Many people are asking why so many banks are still failing even though the roots of the credit crisis go back to 2007. The simple answer is that the FDIC has limited resources and can only focus on a certain number of banks at any given time. Just like a doctor in a hospital ward focuses on the sickest patients first, the FDIC has focused their attention on the weakest banks first.
The bigger question is when it will all come to an end and get back to “normal”, whatever that means these days. My guess is that it could literally be 10 years before we start seeing new bank charters being granted on any significant level. We still have a long way to go before banks are finished working through the bad loans they have now and the regulating agencies that grant bank charters will likely be slow to forget the lessons of the past three years (and years still to come).
The first wave of bank failures was associated with institutions that had heavy concentrations in residential real estate. This market fell very far, very fast and took many banks down with it. Early in the credit crisis, many of the banks that were not concentrated in residential real estate touted the fact that they were concentrated in commercial real estate loans and that they were insulated. Unfortunately for these banks, there problems were just over the horizon.
Commercial real estate is generally valued on the level of rents a property can earn. During a time of high unemployment there is lower demand for all types of commercial rental properties — office, retail, warehouse, and others. Lower demand produces lower rents.
Weakness in the commercial real estate market has developed more slowly because leases expire at different times. Any given property many have a series of leases that expire any time from this year to five years from now or even longer in some cases. As leases expire in a market like the one we are in, tenants have many options and can lock in lower lease rates.
On the surface this does not seem like a huge problem but a quick analysis reveals the real issue. Take a typical office building in which the average rent is $20 per square foot. The total expenses for this building may add up to somewhere in the neighborhood of $17 per square foot and the last $3 per square foot is the profit to the owner (known as “net operating income” or NOI in the real estate business). In the current market, a building with an average rent of $20/sf in 2006/2007, may only be able to sign new leases with rents of $15/sf. The owner’s costs of managing a building are relatively fixed so in this example, they are now taking a $2/sf loss but this is far better than letting the space go unleased which would result in a $17/sf loss for that particular space.
For banks that are concentrated in Commercial Real Estate, this is a major issue because the building they hold as collateral is now valued at significantly less than it was at the time the loan was made. But because leases expire at different times, the cracks in the foundation of the Commercial market have been much slower to emerge than those of the residential market which appeared almost overnight.
This problem will continue for several more years as commercial real estate owners work through the challenges of covering a relatively fixed expense based with lower rents. Compounding the problem is the increasing number of commercial foreclosures………..If an investor buys a building out of foreclosure, their cost per square foot is lower than that for neighboring buildings and they can make a profit even at much lower rental rates. This puts owners of non-foreclosed properties at a further disadvantage as they try to compete against properties with a much lower cost basis. It is a downward spiral that will negatively affect commercial real estate for years to come as well as the banks that have financed those properties.
So what about the banks that will survive? Where are their loans concentrated? The best performing loans in the current market are ones to strong individual borrowers and to profitable operating companies. Contrary to many media reports, banks ARE still lending and many banks never stopped lending at any point throughout the credit crisis. Generally, credit standards are very similar to what they were at any point in the recent past and banks are still lending based on these standards. The banks that aren’t lending, in many cases, are avoiding adding new loans because of capital issues (see previous post on capital).
As the economy reemerges (yes, it will reemerge) consumers and commercial borrowers will regain their strength and many of the banks that lend to them will in turn regain their strength. In the short term however there will be some additional weakness in the market and there will be additional bank failures as a result.
You probably received a notification from your bank within the past few weeks inviting you to opt-in on debit card transactions that exceed your balance. We used to call those overdrafts but I guess that’s not cool any more. In any case, here’s the deal………..Banks have historically allowed small dollar overdrafts on ATM or debit card transactions. For example, you are at a restaurant with friends and your debit card is rejected because you forgot to make a deposit and your account balance is insufficient to pay the bill. The bank allows the overdraft to go through and even though it is expensive to do so, the consumer sees some value in not having ask one of their friends to pick up their portion of the tab. The charges around $25 – $30 to pay this charge through. You could argue both sides in terms of whether or not this is fair but that’s for another post.
