Friday, 8 April 2011

How the bubble burst: securities, mortgages and collateral damage

In my previous post I drew attention to the lax attitude to risk of the US investment banks and institutional investors arising from the tacit government backing of investment banking, which led to them taking ever greater financial risks in search of higher and higher returns.  There has been much discussion of the collapse of the "derivatives tower" which brought down Bear Sterns and Lehmann Brothers among others, and there has been major criticism of securities trading in general and mortgage-backed securities in particular.  I think this criticism is unjustified and distracts attention from the real issue, which is the worldwide failure of retail bank lending (more on this in my next post).  So in this post I aim to debunk securities and derivatives trading and show that the investment banks that were brought down through the collapse of the "derivatives tower" were not the cause of the financial crisis, as has been widely reported, but victims of it.

First, some basic facts about securities and derivatives. 

1. Securities.
security is a piece of paper that can be bought or sold through a recognised financial trading exchange.  Securities are issued by organisations such as companies and governments as a way of raising money. Basically these organisations sell pieces of paper which represent shares in the equity of the organisation (share certificates) or loans made to that organisation (debt securities or bonds).  Buyers of securities include pension funds, governments, rich people and even some poorer ones. Once the security has been sold for the first time (new issue), it is traded freely on recognised trading exchanges until the issuing organisation buys back the equity or settles the debt.  When the organisation does this the payment goes to whoever owns the security at the time, not to the original issuer. It's a bit like Pass-the-Parcel - the security is passed around among various investors until the organisation calls it in, when whoever is holding it gets the prize.

Securitisation is the process of pooling contractual debts such as mortgages, credit card loans and car loans and selling bits of paper that represent that debt to various investors.  Suppose for example that Bank X has lent £10,000 each to 100 people for car loans.  The total debt owed to it by these people is £1m.  It could issue a single piece of paper saying £1m, and hopefully someone very rich who doesn't mind having all their eggs in one basket will buy it. Much more likely, though, is that Bank X chops the debt up into £10 portions and sells 10m £10 debt securities.  These are snapped up by institutional and private investors and traded on as and when they wish.  When the debt is redeemed the paper is everywhere and lots of pension funds and individuals get a proportion of the payout.

2. Derivatives
A derivative is a financial agreement whose price is determined by the performance of one or more underlying assets.  Hard assets underlying derivatives are shares, bonds or currencies, but derivatives can also be based upon market indexes (the derivative price is governed by movements in these indexes) and interest rates (the price is governed by changes in interest rates).  The actual derivative itself can be regarded as a type of insurance or a means of offloading risk. 

For example, I might want to buy some of Bank X's debt securities (see above), but I think the issue price is a bit steep.  So I purchase an "option to buy" (known as a CALL option) these bonds when the price falls to a level that I think is reasonable.  I pay a small amount of money for that option - like an insurance premium.  The total amount of option premium plus agreed purchase price for the underlying bonds should be less than the amount I would pay if I bought them at their current price.  If the price of the bonds doesn't ever fall I lose the premium, of course.

Alternatively, Bank X might decide to keep some of its car loan debt - after all, it earns interest. But it doesn't like the fact that the interest rate on these loans is fixed.  After all, the base rate is very low at the moment.  If interest rates rise Bank X will lose out because new loans would be at higher rates.  Really it wants to be able to raise the interest rates on these loans, but it can't because that breaks the contractual agreement. So it finds someone who has the opposite problem (has variable interest rates but wants fixed) and they agree to swap their interest rates.  This is called an interest rate swap. 

Derivatives can be - and often are - issued as securities and traded on exchanges.  The examples I have given here are "over the counter" deals (no securitisaton or exchange trading involved), but the bank could simply issue pieces of paper saying "warrant" (which is an option to buy bonds) or "fixed/floating interest rate swap" and wait for investors to buy them.  It doesn't need to know who the investors are.

Now to return to the "derivatives tower" and its underlying assets.  I have explained how the securitisation process works.  When this is applied only to residential mortgages the ensuing securities are known as "collateralised mortgage obligations" (CMOs).  But of course retail banks have a range of different types of secured and unsecured debt and there is no particular reason to limit securitisation to only one type of debt.  A security created from different types of secured debt, including but not limited to residential mortgages, is called a "collateralised debt obligation" (CDO).  There is nothing wrong with spreading debt in this way - in fact securitisation is a highly effective means of spreading risk among a much greater number of players and thereby reducing the risk to each individual organisation.  But it was CDO trading, above all, that brought down the US investment banks. So what went wrong?

