you are capable of paying the installments. If your financials are not sound, the bank will not give you a loan. But sub prime loans are just that - loans given to persons (in particular house buyers) whose financial backgrounds are not too credible and the chance of default are higher. Why would the banks take on such risks?
They don't. Enter the world of Mortgage Backed Securities (MBS), Collateralized Debt Obligations (CDO), Hedge Funds and Credit Default Swap (CDS). The name of the game is musical chairs and the thing being passed on are the risks, masquerading in financial double speak and ambiguous investments grading (AAA graded investment anyone?)
This might give you a short overview on how the scheme works:
The lenders (the bank) made an offer for a home loan to a sub prime customer with a dubious credit rating (that's why they are called sub-prime). The risks of default are high and the bank knows this. But no matter, as soon as the deal is signed it is packaged into several classes of MBS (Mortgage Backed Securities) and sold off to another financial institution. The bank has passed on the risks to another, got the loan and the loan income back in a matter of weeks instead of the 15 or more years required if it waited on the loan installments payments. And it's ready to offer the cash as another loan to another sub prime customer. The population is happy because they can get easy loan, more houses are sold and the house price shoots through the roof because of demand. A housing bubble is created. The developer builds more houses in anticipation of future roaring demands, people get more loans and more houses are sold - prices go up again.
If you are starting to sense something's amiss by now - you are not wrong. But what's wrong with the picture? People are happy because they can afford to buy homes (easy loans remember?) and developers are happy because they can build and sell more house at a higher profits (remember the house price going up?). Looks like a win win.
Remember that the bank sold of the debts to another? Which financial institution would buy sub prime loans off the bank? These are risky debts. What the bank does is to sell these off to an investment bank, perhaps funded by the original bank itself, as MBS (Mortgage Backed Securities) product. These Investment Banks then slice these MBS and repackaged them as Collateralized Debt Obligations (CDO) product. These CDOs are typically divided into a few classes depending on the chances of default by the original house buyer borrowers. 70% or so of these MBS would be graded as Investment Quality and given perhaps AAA rating by the rating agencies (these are the top 70% of the sub-prime borrowers who are less likely to default) and the rest would be divided into a mid risks and high risks (high returns too supposingly) type of 'investments'.
The 70% or so of investment grade MBS would be easy to sell off as they are considered solid investment and given good rating by the investment rating agencies. But what about the other 30% of less than Investment Grade 'investments' (30% of the sub-prime borrowers who are most likely to default their loans)? Before we move on, remind yourself that all these MBS are derived off the sub-prime loans in the first place, hence they may not actually be anywhere near 'Investment Grade', regardless of the grading given. These are merely marketing techniques to 'upgrade' the apparent quality of the MBS and shield the buyer from the fact that it's derived from sub-prime loans.
Back to the 30% of the high risks CDOs. Now, the bank then proceeds to sell these high risks CDOs to a hedge fund. Remember the housing bubble? As the house price soars, these high risks CDSs appear to be safer because the higher prices of the house reduces the chances of defaults by the home owners. They now seemed more valuable and are marked-up to be of a higher price than when it was issued. It now seems like the high risks CDOs (30%) are performing well and this will induce investors to have more confidence and pour more investments into them - driving the price up further.
Meanwhile, the hedge fund owner knows that these CDOs are risky still. He wants to get them all off his hands - quickly. So what he does is to convince a bank (perhaps a foreign bank) to give him a loan using these high risks CDOs as collateral. The bank agrees to give out the loan because these CDOs are now performing well and it appears like a good business. The hedge fund now has more cash on hand and proceeds to buy more high risks CDOs (the 30% remember) off the Investment Bank. The cycle then continues and more cash is created - out of thin air!
All this will continue to work well (and money will continue to be created) if the housing price continues to rise and the home owners do not default.
From the process of giving loan by the lender bank to the home owner (borrower) to the selling off of the CDOs derived from the loan. The original value of the loan has been sliced and re-sliced multiple times and each slice has been marked up according to the housing demand and the apparent 'value' of the CDO as it 'performs'. So from a single loan, we have created an amount of cash multiple times over. Multiplied that by the amount of home loans offered and taken by house buyers, the figure can become mind boggling quickly.
The whole thing is build like a house of cards, and any trigger like a default of the original loan owners or an increase in the loan interest rates can make it tumble down in a hurry. But the housing price continues to soar... until in late 2006 when the defaults begin.
Because of the structure that was build (the MBSs, CDOs etc) each default of the home loan is now multiplied many times over and instead of the (in maybe billions) losses which should be limited to the value of the defaulted home loan, the loses is now in the tune of trillions. On top of that, these 'investments' are traded across investment institutions, banks and foreign parties in various forms and mark ups - hence the large scale collapse of so many prominent financial institutions in US. You can create money out of this air, but you can also lose it all in the blink of an eye.
That is basically a part of the story of the current US financial crisis. There are other factors which pull it down to where it is now - but this, I believe, is how it all starts. Now we have a problem that is too large and too hot to handle.
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My favourite...
Understanding the US Financial Crisis - From Sub Prime Loans to Derivatives and Toxic Waste
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