Congress, in their attempt to provide consumer protection, decided banks were making too much off of these fees and that those that were paying them typically were those least able to pay. The answer was to make everyone to perform a one time opt-in prior to allowing their account to be paid over. There is no opt-out option. If you opt in, the bank will continue to pay you into overdraft if necessary but you will also have to continue paying the fees. If you haven’t opted in yet and want to do so your bank likely has a quick way to do so on their website. Mine says “Important! Changes to overdraft service coverage”.
If you want to talk offline to get more info dm me on twitter or send a facebook message.
The Texas Ratio has been widely quoted as a standard measure of a bank’s health but as you will see below it is not an accurate measure. Below is a high-level, simple definition of the Texas Ratio and then the reason why it is not a fool-proof measure.
The Texas Ratio measures “bad” loans (going bad and already bad) in relation to the bank’s financial strength (i.e. their ability to weather the storm). The top number in the ratio is the bad loans and the bottom is the bank’s capital & reserves. If the ratio is high, that means their bad loans are high in comparison to the resources (capital & reserves) they have on hand to manage these loans.
The Texas Ratio is not a fool-proof measure because the top number (bad loans) has the very real potential to be subjective. Example — a bank knows one of its borrowers will not be able to repay a loan but for reporting purposes the bank can’t afford to add this loan to Non-Performing Assets. If they do claim it as a bad loan (along with all of the others) the FDIC will have to close the bank. In order to avoid this, they decide to extended it for three years and made it a “bullet” loan meaning no interest & no principle is due for three years at which point the entire note is due.
This is very typical of the actions of many banks over the past three years and has been cleverly dubbed “extend & pretend”. The only way this strategy would have worked would have been for the economy and the real estate market to make a truly miraculous rebound but this didn’t happen. In the mean time, many people were comparing Texas Ratios and judging many failing banks as healthy institutions when in fact these banks’ executives simply had trouble reporting the truth.
For the FDIC’s part, they didn’t have the staff to accurately track every one of these misleading attempts by bankers and many stayed under the radar. They have though, in my opinion, done an excellent job of managing the banking crisis in a reasonably orderly fashion. They now have more staff but the gray area in judging whether a loan is good or bad is still there and the Texas Ratio is only a marginally more effective measure today than it ever was.
A better measure? This is not something I’ve researched at length but there is one measure that I’ve seen more than any other that has had a positive correlation with bank failures — percentage of loans in the construction & development (C&D) category as of mid 2007 (approximately). Again, this is not scientific but any bank I have personally seen with 45% or more in that category as of that time period has either failed or the rumors are flying about failure or acquisition. Certainly banks with less than 45% in this category have failed but I’m just providing a general observation. Additionally, a small percentage of banks with over 45% in this category have been able to raise additional capital which of course enhances their viability.
The true measure of a bank requires significantly more analysis. For larger publicly-traded banks, the equity analysts make a reasonable attempt at judging the banks and there are plenty of these reports available. For smaller banks, you have to gather information from Call Reports which every bank (public or private) must submit to the FDIC every quarter — access these at fdic.gov, search “call reports” and follow the directions to pull specific bank reports. Also, SNL data is a very complete database of all information contained in call reports in a format that is more user friendly but it requires a subscription.
That’s a little more than an explanation of the Texas Ratio. Please send any other questions you have (related or unrelated).
[Updated: One of the readers of this post referenced a related article that has some interesting ideas on how to solve the problem addressed below: http://www.wired.com/techbiz/it/magazine/17-03/wp_reboot. Maybe regulating Wall Street more effectively isn’t a fallacy. I still contend that the wiz kids will get to work right away to figure out how to manipulate whatever requirements they are presented with whether they are successful or not.]
