Middle East Economic Survey

 

VOL. LI

No 17

28-April-2008

 

The Subprime Issue: The Real Causes

 

By A William Bodine and M Khaldoun Hejazi

 

Dr Bodine is Director of Certified Finanacial Planning Education, Concordia College, Bronxville, NY. Dr Hejazi is Executive Vice President International Operations, Wells Associates International, Watergate Office Complex, 2600 Virginia Ave NW, Suite 606, Washington D.C. 2003.

 

With many world markets down 20% or more, and the value of public companies decreasing $5 trillion in January alone, everyone seems focused on avoiding a global financial meltdown, rather than examining the real causes and issues of this crisis. On the surface, the current crisis appears to arise from excessive sub-prime mortgage lending in the US. Subsequent defaults have been triggered by rising monthly obligations for many who simply could not afford stepped up mortgage payments. All this has crippled the value of otherwise AAA rated bonds created by securitizing those mortgages. It has also led to virtually no market for such instruments.

 

Further, a sudden credit crunch and huge capital write-downs at leading US financial institutions have spooked markets, regulators and, most of all, consumers. Now, a recession in the US is predicted, one led by consumers experiencing declining wealth, and a markedly reduced ability to continue to spend based on easy credit and low interest rates. Under such circumstances, it is useful to think through the influences and factors of recent years that have contributed to this crisis. In this, there are important lessons for policy makers and market regulators which all Americans should understand.

 

As trained research analysts, our focus in this brief analysis is to begin with the seeds of this crisis, ie a Federal Reserve which, influenced by events of 9/11, Enron, and WorldCom, was forced into loose money policies and low interest rates. As a consequence of such policies, all levels of this financial system, particularly in the US, have been awash with funds since 2001. Banks, mortgage companies, some new and very aggressive, and institutional investors, especially hedge funds, developed increased appetites for risk as they felt pressured to chase higher returns in a weak dollar, low rate, cheap assets environment.                                                                                                                                                                                                                                                          

 

Home Ownership

Meanwhile, home ownership was promoted aggressively, especially to first-time home buyers, many of whom under normal credit practices could not qualify for mortgages. Closing documents containing rate step-up provisions were pushed onto less sophisticated people who were often simply told to sign and get their new home. In addition to many of these borrowers not understanding the complicated mortgage contracts, others did not understand the risk and consequences of an adjustable rate mortgage. Given low incomes, such individuals when faced with subsequently higher monthly mortgage payments, simply could not pay as higher rates kicked in.

 

On Wall Street, aggressive investment bankers packaged up these higher rate bearing mortgages in what first became known as Collateralized Mortgage Obligations (CMOs), to sell to institutional investors. Subsequent creations called Collateralized Debt Obligations (including credit card debt and car loans) followed. Such structured fixed income instruments, essentially bonds, when mixed by math wizards for geography, credit type etc gained not only AAA Credit Ratings from Standard & Poor’s, but also some insurance protection, making them appear to be the perfect investment: high return/low risk and AAA rated. Further, creative use of leverage, layered options (aka: derivatives) and highly sophisticated mathematical based applications led to almost unlimited demand for such structured paper. Under these conditions, investment bankers were more than happy to originate, warehouse, trade and own these investments because of the huge fees associated with such activities, especially origination.

 

Given big incentives and pressures upon institutional investors worldwide to perform in order to justify management fees, such “high return/low risk” paper was sought in massive amounts. Added borrowings against such assets, in combination with increasingly complex derivatives, allowed such investors to demand even more. As the game became more and more profitable and global in scope, commercial and investment banks themselves leveraged their own assets and balance sheets to make what appeared to be “easy money.” In addition, Structured Investment Vehicles (SIVs) were created and funded by Citigroup, and others, to further utilize such instruments as a basis for then issuing their own commercial paper for added profit opportunities. As the meltdown began with missed mortgage payments, the SIVs quickly found their assets and liabilities mismatched and billions of dollars were lost in the squeeze. Obviously, the assumption of “high return/low risk” has clearly turned out to be what every investor should know: there is no free lunch on Wall Street. High returns almost always mean high risk. As in the case of Enron, too few analysts studied the fundamentals driving this situation and were not brave enough to say, “The emperor has no clothes.”

 

At trading desks on Wall Street, market mechanisms (ie dealer markets with less transaction transparency), also made the sale and distribution of CMO/CDO’s especially profitable. In fact, such fixed income creations provided huge incentives in wider bid/ask spreads and higher transaction costs, thereby encouraging brokerage and investment firms to create even more structured debt instruments, to buy more for their own account, and to sell even more to eager institutional investors now worldwide.

 

Sophisticated Evaluation Methods

As a backdrop, it must be noted that since the mid-1970s, when markets collapsed from the impact of extraordinarily high inflation in oil, commodity and food costs, Wall Street valuation methods became more disciplined and sophisticated. Increased availability of data, use of computers, Modern Portfolio Theory and more advanced applications of mathematical techniques also combined to make “quant geeks” Wall Street’s newest heroes. As their impact spread in the 1980s, Value at Risk Models, led by JP Morgan, gave investment firms a false sense of financial security. In fact, such probability-based models are derived from past norms, yet the world has become increasingly uncertain, less predictable, more complicated and, as a consequence, more “event” driven. For example, in the late 1990s Greenwich-based Long-Term Capital Management using such advanced techniques, leveraged underlying capital of only $250mn, and nearly took down the world’s financial system with its mistakes, excesses and misuse of such tools. Given their initial success, the firm’s principals got predictably careless, failed to understand the limits of their disciplines, then bet wrong.

