The Other Side of SubPrime Loans
83A wise man by the name Warren Buffet had once remarked “Derivative products are financial weapons of mass destruction”. He was spot on but the so called finance wizards paid no attention to his wisdom.
By this time we all know why subprime crises happened, who were the parties involved and what impact it has had on world economy. Infact the world economy is still reeling from its impact.
The roots of subprime crises can be traced back to as early as 2001, when the terrorist attacks happened and US economy had started reeling under immense pressure and that was also the period when dotcom bubble had burst. During that time in order to spur growth, the Fed flooded the US banks with loads of liquidity. People were encouraged to borrow and savings plummeted. Loans were given to all and sundry including NINJA(No Income No job assets). That era was also an era of low interest rates. Bankers aggressively started lending loans at cheap rates and people who could not even afford a proper house, with the help of banks now owned a house.
By 2004, inflation started rising due to low interest regime. Now inorder to curb inflation, Fed increased the interest rates which affected the American borrowers. This hike in interest rates impacted NINJA’s dramatically and they failed to repay the loans, which started the now famous subprime crises. But that does not gives us a complete picture. For complete picture read on.
Giving loans do not amount to crises that we are witnessing today. Banks do make provisions against loans and their required to keep some amount of capital aside i.e. minimum 8% according Basel norms.
What gave rise to this crises was 2 derivative products, namely CDO Collaterized Debt Obligation and Credit Default Swaps(CDS). These derivatives are also called credit derivatives. Collaterized Debt Obligation consists of different types of tranches, i.e. loans are bundled together as securities. Here both subprime loans and good loans were bundled together. Now tranches consist of senior tranches and junior tranches. Tranches which are rated the highest give low returns because the risk associated with them is lower as compared to tranches rated lower but low rated tranches have high returns. Subprime loans were rated low because of high risk of default associated with them.
Many Large financial institutions and corporations invested in these tranches, specially the tranches that had a high rating because they believed the probability of default is low. AIG one of the largest insurer in the world went 1 step ahead and insured these CDO’s with Credit Default Swaps.
This is how a CDS works:
Say for Eg. Bank X lends to a corporate but does not want to take the full credit risk. So, Bank A enters into a CDS deal, say with AIG; under this, AIG promises to pay Bank A if the corporate defaults. The money that AIG earns for this is the CDS premium, which is similar to an insurance premium.
Here Bank X is the protection buyer and AIG is protection seller
AIG got into insuring CDO’s and paid heavy price for it, because the tranches consisted of subprime loans and it had to cover the foreclosures it had promised to cover.
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Now other financial institutions and investment banks had invested into CDO’s , hoping to make good money. Interest rates began to rise and price of houses started going down. Due to this, the default rates on subprime loans started to rise and when it turned out to be way higher than expected, these very institutions became jittery and they started running helter skelter to get rid of these subprime related securities. In the market, when everybody wants to exit, prices of securities will definitely plummet.
Many of these large financial institutions were highly leveraged some were in excess of 30. Add to this the loss in these securities and the total loss was huge in magnitude causing big institutions like Lehman and Bear Stearns to collapse. Also the credit rating agencies paid their part in this downfall.
Another reason why these institutions failed was the difference of accounting treatment of loans and securities. As these loans were converted into tradable securities i.e. CDO’s, the accounting norms required that they have to be marked to market i.e. they have to be valued at current market price, as against a normal loan which does not have to be marked to market. When the market price falls below the face value of the securities the same has to be recognised as loss. Banks on other hands do make provisions against loans and they are required to keep some amount of capital aside i.e. minimum 8% according Basel norms.
Now let us discuss about regulation or the lack of it. Banks are regulated by Basel norms, they did make huge losses on these tradable securities, but because of the regulations they some what survived, but that was not the case with other investment banks or financial institutions like AIG, Lehman and Bear Stearns. The lure of big money for these financial institutions was too good to resist. What happened to the sophisticated risk models that were developed? It is a shame that these institutions attracted the best minds form across the world, but greed undid everyone of them.