In December of 2008 I wrote the first of two posts on the Sub-Prime Crisis and have delivered a presentation on the Credit Crisis in 10 cities around the Southeast over the past year and a half. Preparing for both involved many hours of research and interviewing experts. “Experts” may be a bit of a stretch, which I’ll explain below, and is one of the reasons for the title of this post.
A frequent question relates to how we can regulate financial markets in order to avoid future crises and my answer is that we can’t which, sadly, I really do believe. That is not to say that we shouldn’t try to take every step possible to limit market abuses like the ones that led to the credit crisis that started in 2007* but I really don’t think it is practically possible. In order to effectively regulate abuses out of the market, three elements must be present: an informed regulating & legislating community that understands the issues, a willingness on their part to make effective changes, and a relatively static market environment (i.e. rapid changes to structure or business practices are not possible).
[*Note regarding the issues that led to the credit crisis: It can be argued that governmental requirements on banks and mortgage companies created an environment in which banks felt the need to bundle certain “toxic” assets with other assets and sell them to remove them from their balance sheets. There is certainly some truth to that claim but there was nowhere near enough of this type of activity to cause the credit crisis. The real culprit was the ridiculous amount of synthetic derivatives that caused the markets to expand and then burst — see previous posts Sub-Prime Primer 1 & 2 for more explanation.]
Back to the three elements……..the first one, an informed regulating & legislating community that understands the issues, is the most critical and without this there is no hope of establishing effective regulation. If you read Sub-Prime Primer 1&2 and articles like The End by Michael Lewis and books like The Greatest Trade Ever you will quickly realize the dazzling complexity of financial derivatives that were created and the enormity of the market for these derivatives.
When I was first researching the topic I contacted several people who were either at or close to the top of mega-investment firms as well as individuals that had sold synthetic derivatives before the crash to inquire about a few basic questions. At the time I didn’t know they were so basic because I was just learning about it myself but, in retrospect, these were indeed basic questions and not one of these individuals had any idea what I was even asking nor did they know who to send me to in order to get the answers. That is not to say that the answers are simple because they are not. In fact, the mechanics are fairly complex but somewhere I should have been able to find somebody to give at least a modest amount of guidance since these were such huge markets.
I ended up pouring through charts, documents, papers, and other literature to find the answers and when I found them I was again dumbfounded. Again, these are complicated issues but somebody should have known these answers. In reading books on the subject later, I came across the same thing again and again — very, very few people actually understood the mechanics and issues involved in a market that generated tens of trillions (that’s Trillion with a “T”) worth of these derivatives……..not the people at the tops of the investment houses and not the people that were selling the derivatives.
If only a handful of people in the world actually understood all of the inner-workings of these derivatives, can we really expect that these issues could be understood by regulators. And can we really expect that these issues could have been explained to Representatives or Senators in a way that would allow them to craft effective legislation to limit abuses? I really don’t think so.
Take the Bernie Madoff case for example which was a relatively straight-forward ponzi scheme. Some of Madoff’s competitors had reasonably good indications years before his arrest that he was indeed running a giant ponzi scheme and provided regulators with a trail of evidence. If it took regulators that long to come to the conclusion that Madoff was a criminal how much longer would it take for them to understand much more complex issues like the relationship between synthetic collateralized debt obligations and credit default swaps?
And, again, understanding the issues is just the first step. The real test is trying to craft regulations or legislation to limit the abuses, which is even more complex. Even if they had the political will to regulate or legislate the abuses out of the market, it is difficult to envision a situation in which this could happen. For example, would a legislative bill that on the surface looked like a hindrance to the growth of the housing market be very popular?
