Credit Crisis-the know how it happened!

Published in The Hindu - Sunday Magazine on Oct 5, 2008
The bursting of the speculative bubble in the U.S. housing market has destroyed
billions of dollars in investor wealth across the world, crippled the banking system,
expunged close to a million jobs…and India has not been spared either. With banks
failing by the day…definitely, these are uncertain times for the financial services
industry. While many people who have lost their jobs, are faced with permanent
shrinkage of their lifestyle, others in the industry are going through the trauma of
not knowing if and when their turn would come. Who is to blame?
Flashback to year 2003:
Rohit (name changed to protect identity), a good friend of mine and someone who
was officially considered to be a genius with an IQ of 150+, graduated from one of
the leading IIM’s. Rohit managed to make it into the New York Headquarters of the
most sought after firm that had arrived on campus for the first time – Lehman
Brothers – a top U.S. Investment Bank (then). On joining, he was assigned to
Lehman’s mortgage securities desk that dealt with Collateralized Debt obligations (or
CDO’s).
Following is an extracted transcript of a chat session I had with Rohit back in 2004:
Me: So man, you must feel like you are on top of the world.
Rohit: Yes dude, the job here is amazing, I get to interact with people around the
world, investment managers – who want to invest millions of dollars
Me: great…so tell me something interesting. What’s your job all about?
Rohit: You know there is a great demand for American home loans, which we buy
from the U.S. banks. We then convert these into what is called as CDO’s
(Collateralized Debt Obligations). In plain English – this refers to buying home loans
that banks had already issued to customers, cutting them into smaller pieces,
packaging the pieces based on return (interest rate), value, tenure (duration of the
loans) – and selling them to investors across the world after giving it a fancy name,
such as ‘High Grade Structured Credit Enhanced Leverage Fund’.
Me: Wow! I would’ve never guessed that boring home loans could transform into
something that sounds so cool!
Rohit: hahaha…actually we create multiple funds categorized based on the nature of
the CDO packages they contain and investors can buy shares in any of these funds
(almost like mutual funds…but called Structured Investment Vehicles or SIV’s)
Me: Dude, you make your job sound like a meat shop…chopping and packaging. So,
in effect when an investor purchases the CDO’s (or the fund containing the CDO’s),
he is expected to receive a share of the monthly EMI paid by the actual guys who
have taken the underlying home loans?
Rohit: Exactly, the banks from whom we purchased these home loans send us a
monthly cheque, which we in turn distribute to the investors in our funds
Me: Why do the banks sell these home loans to you guys?
Rohit: Because we allow them to keep a significant portion of the interest rate
charged on the home loans and we pay them upfront cash, which they can use to
issue more home loans. Otherwise home loans go on for 20-30 years and it would
take a long time for the bank to recover its money.
Me: and, why does Lehman buy these loans?
Rohit: Because we get a fat commission when we convert the loans into CDO’s and
sell it to investors
Me: Who are these investors?
Rohit: They include everyone from pension funds in Japan to Life Insurance
companies in Finland
Me: But tell me, why are these funds so interested in purchasing American home
loans?
Rohit: Well, these guys are typically interested in U.S. Govt bonds (considered to be
the safest in the world). But unfortunately, Mr. Alan Greenspan (head of Federal
Reserve Bank – similar to RBI in India ) has reduced the interest rate to nearly 1%
to perk up the economy after the dot-com crash & Sep 11 attacks. This has left
many funds looking for alternative investments that can give them higher returns.
Home loans are ideal because they offer 4-6% interest rate.
Me: Wait, aren’t home loans more risky than U.S Bonds?
Rohit: We have made home loans less risky now. In fact they have become as safe
as U.S Govt bonds.
Me: What are you saying, man? What if the people who have taken these underlying
home loans default? Then the investors would stop getting the EMI’s, and their
returns would take a hit. Wouldn’t it?
Rohit: Boss, may be some will default, but not definitely more than 2-3% of them.
Moreover, we have convinced AIG (a leading insurance company) to insure our
CDO’s. This means that even if there were big defaults – the insurance company
would compensate the investors.
Me: that’s amazing. What are these insurances called?
Rohit: Credit Default Swaps
Me: Definitely you guys are the most creative when it comes to naming.
Rohit: Thanks
Me: and why has this AIG guy insured millions of home loans?
Rohit: see man, the logic is simple. Home prices in the U.S always go up. In fact
over the last 3 yrs alone they have doubled. So even if someone defaults paying the
EMI, the home can be seized and sold for a much higher price. So there is no risk.
Insurance companies are actually competing to insure this, because they can earn
risk-free premiums.
Me: no wonder investment managers from all over the world want to put money in
your CDO’s. *end of conversation extract*
NINA and the Housing Bubble
A global financial cobweb started getting built around the American dream of
purchasing a home and it rest on the assumption that “home prices will keep rising”.
As demand for the CDO’s started growing across the global investment community,
the investment bankers (like Lehman) who were meant to sell these instruments also
started investing a significant portion of their own capital in these. I guess after
selling the story to the whole world, they themselves got sold on the seemingly
foolproof concept. Gradually the markets for CDO’s and Credit Default Swaps started
expanding with traders and investors buying and selling these as if they were shares
of a company, happily forgetting the underlying people behind these products who
took the home loans in the first place and on whose capacity to repay the loans, the
safety of these products depended.
