a readable and understandable short course in the subprime crisis, by a person who identifies himself as “Informed Trades.” I have copied the text of the three lessons below. On the Web, the lessons are available in video as well as text, and there are also readers’ comments with further answers by the author. Yesterday I had a long conversation with a friend who had already listened to the course, and we began to piece together this amazingly complex and strange picture so that it started to make sense.
How to Explain the Subprime Financial Crisis Part 1
There is lots of news out about sub prime loans and the issues they are causing for the consumer, the economy, and in the financial markets in general. While I have seen a lot of coverage of recent events with subprime I have not found through my research many good resources for leaning about how exactly this all happened.
So in this three lesson series we are going to examine exactly how all this came about by looking at things from the borrowers side of the equation in this lesson, and then the lenders side of the equation in lesson 2. Then we are going to tie everything together in lesson 3 by bringing our newfound understanding of both sides together to understand exactly what caused the problem, what we are experiencing now, and what we are likely to see going forward.
A subprime loan is a loan given to borrowers that are considered more risky, or less likely to be able to make their loan payments, in relation to high quality borrowers because of problems with their credit history. When you go to get a loan you need to get a credit check, and what results from this credit check is something that is known as your FICO score. A FICO score is a number which represents how credit worthy you are considered which is based on factors such as the amount of money that you earn, your record of paying back past debts, and how much debt you currently hold. The higher the score the better your credit is considered, and the more likely you are to get a loan.
In order to understand how these sub prime loans have caused so many problems, we must first understand what happened in the years leading up to the recent problems. In the years leading up to the sub prime crisis interest rates (or the cost of borrowing money) had been at historical lows as the fed had aggressively cut interest rates to avoid going into recession after the tech bubble burst in 2000. While you don’t need to understand all the details of the effects that low interest rates had you do need to understand two things:
1. When interest rates are low in general it causes the economy to expand because businesses and individuals can borrow money easily which causes them to spend more freely and thus increases the growth of the economy.
2. What drives interest rates lower is the fact that there is an increase in the supply of money, meaning that there is more money to go around.
Before the Fed lowered interest rates substantially after the bursting of the NASDAQ bubble in 2000, if you wanted to get a loan for a house you had to have a relatively good credit score. Buyers with a FICO score below 620 (generally considered sub-prime) where in most cases considered too risky to lend to and therefore could not get a loan.
After the fed lowered interest rates to historical lows however there was so much money (also referred to as liquidity) available that financial institutions started offering loans to buyers with FICO score’s below 620. Because these borrowers were considered less likely to be able to pay the loan back than borrowers with higher credit scores, these sub prime borrowers were charged a higher interest rate.
Things initially went very well for the financial institutions that made these loans because in the years that followed interest rates stayed low, the economy continued to grow, and the real estate market continued to expand causing the value of most people’s houses (including the sub-prime borrower’s houses) to go up in value pretty dramatically. This made it relatively easy for these borrowers to make payments on their loans as if they ran into financial trouble they in more cases than not could tap the equity in their home (which came from the increase in the house price) to refinance at more favorable terms or to make their mortgage payment.
Because a relatively few of these sub prime borrowers were defaulting on their loans, the financial institutions which held these loans were enjoying the additional profits earned by charging these borrowers a higher interest rate, without many problems.
After the initial success and profitability for those offering sub prime mortgages the practice expanded dramatically and the terms which borrowers were given in order to allow them to obtain loans became all the more creative.
There are now many different types of sub prime loans such as:
Interest Only Mortgages: These loans require the borrower to pay only the interest portion of the loan for the first few years thus keeping the payment relatively low for the first few years before the interest only component expires and the borrower must pay the principle and interest component of the mortgage payment (of course a much higher amount)
Adjustable Rate Mortgages: Unlike traditional mortgages have a fixed interest rate so your payment is the same each month, with an adjustable rate mortgage if interest rates rise (as they have been recently) your monthly mortgage payment goes up as well.
Low Initial Fixed Rate Mortgages: Mortgages that initially have very low fixed rates and then quickly convert to adjustable rate mortgages. .
Because house prices had increased so rapidly in the last few years many of these sub prime borrowers took out loans that they could not afford in the anticipation that, when the mortgage reset to the higher payment, they would be able to refinance at more favorable rates using the increased value of their home and the equity that they now had as a result of that.