As if these first two elements wouldn’t have stopped any attempt to regulate abuses in its tracks, the third element, a relatively static market, would have crushed any attempt. The fact is that regulatory efforts or legislation take time and Wall Street is far too nimble and creative to stand still while a lucrative market is taken away from them. They would begin with intense lobbying against any such regulation and even if that didn’t work they would simply innovate and adapt to the new environment. Effectively, they would just create another world of lucrative opportunities that were yet to be regulated or legislated away and the game would continue. It is sort of like a game of cops & robbers where the cops are not very effective……..every time they think they have the robbers nabbed they are frustrated to learn that they are already 500 miles down the road and nowhere to be found.
I believe that the lawmakers in Washington that recently recommended limiting Wall Street compensation already know all of this. I believe they know that they will always be 500 miles behind and that the only hope they have is to limit compensation to the point where the real whiz kids of Wall Street will lose the incentive to take major risks in order to have a chance at millions or billions in profits.
And now Wall Street is hiring “quants” at a greater rate than ever before. Quants are quantitative types (math whizzes) that are focused solely on numbers & trends. They really don’t care about creating lasting value or even if the value of an investment goes up or down — they just want to calculate the odds and get on the right side of the trade, whether it is rising or falling. On the surface, this is nothing new since this type of activity has been going on to some degree since markets were created.
The difference is that instead of the credit crisis sobering up Wall Street and helping it return to fundamentals and sound investing principles, it has done the opposite. There is a new level of greed that has been created by stories of individuals like John Paulson who bet against the housing market and personally netted $4 Billion and made over $20 Billion for his clients. The new Wall Street wants to emulate John Paulson and others like him to make their fortune and they are ignoring the fact that many more lost huge fortunes in the last cycle seeking the same thing. And the game continues……….
As I said in the beginning of this post, the regulating & legislating community has to keep trying to do their best to limit abuses but in reality it is becoming more difficult to do so. For the every-day investor like most of us, this means we need to stay on our toes more than ever.
As you manage your investments (or manage those that manage your investments), keep an eye on markets that seem to be overheated and avoid the temptation to either buy the “hot” investments or fail to sell certain investments that have had a good run. Personally, I also maintain a higher level of cash than in the past to limit the downside and to be able to take advantage of future market dips. Of course, this also limits the upside in a rising market but, with the market volatility of the past couple of years combined with the apparently ineffective regulatory community, I sleep better that way.
Here are answers to a few questions I’ve received recently………
What is a “toxic asset”?
This generally refers to either mortgage-related derivatives (see previous posts “Subprime Primer I & II for more about derivatives) or loans related to land, lots, and houses that are in foreclosure and held on bank’s balance sheets — see previous post “Why Banks Aren’t Lending” for information about how these ended up on their balance sheets.
What is a “Short Sale”?
A short sale occurs when a bank allows a residential builder to sell a house or condominium at less than the amount the builder owes the bank for that particular unit. Simplified example: a bank lends a builder $200,000 to construct a house. The builder completes the house but cannot sell it, at least not for an amount that would net the builder enough to pay off the bank loan. If the builder gets into financial difficulties and cannot afford to make the payment to the bank on the $200,000 loan the property often goes into foreclosure, meaning the bank takes ownership of the home. Banks don’t like to do this because they typically recover much less than is outstanding on the loan and they also incur legal and administrative expenses. Alternatively, the bank may consider a short sale which would net them a higher recovery on this house. Here is how it would work…….a potential buyer offers $190,000 for the house in the example above. The builder then goes to the bank and asks to have the house released for less than the $200,000 loan amount which is typically required. If the bank agrees, the sale takes place and the bank realizes a $10,000 loss vs. what would likely be a much higher loss if it went into foreclosure. The $10,000 is not typically forgiven but instead remains as a debt of the builder who would much prefer to pay interest on $10,000 than on $200,000.
What is “Mark-to-Market”?