As Wall Street firms like Lehman were churning more and more home loans into
CDO’s and selling them or investing their own money, there was a pressure on the
banks to issue more loans so that they can be sold to the Wall Street firms in return
for a commission. Slowly banks started lowering the credit quality (qualification
criteria) for availing a home loan and aggressively used agents to source new loans.
This slippery slope went to such an extent that in 2005, almost anyone in the U.S
could buy a home worth $100,000 (45 lk INR) or more – without income proof,
without other assets, without credit history, sometimes even without a proper job.
These loans were called NINA – ‘no income no assets’.
The U.S. housing market went into a classic speculative bubble. Home loans were
easy to get, so more and more people were buying houses. The increased demand
for houses caused the price to increase. The rising prices created even more
demand, as people started to look at homes as investments -- investments that
never went down in value.
When I touched base with my friend Rohit in late 2005, he was on cloud nine. During
the previous one year, he managed to buy a home in Long Island (a posh area near
New York City ) worth almost a millions dollars, and got himself a Mercedes. All this
was interesting to hear, but what shocked me was that although he was earning
close to $20,000 a month (that is what CEO’s in India make) he was not able to save
anything because his lifestyle expenses where growing faster than his salary.
The popping of the Housing Bubble
In late 2006, Mortgage lenders noticed something that they'd almost never seen
before. People would choose a house, sign all the mortgage papers, and then default
on their very first payment. Although no one could really hear it, that was probably
the moment when one of the biggest speculative bubbles in American history
popped. Another factor that lead to the burst of the housing bubble was the rise in
interest rates from 2004-2006. Many people had taken variable rate home loans that
started getting reset to higher rates, which in turn meant higher EMI’s that
borrowers had not planned for.
The problem was that once property values starting going down, it set off a reverse
chain reaction, the opposite of what had been happening in the bubble. As more
people defaulted, more houses came on the market. With no buyers, prices went
even further down.
In early 2007, as prices began their plunge, alarm bells started going off across
mortgage backed securities desks all over Wall Street. The people on Wall Street,
like Rohit, started getting calls from investors about not getting their interest
payments that were due. Wall street firms stopped buying home loans from the local
banks. This had a devastating effect on particularly the small banks and finance
companies, which had borrowed money from larger banks to issue more home loans
thinking they could sell these loans to Wall Street firms like Lehman and make
money.
Everyone got into a mad scramble to seize and sell the homes in order to get back at
least some of the money. But there were just not enough buyers. The guys who had
insured these loans thinking they had near zero risk (e.g. AIG) could not fulfill the
unexpectedly huge number of claims. The best part was that since these insurance
policies (credit default swaps) could themselves be traded, multiple people had
bought and sold them, and it became so tough to even trace who was supposed to
compensate for the loss.
Back to 2008: The carnage
The global financial cobweb built around mortgages is on the brink of collapse. Firms,
large and small, some young some as old as a 100 years have crumbled as a result
of suing each other over the dwindling asset values. Lehman’s India operations- that
employed over a thousand staff is up for sale and many of the employees have been
asked to leave. The Indian stock market has crashed almost 50% from its high (and
so have markets around the world) as the Wall Street giants sold their investments
in the country in an effort to salvage whatever is good in order to make up for the
mortgage related loss. Hedge funds, pension funds, insurance companies all over the
world have lost billions in investor’s money. Many Indian Bschool graduates with
PPO’s (pre-placement offers) in the financial sector ( India and abroad) have either
received an annulment or indefinite postponement of joining dates. IT firms that built
and maintained software for the U.S. mortgage industry or the related Investment
Banks, have shut down their business units, laid-off people or transferred them to
other verticals.
For all the hoopla over the sharp and sophisticated people on Wall Street, the current
financial crisis has exposed the fragility of the system. Wall Street is blaming the
entire episode on people who could not repay their home loans. But the reality
seems to point towards the stupidity of people who lent all this money, financial
institutions that built fancy derivative packages and in effect facilitated billions in
trading and investments in these fragile low quality loans.
The U.S. Govt is planning to grant 700 billion dollars to the Wall Street firms to
compensate the financial speculators for the money that they have lost. Isn’t this like
rewarding greed and stupidity? The head of a leading Investment Bank has stated,
“This is necessary to sustain financial ingenuity. We don’t want to spend this money
on ourselves. We just want this money to go into the market so that we can carry on
trading complex securities, borrowing and lending money.” (Yeah…right, so that one
can act as if nothing had happened without analyzing too much into it). The real
question is: who is going to compensate the common investors across the world who
have lost their wealth in the resultant market meltdown? (either directly or through
pension funds).
After being unreachable for a month now, finally I heard back from my pal, Rohit,
saying he is back in India to take a break from the roller coaster ride that he had
lived through. After Lehman’s collapse he has lost his job and probably the house
that he had bought by taking a hefty loan. I really don’t know whether to feel happy
for him, for getting an opportunity to learn a lesson or two from the experience or to
feel sad for him for losing his job. May be I’ll get a better sense of things once I meet
him next week.