We all, whether those who are part of financial markets or those who are not, have been hearing, reading and (now started) speaking about SUB-PRIME or U.S. financial crisis or credit crunch or financial market breakdown or … (the list goes on). No one has been fortunate enough to skip the aftermaths of inventions of complex financial products (CDO, CLO, CMO and alike) and have seen markets crumbling, whether developing or developed. In fact, this crisis has been hitting the hardest to the developed economies like world-power United States, U.K., etc. The question of how well regulators have been undertaking their responsibilities and how far can market-makers (big banks like erstwhile Merrill Lynch, erstwhile Bear Sterns, Goldman Sachs and counting) can go to innovate (without assessing the potential risks associated) has popped up.
For those, like me, who are still trying to understand the market, and need a primer on what is sub-prime, let us begin to explore the concept. First of all, as the classic definition goes, something which is not a PRIME is named as SUB-PRIME in the market (market in this article shall refer to financial markets). These refer to rates of interest or the credit-worthiness of the borrower. In clearer terms, a borrower who has a good credit history of honoring his/her obligations is said to be PRIME borrower and the one who has either defaulted or is expected to do so is called SUB-PRIME borrower. But how are these simple definitions responsible to collapse of such giants who have dozens of sophisticated investment analysts, economists and other experts? Also these institutions are not in retail lending / mortgaging, so how come these two are related?
Let’s first answer the second question. The story begins from a year 2000’s DOT COM bubble burst, when the markets crashed like pack of cards and there was an urgent need to revive the markets and boost confidence. For achieving the said goals, FED (Federal Reserve – US’ central bank) reduced interest rates to stimulate borrowing and kick-start business again. As expected, markets picked up and confidence was restored. There was a huge increase in amounts of loans granted by banks during this period.
In the real estate market, mortgagers (who get commission on the number of mortgages done) and bankers who wanted to increase their portfolio, went beyond and started serving those who did not deserved them (SUB PRIME borrowers). But since these borrowers gave more commission to the mortgager and more interest rates to these bankers, all were happy. Banks actually modified their lending criterion to book more profits without realizing the aftermaths of such loans which were slowly becoming a major chunk of their portfolio. Such borrowers kept their houses (which they bought with the money lent by banks) as collateral to banks for the funds borrowed, as a typical mortgage-backed transaction. And with easy and cheap money, it was not difficult to buy a home in US (the dream of – a house for each American – seemed to be becoming a reality). This led to surge in house prices, which further enabled SUB-PRIME borrowers to obtain more loan as their collateral value increased.
Securitisation is a form of off-balance sheet financing. (Now you must be wondering that why am I suddenly introducing you with another concept. This is because securitization is what brought our big I-Banks into picture.) Not all companies like to raise direct debt. Obviously there are reasons behind it. Firstly, more debt on my books will tarnish my ratios which are one of the primary tools used by market analysts to gauge a company’s worth and performance. Secondly, to comply with regulations (like in banking sector), I would be required to bring in more equity to balance capital structure. These and many other reasons, motivate firms to go for off-balance sheet debt. How they do this is by doing away with their illiquid assets like book debts, loans granted, etc?
Now this is the phase where I-banks play their pivotal role. Since huge amounts of loans given by (conventional/commercial) banks over-burden their balance sheets and restrict their ability to expand their portfolio. To overcome this, banks sell these loans to I-banks, through securitization, and get ready money for providing further loans. Now what these I-banks do with these loans/debts is that they sell these to investors (usually pension funds, endowment funds, high net-worth individuals). This is done by making packets (tranches) of such loans based on features like maturity, credit risk, etc. For e.g. making tranches of AA rated loans.
The story was going simple: Banks gave loans (since we are concerned with sub-prime crisis, so loans to sub-prime borrowers), then sold those loans to I-banks which further repackaged and sold these loans as credit products to investors. In this chain, a not-so-worthy man got a house, mortgager got his commission, bank got high interest rate and I-bank got commission to sell credit products. All are Happy!
The story was going fine until the something happened.
Fed and other Central banks (in countries like UK & Europe) realized that slowly and slowly asset prices went beyond their tolerance limit. To hold prices from surging further and to bring assets prices to their intrinsic (justifiable) value, Fed increased interest rates which actually increased the payments to be made by the ultimate sub-prime borrower. As a result, they started defaulting. This led to fall in the payments made by special purpose companies (those created to sell loans/debts). Since these companies were paying dividends to Institutional investors, defaults of borrowers affected them too. Gradually the defaults got the whole system infected and paralysed. Since now it was unaffordable to purchase property, the property prices started declining. Again one of the affects of this was that the margin of borrower (percentage of amount borrowed against property) declined.
So the outcome of this financial engineering was that all the systems in the financial markets started tumbling with banks (Commercial and Investment banks) facing billions of dollars of losses.
The moral of the story seems to be that innovation should be protected with adequate risk management, else it could be fatal.
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