Here is a link that will tell you about this concept: http://en.wikipedia.org/wiki/Mark-to-market
In short it simply means listing assets (“marking” them) on your balance sheet at their current market value. The alternative is to hold them at cost or a previously appraised value. There are arguments on both sides but very few argue with the logic of mark-to-market in general…….how can you argue that companies should list assets at anything other than their market value? This is not the real question though…….. the real question is how strict to get with the application of this principle. Those against a strict application of MTM would say that if you have what is likely a short-term downward blip in the real estate market and you force banks to mark their assets down this will punish banks in an unnecessarily punitive fashion and one that does not reflect reality, at least for many banks. This argument is very logical too. The challenge is in finding a new standard (modified MTM) that can be applied across all banks that is both fair and reasonably reflects the reality of their particular situation. This is a very high bar to clear so the default is to maintain the status quo which is a strict adherence to MTM.
One of the questions I hear a lot these days relates to why banks are not lending, especially when there are plenty of qualified borrowers out there who need loans (which there are). For most banks the reason is a capital shortfall driven by the ailing residential real estate market. Below is a simple example to explain this. As with my other posts this is an over-simplified example that is only designed to explain a concept and not qualify you for an advanced degree of some sort.
The fictional bank I will use as an example is called “Startup Bank” that opened its doors in 2005. I don’t think there are actually any banks that have that name but if there are this is not intended to describe that bank or any other bank; it is just a random name I picked.
Startup Bank raised $10M in equity capital from various investors. Generally, the regulations allow banks to lend 10 times the amount of capital they hold so, in this case, Startup Bank could lend up to $100 Million. In order to keep this simple, assume capital remains exactly the same throughout this entire example at $10 Million and that the maximum amount Startup can have in outstanding loans is $100 Million.
Startup Bank had a great first year in 2005 and loaned $50 Million, or half of its maximum amount. Startup generated another $50 Million of loans in 2006 to reach $100 million in total. At this point the bank could not make new loans unless existing loans paid off or unless they raised additional capital but they were pleased because they made so many new loans so quickly.
50% of Startup’s $100 million in loans were to businesses & individuals and the other 50% of their loans were related to the residential real estate market which includes land acquisition, lot development (streets, curbs, water, sewer, etc.), and construction of new homes. As of late 2006, all loans were paying as agreed and Startup Bank felt well secured, especially on their residential real estate loans because house values had continued to rise for so many years in a row.
By early 2007 Startup started seeing some trouble developing in their residential loans – small at first but getting much more troublesome as 2007 wore on. Houses were selling much less quickly which, in turn, meant developed lots weren’t selling and, of course, that meant sales of undeveloped land stagnated too. All of this was caused by the collapse of the securitized debt market which I covered in previous posts (Sub-Prime Primer Parts I and II).
Without sufficient levels of sales in land, lots, and houses, Startup Bank’s borrowers started to face financial difficulties. At first, some of the borrowers tried laying off part of their staff and started using savings they had been able to accumulate during the residential boom years………but for many the slowdown lasted too long and they allowed their assets to go into foreclosure. As more and more borrowers did so Startup Bank began realizing losses on these loans.
By late 2007, $90 million of Startup’s loans were still paying as agreed but $10 million had gone into foreclosure. Startup was afraid that the market would continue dropping (which it did) and decided to sell the foreclosed assets for a deeply discounted price of $6 million and booked a loss on these loans of $4 million ($10 million loaned out minus $6 million received from the sale of assets).
This loss of $4 million was deducted directly from capital which was then reduced from $10 million to $6 million. As a result, the maximum amount of outstanding loans was decreased from $100 million down to $60 million. The problem was that they still had $90 million in outstanding loans ($30 million more than allowed) and Startup was then classified as severely “undercapitalized”, a classification that bears many problems including dramatically increased funding costs, intense regulatory scrutiny, and bad PR that can lead to many depositors withdrawing their funds. Startup Bank needed to return to a status of “adequately capitalized” or “well capitalized” in order to have any chance of survival. In order to do so they had two choices:
1) Raise additional capital of $3 million. Probability: Low. It is very difficult to raise equity capital from individuals that either don’t have funds to invest (due to other investment losses at that time) or, if they have the funds, don’t want to invest in a highly uncertain banking market without some significant return – a return so high that the bank is unwilling to pay it.