To understand what went wrong, look at the wording of the security. "Collateralised debt obligation" means that the debt represented by the security has collateral associated with it. Collateral is a hard asset which is made available to the lender in the event of default by the debtor. A mortgage is the best-known example of a collateralised loan, where the house bought with the mortgage can be repossessed if the homeowner doesn't keep up with mortgage payments, but collateral could also be shares or valuables.  But what if the value of the asset isn't enough to repay the loan? 

Mortgages have traditionally been regarded as "safe" forms of lending. Mortgage risk is routinely valued at 50% or less, which means that in calculating how much capital to hold to support this lending banks only need to take into account less than half the loan value: the rest is assumed to be covered by collateral.  But the aggressive expansion of mortgage lending in both the US and the UK made these loans far more risky.  When the defaults started to rise massively because mortgage lenders were lending silly income multiples and giving loans of 100% or more(!) of the property value to people who couldn't really afford houses, the property market in the US and UK crashed.  House prices fell and repossessions skyrocketed, especially in the US. Lots of people found their house value fell so much that it didn't cover the amount owed on the mortgage.  Suddenly huge numbers of mortgages were no longer adequately secured - they became high-risk loans.

Investors expect to be paid for taking on higher risks.  Well, this isn't unreasonable, because after all they could lose out if it all goes wrong.  So when the assets underlying a security become more risky, the price of
 the security rises. In my previous post I noted that because investment banks are funded by clearing banks, which are supported by government, both dealers and institutional investors stopped worrying about the risks inherent in the instruments they were trading and looked only for higher returns.  So when the price of the CDOs started to rocket because the underlying mortgages were junk, dollar signs went up in the eyes of both dealers and investors.  Trading in these toxic instruments actually INCREASED as the property bubble burst.  Dealers put together ever more complex structures mixing high-risk mortgage debt with safer types of security to increase the return to those investors - including banks such as HSBC - who didn't have a high risk appetite. This was the so-called "derivatives tower", and it was built from the start on shifting sands.

Eventually, though, the genie came out of the bottle. The US and UK governments were forced to bail out their major mortgage lenders - Fannie Mae and Freddie Mac in the US, and Northern Rock, HBOS and Bradford & Bingley in the UK. Mortgage-backed securities and their derivatives, including the fancy packages dealers put together to attract sounder investors, became worthless and investors lost an AWFUL lot of money. A large number of US institutional investors - especially hedge funds - failed, and some investment banks were bailed out by the US government.  HSBC suffered losses on its worldwide income due to its investment in now-junk mortgage-backed securities, but covered this from its own capital.  It was HSBC that raised the alarm about the failure of the sub-prime securities market - it saw the crash coming but too late to protect itself completely from loss.

I'm not saying that there wasn't a fair degree of stupid and immoral behaviour by dealers and investors in the run-up to the collapse of the residential mortgage market.  But the real villains were the retail banks and mortgage lenders, who had destroyed what had always been a safe long-term lending market by their irresponsible, aggressive and possibly fraudulent expansion of mortgage lending. And the worm in the apple - the mechanism that makes it possible for bankers to mismanage their business so appallingly - is the support that all governments give to their retail banks. I shall return to this in my next post.

And before anyone feels too sorry about the businesses that failed and the dealers who lost their jobs, spare a thought for the thousands of people in the US who lost their homes.  They, and taxpayers in the US and Europe who are now feeling the pinch because their governments bailed out the banks, are the real victims in this unholy mess.

1 comment:

  1. Of course, in the states there was a deliberate, government-sponsored push behind sub-prime lending especially to minorities:

    "Today’s subprime mortgage meltdown began with a lofty, deliberate, fuzzy-headed effort by the Clinton administration to turn more latinos and blacks into homeowners, or so it appears from 1999 news reports — buttressed by hard data from a 2007 study of subprime lending. Yesterday’s soft and cuddly government program is today’s financial chainsaw massacre."