 

Notably, the “best and brightest” quantitative analysts on Wall Street today are so technologically advanced that many of the principals now running firms do not understand what their “quants” are doing. Just ask the former managing partners of the now defunct Barings. Its partners only saw huge fees enhancing their wealth and virtually had no idea of what could go wrong. In today’s financial crisis, it is sobering to read the statement of Citigroup’s former Chairman Charles Prince that “our risk models simply did not work”. This, as he announced billions of US dollars in capital write-offs just before his forced resignation. It is also fair to suggest that today’s extraordinarily talented quantitative analysts are so advanced and creative that even the world’s best central bankers and regulators have not demonstrated a capability to keep up with, nor to understand what has been going on with these “geeks run wild.” Additionally, the world’s financial watch-dogs have seemingly been unable to recruit equally capable watch-dogs.

 

What triggered this immediate crisis? First, individuals who fundamentally could not ultimately meet their mortgage obligations have missed payments. Payment defaults then undermined the “perfect” investment thesis of CMO/CDOs. Then, holders of such paper suddenly discovered what they owned is not what they thought they owned. The irony is that there is, inherently, much value in the underlying assets of CMO/CDOs (ie the mortgaged homes, cars etc) despite a bubbly housing market and abuses by aggressive mortgage lenders. However, the practical problem is that huge financial players all over the world, especially in the US, now have massive amounts of structured paper they want to sell or to reduce in portfolio positions. Further, such investors have found that Wall Street trading desks, normally making markets in such instruments, have effectively closed. In fact, these desks, so critical to a functioning worldwide markets protected themselves in advance of the meltdown and had no incentive to make markets, as nervous institutional investors heard: “No bids.”

 

Accounting Requirements

As 2007 ended, major investors, most visibly publicly owned investment banks, had to meet regulatory accounting requirements to write down assets of questionable valuation. Such massive write-downs have wiped out huge amounts of their capital and crippled their ability to act as financing institutions. Thus, the urgent scramble by new chairmen at Citigroup, Merrill Lynch, Bear Stearns and others to get capital from the Gulf and Asia, or anywhere possible. While the economic effect of missed mortgage payments, estimated at 5-10% of all mortgages outstanding, is not by itself catastrophic, the global financial system is so choked with structured debt paper, related debt creations, and capital account hits that it is struggling to breathe. Meanwhile, capital bases melt down, capital markets and regulators are showing signs of panic. And, consumers exposed to media frenzy about a global financial collapse are watching their asset values and life savings decline. Ironically, just as consumers begin to halt their spending, major Dow Jones companies continue to report increased earnings progress, and the underlying fundamentals of the US economy appear to remain healthy at least at the macro level.

 

Finally, in a political year, now full-blown with presidential politics and with President Bush eager to preserve an economic legacy, our Executive and Congressional leaders have, in record time, created a “Stimulus Package” of over $150bn to include immediate (ie May 2008) cash in hand to consumers, as well as tax incentives, especially for small businesses. However, as understandable as this action may be, it fails to address what are believed to be more fundamental issues, ie the need to reduce the possibility of a future crisis of this type:

 

1.     Policy makers and regulators must study this matter in depth and then take appropriate actions to curb future excesses on various fronts:

2.         Major Central Banks need strategic global monitoring groups staffed by extremely capable professionals to match wits with Wall Street’s “best and brightest” to examine all aspects of Wall Street’s latest quant products. Earning huge fees on such products is one thing but not when enormous risks threaten an otherwise fragile global financial system that reacts at lightening speed when problems arise. [Note: The level of unregulated derivative activity alone in the world today, now estimated at $400 trillion, demands such attention.]

 

3.         The credit ratings agencies, paid large fees by the investment banks creating this paper, should be challenged about their methods, their conflicts of interest, and what AAA ratings actually mean to investors;

 

4.         Longer-term, the US needs a better tax system, (simplified, fairer and more competitive with industrialized countries) to reduce corporate tax burdens so companies can compete more effectively globally. This is a sounder fundamental basis to support a growth-oriented US economy rather than short-term politically-driven cash-handouts and temporary tax incentives for small businesses which now appear as Washington’s answer to this financial crisis;

 

5.         Risk management methods must be applied more effectively to promote greater understanding of their applications and limitations;

 

6.         A culture of greed needs to be addressed, something which has clearly been a major force underlying the pain we are now witnessing, and may soon experience personally. Even a weekly visit to a church, synagogue or mosque would encourage most people to observe better values rather than simply chasing money with no concern for consequences; and

 

7.         Finally, we all need to remind ourselves what Warren Buffet has said: “If I do not understand what a company does, I simply do not invest.”