2) Reduce loans from $90 million down to $60 million. Probability: Extremely Low (at least in the short-term). The average borrowing client would respond very poorly if the bank approached them and asked them to pay their loan off early. It is simply not feasible for most borrowers.
[Note: there is a third way to improve equity which is through retained earnings, meaning that the bank keeps profits in-house vs. paying them out in dividends. The problem is that very few banks are making profits right now because of the current interest rate environment, which I’ll write about later. So earning your way back to health is not likely for banks these days.]
With a $3 million capital shortfall and very poor prospects for quickly returning to an acceptable level of capitalization, Startup Bank was in a very precarious situation. The FDIC (which insures Startup’s deposits) took a keen interest in the bank because they believed Startup’s problems were even deeper than reported. Compounding the drama, the rate at which Startup borrowed from other banks to support operations skyrocketed since they were undercapitalized. Additionally, borrowers started pulling deposits at an alarming rate as word got out that the bank was facing financial difficulties. Startup was forced to increase depository rates in an attempt to save the deposits they had but this further reduced the bank’s profitability (or created a larger loss).
The problems with the FDIC, increased borrowing rates, and loss of deposits all stemmed from Startup’s deficient capital position. At this point, they realized that attempting to make additional loans would only compound the problem, like tossing gasoline on a fire, and Startup’s leadership decided to at least temporarily stop making new loans.
That, in a nutshell, is why banks are not lending. Startup is an example of a very small bank but the same concepts apply to the largest financial institutions too. Simply multiply the numbers above by a few thousand and replace “residential real estate” with “derivatives” (See Sub-Prime Primer I & II).
So what were the TARP funds used for if not to allow/encourage banks to lend again? In the case of some banks lending has restarted but in others, even billions of TARP funding hasn’t returned certain banks back to an adequately capitalized position……..yes, really. Additionally, most banks have not received TARP funding for one reason or another (e.g. in Georgia only 7 banks have received TARP funds to date). That does not mean that these banks will necessarily fail. Likewise, all banks that have received TARP funding don’t necessarily have bright futures.
Until a bank’s capital position is restored to at least “adequate”, if not “well capitalized”, they are unlikely to begin lending again. And it will be a long road for banks for the foreseeable future with only the three ways mentioned above to improve their capital position, none of which seem very likely right now.
[Read previous post “Subprime Primer I” below first]
OK, so where did we leave off in Part I………lots of factors contributing the “fertile soil” into which the seeds of the credit crisis were planted; mortgages being bundled into MBOs…………that’s a good place to pick back up.
After the bundling process creates an MBO these securities are sold to various large institutional buyers including pension funds, mutual funds, sovereign funds (owned by countries that have excess cash flow, unlike the U.S.), and municipalities that are looking for safe investments. And they did appear to be safe because they had solid ratings from the rating agencies like S&P.
With more and more pressure to encourage the huge money-making machine that the securitized debt market had become, two important changes occurred that heavily contributed to the Credit Crisis that began in 2007 and the collapse of Wall Street in 2008………
Change #1: Sub-Prime Mortgages
When mortgage securitizations were first introduced (late 60’s/early 70’s) investors bought generally homogeneous portfolios of mortgages…….similar credit profile, income, liquidity. The homogeneous portfolios would be rated by S&P just like they were being rated at the height of the sub-prime mortgage market.
The HUGE difference was that the early portfolios contained only borrowers with reasonably strong (and documented) credit, liquidity, and income. Sub-Prime and no-doc mortgages had not been invented and investors experienced a very predictable and consistent return on these portfolios of relatively homogeneous mortgages. MBOs built a strong reputation as safe havens, especially for investors concerned first and foremost with safety-of-principle.