So now that we have a background on what was happening on the borrower’s side of the equation the next thing that we will look at is what was happening on the lender side of the equation. Once we have a background there then we will tie everything together in the third and final article so you have a good understanding of all the factors at play here in the sub prime crisis.
As always if you have any questions or comments please feel free to leave them in the comments section below, and have a great day!
How to Explain the Sub Prime Crisis In Simple Terms Part 2
So now that we understand things from the borrowers side of the equation lets look at things from the lender side.
One of the reasons why this is such a big problem is because so many different types of financial firms and investors have exposure to these subprime loans. To understand how we must understand something which is known as securitization. Securitization in simple terms means taking a bunch of assets, pooling them together, and offering them out as collateral for third party investment. Securitization happens with many different types of assets but for the purposes of this article we will focus on how they apply to mortgages.
Up until relatively recently when you went to get a loan for a house from a bank, they would lend you the money and then hold your loan, earning money from the fees they charge you to give you the loan and the interest that you pay the bank on that loan. As the money the bank was lending out was the money that people were depositing in the bank, the bank was limited on how many loans it could do by how much money it had on deposit. As the bank was holding all of the loans on its books so to speak it also held all the risk for those loans.
As a way of diversifying risk and allowing the banks to make more loans (thus earn more fees) investment bankers came up with a process for securitizing mortgages so they could be sold off to other financial institutions and investors in a secondary market. So very basically instead of holding all the loans they make to homebuyers on their books, lending institutions will now pool a bunch of these loans together and sell them in the secondary market to another financial institution or investor.
The pools that the loans are put into are referred to as Mortgage Backed Securities (MBS for short), Collateralized Debt Obligations (CDO for short) or Asset Backed Securities (ABS for short). For the purposes of this article you do not need to understand all the details of each as they are very similar in the fact that they all act as a way of taking individual loans and bundling them up so they can be sold in the secondary market. This frees up capital for the bank and reduces their risk, so they can make more loans and earn more fees. What you do need to understand however is the following:
1. A large portion of the financial institutions that are potential purchasers of these mortgage pools will not buy or are restricted from buying sub prime debt because it is considered too risky.
2. To get around this what investment bankers did was take a pool which contained subprime mortgages and divided it up into different levels (also referred to as traunches). Each level was then defined by who would take the first losses if and when any of the subprime borrowers in the pool stopped making their mortgage payments. The lower levels were the first take these losses and the higher levels were the last.
3. Next they got the companies who assign credit ratings to different types of debt instruments which are referred to as ratings agencies to come in and assign different credit ratings to each level. The higher levels which were the last to take losses if and when mortgages defaulted were given high credit ratings and the lower levels that were the first to take losses were given the sub prime ratings.
4. What this allowed investment bankers to do was to sell off a large portion of the sub prime loans as debt instruments with above prime credit ratings thus expanding the number of potential buyers of that debt.
The types of firms that invested in these instruments varied widely from other banks, to hedge funds, to pension funds, to insurance companies not only here in the United States but all over the world.
The last thing that it is important to understand in this lesson is that many of the financial institutions which held large amounts of these instruments held them in what is known as a Conduits, Special Investment Vehicle (SIV) for short, or Special Purpose Vehicles (all basically the same thing). These are semi separate off balance sheet entities which allow banks and other financial institutions more flexibility from an accounting and regulatory standpoint in their operation. Again here the details are not important but what is important to understand is that:
1. These entities hold large amounts of mortgage “pools” as one large “pool of pools”. So instead of holding say $50 Million in mortgages they will hold a bunch of those smaller pools as one pool of $1 Billion or more.
2. They finance or fund their operations by issuing short term debt to buy this longer term debt essentially having to pay a lower interest rate on the short term debt that they issue to raise money than they earn on the mortgages that they are investing in.
3. Because these loans are short term they have to be “rolled over” or redone fairly frequently to continue the financing of the Special Investment Vehicle.
For the first few years as interest rates stayed low, the economy continued to expand, and real estate prices continued to rise, everything went smoothly and pretty much everyone was doing well. As we will learn in our next lesson however this all started to change when these trends started to slow.