The one basic fact that each of these financials bigwigs forgot, was, that nothing is permanent in this world. They expected the good times will last forever and they failed to see the risks associated with their investments. They were driving at a rate of 150 kms per hour and thought the ride will be smooth forever. Today because of these greedy men the entire world is suffering and will continue to suffer for some more time. Tax payer's money is being used for bailouts which is creating moral hazard, and some souless companies like AIG is using the bailout dollars to pay bonuses to their top honchos. GDP’s across the world have shrunk. Demand has collapsed. Number of job losses throughout the world is at a record high.
Although things have started showing signs of improvement, but it will take some time to return back to normalcy. This incident has taught us a hard lesson and it is better to be safe than sorry.
I pray and hope that some years down the line, history should not repeat itself. Amen
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Thanks khushboo for your never ending encouragement and support.
I really like the holistic picture you have painted of the root evil of today's financial and economic crisis. Great hub!
One question, do you think Obama's plan of buying up toxic assets with small investors would help in improving the situation? Plus, FASB has proposed a new accounting rule for mark-to-market value, do you think that would be able to delusion the investors, raise banks' value and put an end to this whirlpool?
Thanks Nazishnasim for ur comments. Ill answer your 2nd question first. I believe FASB under the pressure of congress has eased down MTM rules. I can look at it from 2 sides. If I were the head of Citibank or Goldman or JPmorgan, I will be very happy, because now I can show impressive numbers as I wont be writing them down at their current market price which is abymsal at this point in time. Infact market for these toxic assets has virtually dried up. Companies can account for mortgage-backed securities and other assets based on their internal estimates of cash flow and other factors. But on what basis will these institutions determine the cash flows remains to be seen. Are these assets good enough to be traded in near future ? I do agree fair value rules hav reduced the profitablity of banks, but we want banks who are transparent.
Now if I look from other side say as a investor. Investors needs transparency. How many investory know accounting rules. This is just a number tweaking, yes which will boost up da profit, but does it addresses the real problem? The problem of lack of underwriting standard during credit boom, lack of regulation.
I dont think so by tweaking rules a wee bit can solve the problem. Also the rules were made under pressure from banks who had to declare the quarterly results and wanted to show impressive numbers. But the real issue still has to be addressed. This is akin to applying band aid to a person who has met with a serious accident.
To answer your first question:
I have my doubts. This plan might work, in the sense of facilitating the removal of some toxic assets from the balance sheets of banks which will improve the numbers. But it is unlikely to work, in the sense of restoring the banking system to health. I believe the confidence of American people in their banking system isnt that good.
This plan may prove to be part of the solution, but a relatively small part. I still believe corporation have to act more responsibly and there has to be bit more regulation in place. This plan will fail to take off if american economy goes further in recession. I also believe that this plan is just worth $500 billion which is on small scale. So if this plan has to work, its scalability has to increase.
This is what I could think off of your questions. Suggestions are most welcomed. Infact your question really made me think. I would like if you can put your views too. I will also be able to learn. Cheers
Hey Jay,
I promised by comments but forgot that I had actually written a hub on the same topic sometime back *embarrasing smile* , here's the link : http://hubpages.com/hub/Who-benefits-with-FASB-acc Also, I have written two posts at the following forum :http://hubpages.com/forum/topic/12350
Also :), I think your knowledge has helped me a lot in having a firmer grip on the issue. Thankyou Jay :).
Term's like tweeking are, what got us into this mess.What is needed is Firm oversight by those parties who are potentially negatively affected by questionable financial transactions,like dirivitives.
Hey Jay,
I am really enjoying the forum discussion you are having with that 'loser'. I couldn't stand him. Admire your patience for dealing with him and setting him right in place by 'actual knowledge'.
Touche!
Thanks nazishnasim. I do get irritated when people talk even without thinking. I feel sorry for that loser.
Thanks jay,
You hit on every major point that I could think of and some that I was not aware of. Nice inclusion on shoes. ;)
G|M
Thanks Generiquemedia for stopping by and commenting
Jay, you really summed this up in a way that anyone can understand. Thank you so much.
I hope things change. If the economy comes back but Wall Street gets to do it all again, then we will just see another bubble and another mess. Let's pray that yes, this doesn't happen again. Great hub!
i just read your profile and see you are in Mumbai. That is amazing. You understand this better than 98 out of 100 Americans.