For the sake of argument assume S&P rated one of these portfolios an “A+” and that this rating correlated to an expected loss of investment only one out of ten thousand times — almost risk-less. People very rarely missed their mortgage payments because didn’t want to lose their home, especially since home equity was the primary method of “saving” for most people. And home prices had gone up relatively consistently for many years with few exceptions. Seemingly, almost everyone agreed that for all these reasons MBOs were indeed almost risk-less investments, until…………the introduction of sub-prime (SP) mortgages.
The original sub-prime mortgages offered were actually considered a success……..Fannie & Freddie took a baby step out of the risk continuum by slightly lowering credit standards and increasing borrowing rates by a small amount for sub-prime mortgages.
[Side Note: If Fannie Mae charged an extra 1% for a sub-prime loan they would get far more than an additional 1% in revenues. Here’s why in an overly-simplified example……….Assume Fannie and Freddie received a margin of 1% for packaging and selling MBOs. If they then increased rates by 1% for sub-prime mortgages, to account for the additional risk, they would increase their margin from 1% to 2% — increasing revenues by 100% (again, this is a very over-simplified example). Don’t worry about the math — just focus on the fact that a small increase in rate can lead to a huge increase in revenues.]
Initial payment records were strong as were margins. Fannie & Freddie were happy, investors were happy, mortgage companies & banks were happy, and the new mortgagees were glad to be approved, even at a higher rate. So what happened????????
What happened next will be the focus of many books in years to come. Many explanations will be offered but here is what everyone will likely agree on………..everyone got greedy from Fannie & Freddie to banks & mortgage companies to Wall Street giants. The only way to feed this insatiable greed was to continue to increase the pool of mortgagees and the only way to do that was to lower approval standards again and again. Eventually, terms like “no-doc”, “low-doc”, and “stated income” were part of our everyday language. Borrowers with little or no income could say they had strong income and the mortgage originator would put that on the application without being required to verify it, as they would have been in the past.
Note on size of SP market: Experts differ on the actual size of the sub-prime market at the peak but most estimate it around $1 Trillion +/- $300 Billion. For the purposes of this post just focus on the scale in comparison to the estimated worldwide assets values and don’t get too caught up on whether it was $800 Billion or $1 Trillion. For the purposes of this post I’m using $1 Trillion, which is probably not an exaggeration since there were over $600 Billion of SP mortgages originated in 2006 alone (various sources………type “size of subprime market” into your web browser to find more information).
And so the sub-prime mortgage market ballooned to an estimated $1 Trillion by 2007. However, even a 100% failure of every single SP mortgage would not have been enough to trigger the worldwide credit crisis and the death of Wall Street. Even though $1 Trillion is a huge number, at the same point in time, worldwide asset values were estimated at well over $100 Trillion — over $50 Trillion in the U.S. alone (again, various sources…….Google the key words). Sub-Prime represented less than one percent of world-wide assets and even if every single SP mortgage was worthless it would not have been a catastrophe in and of itself. But here is where it gets really interesting……………
Change #2: Derivatives (MBOs, CDOs, CDS, synthetics) and Leverage
Again, many books will be written on this topic in coming years but I’ll try to keep this as simple as possible………….
It turns out that there was MUCH more demand for sub-prime MBOs than there was supply because the return on investment (ROI) for subprime MBOs was higher than traditional MBOs because the risk was higher. For you statisticians & MBA’s out there, you are probably screaming at your monitor that the risk-adjusted ROI was much more modest……..and you are 100% correct but the concept of adjusting for risk seemed to be thrown out the window somewhere in the mid-2000’s, in large part because so many people believed that “real estate always increases in value” (how many times did you hear that?).
So the risk-ignoring MBO investors demanded ever-increasing amounts of these higher-yielding subprime MBOs but there was a limiting factor………the number of MBOs you can sell is (or was) limited to the number of actual mortgages that were available to be bundled. And everyone knows that you can’t just artificially create new mortgages or new MBOs……..or can you? The answer is actually yes and no……..No, you can’t generate a new MBO out of thin air but, yes, you can synthesize all of an MBO’s characteristics and that is exactly what happened. Here’s how………..