So that wraps up our second lesson in this three part series on the subprime crisis. You should now have a good understanding of both the borrower and lender sides of the equation so we can now take a look at where it all went wrong in the third and final lesson of this series.
How to Explain the Subprime Crisis in simple terms part 3
So now that we understand what sub prime loans are and how they are packaged up into pools and resold, we can now look at how the sub prime crisis happened. By late 2004 the US economy was growing fast enough that the federal reserve decided to start raising interest rates, which it has continued to do until fed funds rate stood at 5.25% in January of 2007 (up from 1%). Several things happened as a result of this.
1. It became much more expensive to borrow money so less people could afford to buy a house and those that could, could not afford as large a mortgage as they could when rates where at 1%.
2. As there were not as many buyers, the real estate market began to cool and house prices which had been increasing rapidly in the years leading up to this began falling moderately.
3. If you remember correctly from our first article many of the sub prime borrowers took out adjustable rate mortgages where payments rose if interest rates rose and low initially fixed rate mortgages that quickly converted to adjustable rate mortgages. Their plan was to refinance these loans using the expected increase in value of their house to help them qualify for a better loan. As the housing market stalled however and their houses were no longer increasing in value, they could not refinance and therefore were stuck having to pay a much larger mortgage payment as the harsher terms of the loans they agreed to kicked in. This caused many of these borrowers to not be able to make their house payment and therefore their house was foreclosed on.
So the issue now is that there are billions of dollars in losses relating to rising defaults mostly related to sub prime borrowers.
From the financial institution side of the equation, the problem would be bad if everyone knew where all these loans were, which financial institutions and investors were going to lose money as a result of this, and how much money they could potentially lose.
If you remember from our second lesson however, these loans were for the most part no longer with the financial institutions that made the loans but had been sold off and traded among different financial institutions from around the world. As the subprime portion of these mortgage pools were defaulting at a much faster rate than expected, the institutions that held them stood to lose a lot of money as a result.
This has caused what is known as a liquidity crisis where no one trusts anyone else enough to lend them money at reasonable rates, even the largest banks in the world. This is a real problem for these banks, who basically are the financial system, because they rely on large short term loans from one another to cover their short term expenses.
Because these institutions are normally considered very credit worthy, and because these loans are short term, they normally come with a very low interest rate. As no one knows who has been left holding the bag with the subprime debt, the interest rates that are charged on these loans have gone through the roof.
This is why you read about the different central banks around the world having to step in and add liquidity to the market by basically injecting billions of dollars into the financial system to try and keep things from locking up.
If you also remember in our second lesson we learned about these huge pools of pools which are known as Structured Investment Vehicles. If you remember from that lesson these entities rely on this short term borrowing to buy the longer term debt and have to periodically roll the loans they are issuing over. The problem now is that they can no longer borrow short term to cover their obligations and are therefore in danger of having to sell off huge chunks of these mortgage backed securities to avoid running into financial difficulty. This is why you read about banks like Northern Rock having to be bailed out by the Bank of England and Citigroup having to raise billions of dollars from the Abu Dhabi Investment Authority.
As there are so many problems with the mortgage market right now however the market for many types of these pools has dried up as no one wants to buy them. This means that if these institutions are forced to sell they are going to have to do so at very low values in relation to how much the pools they own are probably still worth even with the problems. What this has caused is a situation where everyone that can is holding on hoping that the market will return to normal so they can exit their positions at a reasonable price.
Lastly and perhaps most importantly because the market for many of these pools has dried up, it is very difficult to tell how much they are worth. This has brought a lot of suspicion to even those who have come clean about how much subprime exposure they have, and how much the losses are they plan to take as a result, because there is really no way to know for sure if they have valued that loss correctly until the market returns to normal.
Currently there is still a lot of uncertainty as to when this will end and how bad it is going to end up being for the economy. All I can say here is that time is the key factor. If the banks and other financial institutions that are holding this bad debt come to a consensus on how much of it they are going to have to write down and how they are going to value the losses quickly, then things will be a bit painful in the short term but better over the long term. If there is no consensus on where and how much the losses are after the first quarter of next year, then we are probably in for lots of trouble and markets will head lower as a result.