No wonder we are in a mess! All the best to you. :)
Thanks pgrundy for your wonderful comments. I really hope things improve normalcy is restored
In 2001 I purchased a home and my lender was trying to get me to spend more money than I wanted on this home. When I got my pre-approval he was pushing me to purchase a home that was well out of my budget at that time. Luckily I did not listen to him and stayed in the price range I originally intended. Now I can still afford my home despite the increases in my budget in other areas.
Interesting thoughts, very informative.. Would the statement "The economic crisis in america started with the implimentation of the Federal Reserve System MANY years ago" qualify as a correct statement? Didn't America's money crisis start the day we decided to start basing our money off of projected profits and took away the gold standard?
Glad to read your thoughts, hope you have some insight as to my question....
Fishin cricket Who do you think wanted us to get off of the gold standard.It was banking interests outside the unitedstates after we became a fair trade country,unlike the country we split from!
I see your a car salesmen,so you should know,we haven't been selling as many locally based exclusively American made car's. meaning cars made from a sovergn American company.not transplants,that don't have as much of a stake in our society,and it's workers.
Hi jayb, I had to attend a seminar to understand the subprime crisis. Thanks for putting it here. Yes, let us hope that we all learn from this one.
By the way, if you didn't know yet, this hub has been chosen as one of the HUBNUGGETS nominees. Click on this link to read more about it. http://hubpages.com/hub/HubNuggets-Overloaded
Be sure to vote and ask your friends to vote for your hub! :-)
Many many congragulations Jay:),
Your nomination makes me really happy :D. And I am sure your hub will have the largest number of votes at the end of the day!
*ovation*
Our government still has a long way to go, and there is a trickle effect but here in the U.S. our banks are still counting losses and there are more foreclosures to come. I give this hub a thumbs up!!!:)
Thank u so much naz for your support, encouragement and motivation.
Thanks Aevans for sharing your insight and support
Thanks ashley for sharing your insights. Im sure you have been lucky enough that you didnt get more greedy that time.
Thanks ripple maker for your comments and giving me the pleasent news that my hub has been shortlisted. Thanks again
Congratulations jayb for nomination for HUBNUGGETS. May God Bless you.
Thanks so much Kulsum for your support and encouragement
I loved this Hub and am honored that you laid all of it out in a way that I could understand it!! Good Job!!!
mdawson17
Thanks Mdawson for your lovely comments
Great work Jay! You really seemed to have put a lot of work in this hub. You got my vote. Cheers!
Thanks so much Anjali. It really means alot to me. Iam honoured. Thanks again
U've been readin up a lot. I wish i had d patience. I suggest, get out and face the damn recession.
great article..btw..i hope u win ....if it helps ur resume;)
Thanks so much Nimisha for your kind words of encouragement :-)
At last I understand what is behind and driving these terrible times. Thank you so much. I appreciate your hub so much.
Jayb23 - I was writing for a mortgage site from 2000 to 2005. I kept talking about the brewing subprime mess, but most people were not ready to hear about it. To the vast majority it looked like we were reaping the benefits of a good economy. While there are many other subplots in the fall of the financial sector, you have certainly captured the overall picture.
I love your tips.
Gr8 article man! its nice to find that my ol' roomie who is a blogger has emerged as a fine artist! the reason i say artist is that u have really painted the whole picture of d crisis! Gr8 gun dude...hope some ppl will understand ur true worth now :)
Thanks Gypsy for stopping by and cur comments.
Thanks Monique for sharing your insights and commenting.
Thanks Sud; my roomie for your never ending support and it doesnt matter if people understand or not, as long pple like u who are close to me understand
Hey Jay!
Many many congratulations to you!
Seems you have been reading a helluva articles these days. In the beginning, I could get you but later, I got lost in translation (LOL). Now I can see that perusal paid off as your article was ranked second. You are a blogger-turned-erudite now. Keep it up.
All the best for all your future endeavors.
keep up the gud work n congrats!!!!
Hey Jay,
Realy a nice work of words and thoughts. Keep it up dude.
Tkcre. Bye.
Jay,
Don't remember if congragulated you on the 2nd position. Gee, am getting real old and it won't be long when I will be 'that old lady who lives with her cats'.
So, where were we? yes, many many congrats sweet Jay! :D
Hey Jay
Good work, very simple and educative article
Congrats and keep up the gud work
I have a question.