Around 2004/2005, some very creative individuals on Wall Street invented a security with the same profile (risk & return) of other MBO portfolios that were in such high demand. This new derivative was known as a Synthetic Collateralized Debt Obligation and, as the name implies, it synthesizes or mimics the risk profile of something else — in this case an MBO. There was only one problem……….taking on the risk is only half of the equation. The party taking on that risk wants to be compensated for doing so but who would pay them to take this risk and what would they require in return for this payment? It turns out that there were actually two groups who were willing to do so……..
Around 2005 certain people started believing that the mortgage market, especially sub-prime, was a house of cards, which it turned out to be. These individuals wanted to, in effect, bet against what they thought were bad MBO’s (we’ll call these the “doubters”). Additionally, some who owned MBOs wanted to hedge against default risk in their own portfolios of mortgages (we’ll call these “investors”).
So the doubters and the investors both needed a mechanism that would provide what each was seeking (one wanted to place a bet and the other needed a hedge) and they both found it in the form of a derivative known as a Credit Default Swap (CDS). In simple terms, a CDS is an insurance policy offered by a Synthetic CDO in exchange for premiums that compensate them for taking on the risk of that insurance. The buyer of the CDS is betting against a “reference” asset (a real MBO with a risk profile & yield attractive to the Synthetic CDO investors). They pay a premium to place this bet and if the underlying MBO portfolio fails they receive a large payoff. If the MBO succeeds, the Synthetic CDO keeps all of the premiums and the CDS contract expires.
Don’t worry if that last paragraph sounded like Greek to you – it does upon first reading to many. You can read up on Credit Default Swaps and Synthetic CDOs later but for now just think of it this way………a CDS is essentially a bet against an MBO (betting that it will default beyond some level) and a Synthetic CDO is then a bet against that bet.
You’ve probably figured out by now that there is not really anything backing up a Synthetic CDO. Its success or failure is tied directly to a reference MBO which has actual assets (houses) backing it up but the Synthetic CDO does not have anything directly supporting it. The problem of course is that if the underlying assets in the MBO fail (e.g. sub-prime mortgage meltdown) then both the MBO and the Synthetic CDO fail — the MBO would experience far greater than expected losses and the Synthetic CDO would have to make a large payout to the Credit Default Swap buyer.
At first this was still a relatively small percentage of the debt market but then it got out of hand and the death knell of Wall Street was sounded……the betting continued until the machine overheated and blew up. At the same point in 2007 when there were an estimated $1 Trillion in sub-prime mortgages there were $60 Trillion in synthetic CDOs– all betting that the underlying mortgages were stable & solid (at least to a certain degree). When the sub-prime market crashed so did the synthetic CDOs (the associated bets for them to succeed) — TIMES 60!
As the reference MBOs started defaulting so did the associated Synthetic CDOs, resulting in Credit Default Swap claims in numbers far greater than virtually anyone expected. And who was liable for paying off the Credit Default Swaps?……….In large part, it was the big brokerage firms and insurers like AIG, Bear Stearns, Lehman Brothers, Merrill Lynch and others. None of these firms had (or have) anywhere near the capital necessary to pay off the trillions of dollars in bad bets and so the collapse of Wall Street ensued.
Now you know what caused the credit crisis. So what’s next? Honestly, there are many more questions that answers but, in my opinion, we’re headed for a completely changed economic paradigm — how can we not be? I’m not 100% sure what that paradigm will look like but there will likely be much less leverage overall and we are likely to see lower levels of both economic growth and profit as a result. The new “normal” will likely feel much different and that is an important starting point. Those who thrive in this changed world will be those who first recognize that things are different and make their decisions based on this new paradigm — not those who bet on returning to the old “normal” of the past decade. Stay tuned…………
If you have another 30-45 mins to kill click on the link below and read something that will make your head spin: