If we are to look at where the subprime crisis came from and where it seems to be going (which is bulls-eye straight into a recession) you can see that one of the biggest casualties are the banks. Banks never get sympathy, but they should – at least a little maybe.Why? Well, if you have a pension it’s likely that indirectly you own part of a bank, if you have a bank account then you are using the service they provide, a service which helps to protect your money and gives you conveniences like ATM card withdrawals etc. In fact, unless you were miss-sold a mortgage at an exorbitant price and you are about to have your home re-possessed then there is no reason to ‘hate banks’ really, but if you ask people on the street – and to my detriment I actually did this – not many of them (in my test pool of 10 people on Pearse St. Dublin 2 it was 100% true) really care much for the bank, including one person who ‘hates banks’ even though she works in one. I wasn’t about to point out the irony in that.
I read an article in the New York Times that said ‘banks were whispering sweet encouragement to take on loans that a person couldn’t really afford’, and quite frankly my only regret is that they didn’t pass my ‘Snake Oil‘ Counter on the way out of the ‘evil’ bank so I could charge them €4,000 for an ounce of my oil, which incidentally will cure any ailment known to man and if rubbed on a goose causes it to lay golden eggs (No, not golden colour dummy! REAL gold!). There is a sucker born every minute (although US real-estate may buyers might buck that trend and bring it closer to ever three seconds) and if you enter into a mortgage ‘not really knowing’ what’s going on then never mind going broke, you should be shot in an effort to cleanse the gene pool of total morons. The sad thing is that this mess was mostly caused by total morons, some of them mortgage holders who would not honour their debts, others were at senior management level in huge financial institutions.
Making sense of the sub-prime mess means understanding to at least a minor degree what actually happens in the securitization markets and property. So take a walk with me down memory lane. Its 1990-something and its raining (my shrink says all of my memories contain rain because deep down I never felt loved, anyways, enough about me), but in that rain Johno is working away laying bricks like they were nubile young lasses and things have never been better, in fact, he makes more money as a brickie than his mates do who went to university. There is a building boom on, and demand is high. Johno doesn’t know it yet but he will buy a site next year, develop it, then another and another and within a decade he is a multi-multi-millionaire. Fast forward today and I just got finished talking him down off the roof for the third time before lunch, he only came down on condition I would lend him a tenner. It’s a jungle out there.
Property world wide surged in the last decade, is that because (this is a fact) 10% of people who were ever alive in the history of the world are alive right now, today? Or is it because the securitization market had taken off? Well, its probably a little of both, securitisation meant that mortgage finance became available more rapidly and also with a greater degree of affordability than it had for generations. There were changes in underwriting, technology sped up processes (although as a person who still deals with banks on a daily basis I believe this happened everywhere in the world except for here) and the general economic upswing – the days leading up to the dotcom boom/bus- meant more people could afford to buy a home, after the dotcom bust money was so cheap that all the disenfranchised would be millionaires who were now broke could still afford a place of their own.
I remember speaking to my landlord years ago, before I was suckered into a lifetime of debt by an unscrupulous financial advisor… wait… I did my own mortgage? Scratch that last line, anyways, talked to my old landlord and he told me that back in the mid 80’s when he got his loan that they had a ‘mortgage party’, I jokingly invited him to attend my ‘I have halitosis’ party (he declined). I really didn’t get it, so I queried him, ‘what happens at a mortgage party?’ – while silently swearing never to attend anything remotely named something like that. Easy, back in the 80’s if you qualified for a loan you threw a party because credit was so hard to come by and it was not given out to anybody except for the absolute cream of society. It made me laugh back then, but today it makes me cry (while I think of rainy days of course).
The other thing that happened was ‘cheap money’, in Europe and in the USA interest rates after the dotcom fall out were at historic lows, and they stayed down for a very long time, in fact from 2003 until almost 2006 the base rate in Europe was 2%! That meant a property with a yield above 3% was a money-maker and prices soared accordingly.
While all of this was happening you have banks in the background, not local banks that you might ever walk into but uber-banks, ones that you may read about in the paper but you won’t ever hold an account there or anything, in fact calling them ‘banks’ is nearly a misnomer, they should be called bank trading or product centres, lets just say that they don’t qualify as retail operations. So, the Big banks are buying debts from smaller banks in different places and bundling them together, they then sell these bundles or ‘books’ of loans to investors, these investors are sometimes other banks or pension funds or hedge-funds or private individuals. Why would you buy a bag of loans? Simple, because they produce an ongoing profit over time, like a stock with a dividend.
The problem though was leverage, for every dollar put into the deal there were sometimes as many at 30 dollars borrowed. A simple way to look at it is this: imagine you have a tenner, you borrow 90 more giving you a 100 and you buy a house with that, the house goes up in value 10% so now its worth 110. You didn’t actually make 10% on the money you put in, you made 100% because 10% was the portion you paid to get into the deal. Big money being made fast brought a whole lot of players into the property game, fast. And every time they borrowed money you can rest assured that somebody else was creating financial products out of their loans.
If you are starting to get the picture then you can see that at some point it would only take a few dominoes to fall before all the others lined up in the same way might do the same but before we cover that it’s important to understand ‘sub-prime‘ which is the lynch-pin of the whole thing. Lending is only done in two ways, secured and unsecured, secured lending means there is an asset to back up the loan, that asset can be a car, a house, an airplane, or it can be ownership titles that have real-asset backing them. The second type and less sure is unsecured lending which is where is not asset backing the loan, its the tenner I gave Johno, or getting a loan for ‘personal’ reasons or whatever, in any case this type of lending has not asset to repossess if things don’t work out and that is a historical fact which is why secured lending – and mortgages are considered some of the most secured loans made – isn’t considered ‘risky’ in fact within lending circles the property a person gets a loan on is often not even called the ‘property’ or the ‘house/apartment/building’ or anything like it, its called ‘the security’. With lending there were always people who managed to get loans who would then mess up and not pay them back for any number of reasons.
In the past when you messed up a loan you became a credit-leper, nobody would touch you, no ‘prime’ lender would advance any more money. Then one day some bright spark was walking around in the rain (I promise that’s the last mention of rain) and he said ‘maybe we could lend people with bad credit money but really charge them a wild rate because they are a riskier client’?. And thus was born Sub-Prime lending. In Ireland sub-prime loans have only really come into existence since about 2004, its a very new concept. And it covers much more than people with bad credit, that is simply where it started off.
Sub-prime and its cousin alt-a or ‘near prime’ are typically used when 1. you have arrears or bad credit 2. you can’t prove your income in the traditional manners (with P60’s, Payslips etc.) 3. if you ‘self-certify’ which means you basically sign a page declaring your income 4. you are self employed and don’t have the 3 years trading required by the regular banks to prove ongoing income. This market is indeed riskier, because this whole melt down is due to individuals who don’t repay their debts, but at the time people didn’t really think about it because there was so much money to be made. This article can get as complex as you like, but if you are into the deep and freaky stuff then email me because its going to stay in layman spreken as much as possible.
So if regular loans are paying off a rate of x% which makes a profit, imagine the excitement when the sub-primers start paying off at y% which is sometimes three times higher? And to curb the investor risk the bank selling you the book of loans will give you an insurance as part of the deal in return for some of the profit! Too good to be true? Yes, it was but that was figured out only after things had gone to halfway to hell. So the investors in these mortgage funds/books – such as pension funds etc.- all lost out, the banks who had insured the loans lost out and the only person who gained… actually nobody really gained. The base of the problem was people not paying their debts, so they are getting their houses repossessed, and the house isn’t worth enough to cover a loan – you can buy a house in parts of Michigan for $100, no joke.
So literally everybody loses, now there are government backed bailouts and the US taxpayer will be hit for that, and the fear has spread to Europe, even though we don’t have the same problem some of the big banks were buying these funds and they lost out so the interbank lending in the Eurozone went to pot and the credit crunch was truly under way. This sucks, especially when Ireland wasn’t really part of what created the crisis, we are just part of the fall out, in a way its a humbling experience to realise that our economy means nothing in the greater scale of Europe and the world. The sub prime loans were always risky, but now there is more and more news coming out about alt-a which are loans that don’t have a bad credit history but were granted to people who didn’t qualify for loans on the high street.
Remain focused though, if you are wondering ‘who’s to blame for the credit crunch’ many pundits will say it was banks, Alan Greenspan, any number of funds but it was and is the individuals who took out loans they couldn’t afford or were unwilling to pay who caused the downfall. I don’t really see the blame as lying with banks, you can say ‘oh rates were too high or they were too lax’ it doesn’t matter, the borrower still signed for that loan. Banks may have exacerbated the situation or even gotten into the realm of bad lending but the base cause remains the same, people are not honouring their debts for what-ever reason. The rate was too high? Get a time machine to the mid-80’s and tell me about rates.
The reason this is being called the ‘credit crunch’ and not the ‘some douche-bag can’t repay their loan and they’ve messed it up for everybody crunch’ is because the market in general has swung into super-conservative mode, all of the banks fear each-other (normally they are all chummy and lend each-other money) because they don’t know what the other might have on their balance sheet, imagine going on the pull and there are 10 stunning guys/girls there, all eager but half of them have some flesh eating STD. That’s how banks feel about one another right now, they don’t know who to trust.
Certainly with a gimp like Alan Schwartz of Bear Stearns saying on a Tuesday that ‘all is well’ and then having to close up shop three days later it means that you can’t trust the word of CEO’s and that only makes it worse. Shareholders are getting literally raped when (in the instance of Bear Stearns) they are getting their stocks bought out for one fiftieth of their value. If any readers are interested I vow to pay you one euro for every fifty you get me: notice the tumble-weed blowing across the clearly marked ‘queue here’ section? All of the banks are hoarding cash now so that they can remain liquid, and of course account holders are making it hard for them by taking their money out just when the banks need it the most!
Credit doesn’t apply to just property, its credit cards and everything else which is why I was surprised at Visa’s meteoric IPO where they raised $17.9 billion, if things get truly woeful then you could see credit card limits coming down and people unable to get car loans which were previously available once you had a pulse and could spell your own name. The American solution is for the government to run in and try to fix a mess it didn’t create, I’m happier with the European answer of ‘let it play out as it needs to’ because throwing cash at the problem will only help inflate the bubble further and it will give a sense of reward or protection for reckless decisions, if people are getting their homes repossessed its sad, but not as sad as what could happen if the economy gets so bad that their kids will still be feeling the pinch when they are adults. This is truly a ‘napalm in the nursery’ story.
What’s worse is that the industry will have to totally re-think itself and we might find ourselves throwing ‘mortgage parties’ once again.