The crisis started with flooding of liquidity in the market and to curb this crisis we are again injecting liquidity to the system, are we trapped in a vicious circle ?
Thanks Rohit so much for your kind words and encouragement.
Thanks Vivek and mukul for your wishes.
Thanks naz for your comments and never ending support. You simply rock :-)
very nice article good hub
Thanks Lgali for stopping by and commenting
Hey jayb, have you looked at the coming reset of Alt-A borrowers and the brewing storm in the commercial real estate sector. I recently went to a mall in St. Louis and it must have been something a year ago. It was huge, had an indoor skating rink and everything. Well not everything. By the time we got there, half of the stores were closed. Now this mall must have cost millions to build. How are the owners going to pay their mortgage if they are at on 50% occupancy? And this is in Missouri, which hasn't been as hard hit as some places like Nevada, California, New York, etc. How are banks going to survive when these guys default. It's way to premature to say the worst is over, what we've suffered through is the gust front, the worst of the storm is still ahead.
Also did you consider the effect of the Community Reinvestment Act in forcing banks to lend to NINJA first time homebuyers? If not look into it. That's a case where regulation caused the subprime mess. The reason banks created CDO's was to get those soon to be toxic assets of their books. Unfortunately, they bought their own hype and started buying these "investments" back before they tanked.
Nice description of the current mess.
Thanks Ralph Deed for commenting
Hi - my theory is that no-one actually knew what they were buying or selling, it was just one big pyramid scheme. Good hub!
Thanks London girl for commenting. You said it best "1 big pyramid" . Totally agree with you
I think the fact that these CDO's and CDS' were effectively over the counter products has added to the problems. If they were exchange traded like stocks and futures then the extent of the losses would have been visible much sooner.
Yep jayrpascua, I completely agree with you and morover not many people can understand the way this CDO and CDS works which added to more confusion. Thanks for commenting and stopping by.
The start of the sub-prime crisis goes much farther back then 2001. It started in the 80's when banks started to become deregulated. You know the regualtions that were put into place because of the great depression. Then the real groundwork was laid in the 90's when these super banks were allowed to be created.
Thanks LennyP for sharing your insight. Yeah I can Imagine the seeds of this crises was laid way back in 80's. Thanks for commenting
yaaar mazzza aa gaya...
I m glad to see a lot of appreciation accross the world fr u..
keep it up.. I told u bro 'U r a Gem'
Thanks varun for such kind words. You are incredible :-)
Though me too in favour of early normalcy ...but history shows something else... never is history govt's are able to control financial markets, which move their way only... I think ,what govt is doing by Pumping greenbacks is just procrastinating the final assault, which will be more affecting & less forgiving. Developed economies will be affected the most...hope for the best anyways
Nice hub too...went back and voted ..cheers :)
I completely agree with you. But i really hope things get back to normal. Thanks for commenting and stopping by.
I'm curious. Why did you include an Amazon link to Men's Reebok Shoes? Oh, I get it. It's for these CEOs and Bankers because they took the money and ran!
HEHEHE...Thanks chris for that Hilarious comment.
Great Hub! it is quite informative. That's comical about the shoes....
Dear Joy !
You are on a right track. Go ahead.
Attaching brief of my article published on UK website ecch.com.
It is named as "US Oil Contango & World Trade Cycle".
US OIL CONTANGO &WORLD TRADE CYCLE (2008) By: Dr. Phopale A.
1. Brief of Article on ecch.com
A Crude oil and its products are necessary energies to every economic progress. Small change in its price affect growth rate of economy. During 2008 recession, by way of Exchange Traded Fund (ETF), the popular shares - United States Oil (USO) over 34 millions per day – were purchased and sold in future trade contracts on oil. Such very speculative activity by stakeholders to Buy-and-Hold during expected high future price than current price called “Contango” happened during this World Trade Cycle (WTC) of 2008. The spreads of contnagos multiplied and accelerated give rise to market apprehensions in terms of financial risk. The wide spread gap in cost of oil and its price generate contango. Cost of production of crude oil per barrel in major oil fields is US$10. The processing, storage and transport add to the price of oil together to the extent maximum US$20 per barrel and not more. As per The Wall Street Journal, March 31, 2008_1/ crude oil spot price was US$ 101.59 per barrel. The oil baron companies like Teekay (NYSE: TK), Frontline (NYSE: FRO), Valero (NYSE: VLO), Marathon Oil (NYSE: MRO); banks, financial institutions and speculators continued betting on oil and USO prices with the help of nonprime – low or undocumented or fraud - mortgage loan. Mortgage Back Securities (MBS) based on Adjustable Rate Mortgage (ARM) have created illegal loans in large magnitude by banks and financial institutions hoarded oil and USO, which increased the oil spot prices further to US$ 145.28 on Thursday, July 3, 2008. Hoarding physically, the scarce oil in tanks, vessels is seen prima-facie, but hoarding USO shares and their spread with mortgage loan supporting oil price speculation is like huge iceberg beneath water. This hoarding of oil and USO lead to “Oil Price Bubble” and result was hyperinflation in oil market during first half of 2008 H1. This is named here as “US Oil Contango” which busted due to panic when USO share prices started dwindling down. Then, there started unexpected sale of USO shares in fear of further financial risk and recession due to mortgage frauds. Highest price US$ 94.26 on June 18, 2008 of USO reduced to US$ 33.82 on March 19, 2009 (data given by – Media Container Format - MCF Insider Trading, Contango Oil & Gas Trading Co. page 1);_2/ mainly busted the articulated Oil Price Bubble. Largely, such unproductive Contango speculations and their unexpected spreads on commodity and stock markets in reality, dotcom, Oil, Gold, Arms & Ammunition, FII, FDI, Sovereign Funds, Participatory Notes mixed with smuggling, gambling, hoarding and so on result in present WTC are the anomalies which must be regulated for over all industrial progress. In past such reality and dotcom bubbles were equally responsible for collapse of economies and sufferings of people of the universe. Government policy to cut interest rate and bail out key financial institutions, assuming significant additional financial commitments to productive, and employment generating industry is partly helpful in creating confidence in economy. Speculation is not a crime, if you play with own money. It is a fraud when other’s money and nonprime security - mortgage loan investments put to high financial risk. It is not only moral but also financial responsibility of every Central Bank to control unproductive allocation of resources, if work contrary to smooth economic and social goals, which are anti-national. This time oil bubble is still more dangerous and repetition could be disastrous. Therefore, Contango anywhere found that need to be curbed by government regulators. Such contangos generating speculative and hoarding trends are mainly the causes of economic instabilities, which resulted in present 2008 WTC. Let us establish quantitative support for the USO contango leading to 2008 recession. Those 34 million speculators in USA almost decide USO prices and hence crude oil prices. All world consumers are forced to accept the unexpected changes in oil price. Since the demand of oil is inelastic, we deteriorate in purchasing power during high oil contango. This article is devoted to the sufferers of 2008 recession. In this article, we deal in with only USO Contango largely responsible for the recession of 2008 and hence GDP growth rate crisis. Our statement problem is whether there is quantitative short run relationship in USO share price and Crude oil price responsible for changes in GDP growth rate during 2007-09Q1 in USA and India. There are nine Parts excluding bibliography in this article. They are Introduction, Background, Causes of Oil Price Bubble Burst, Oil Contango Speculation, Financial Asset Hoarding in 2008, US Oil Contango and WTC, USO Ups & Downs and other Parameters (Data), Methodology and lastly Testing of Hypothesis. Methodology Part is sub-divided into three Techniques: to prove direct relation between USO, Oil Price, as well as Oil Price & US/India growth rates by Technique 1 – Correlation, Technique 2 – Time Series Plot and Technique 3 – Analyses of Quadratic trend. In addition, there are 2 Tables, 10 Graphs with seven sources under Bibliography in this article of 19 pages.
Wooohoo, you made it to top 5! Congratulations! :)
Thanks Ripple maker
Long overdue--but just as heartfelt--congrats on 2nd place!
Thanks anglnwu so much for your wishes. Really appreciate it.
Great Hub Jay...Quite informative and very well put.
Thanks Ravi for your kind comments. Glad that you liked it.
Khushboo 3 years ago
Hey Jay,
This one is real good work. Very well written and precise. Keep up the good work!