Why Wall Street quaked

ONLY WORDS Investors have discovered a whole new lexicon in recent times. Here are some frequently used words and their meanings. SUBPRIME There are two broad ratings of borrowers in the US—prime, or those with a good credit history and a proven record of repayment, and subprime, or those who have a poor credit rating and job history and risky income-to-mortgagepayment ratio. So a subprime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders; the lender could be an independent entity but is usually an affiliate of a mainstream lender. DECOUPLING Earlier, economists had a stock tag: when the US Fed sneezes, the world catches a cold. But with economies in Asia and Europe getting stronger, most of them have decoupled from the US economy as proved by the outperformance of their stock markets until January 2008. However, during the bear phase, the decoupling effect seems to have taken over. MARK-TO-MARKET Recording the net worth of a financial instrument based on its current market price. For instance, mutual funds are marked to market on a daily basis when the markets close so that investors know their unit’s worth, based on the NAV. OVER-LEVERAGING Leveraging means to use borrowed capital to increase the potential return of an instrument. Leveraging beyond the worth of borrowed capital is like taking a loan against a house on which you are already repaying a loan. This leads to over-leveraging and is the root of the subprime crisis.

Even a Martian would have felt some of the aftershocks of the great collapse of Wall Street. Financial institutions that were considered to be the backbone of the US economy have tumbled like so many dominoes. And the effect is being felt worldwide. Possibly the only industry that’s not entirely dismayed by the crash is the media; headline writers have been going to town, telling us that Wall Fall Down and that the US has gone from Wall Street To Fall Street. Reams are written and spoken about subprime, investment banks and hedge funds. But what does all this mean? To know the future, say historians, it is essential to know the past. And so, we decided to trace the events that led to the biggest global financial crisis of recent times.

What is subprime and what’s the crisis all about?

Subprime lending, specifically subprime mortgages, became popular in the US after 1986, when the Tax Reform Act prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home. This made even high-cost mortgage debt cheaper than consumer debt for many homeowners. By then, financial institutions were allowed to charge high rates and fees under the Depository Institutions Deregulation and Monetary Control Act of 1980. And in 1982, the Alternative Mortgage Transaction Parity Act allowed them to charge variable interest rates and balloon payments. More importantly, property prices were rising relentlessly. All these things put together meant that even homeowners with a poor credit history could refinance their loans easily.

Meanwhile, other lenders were not idle. Credit card companies, particularly, had been offering cards to all and sundry, no matter what their credit history. Borrowers who found it impossible to pay their mortgages were using plastic for everything, including paying other credit card bills. Some newspapers in the US carried stories about borrowers who held 27 or more cards, revolved from one card to the other and prided themselves at getting into a debt trap.

As long as house prices went up, all was well, as the risky loans were backed by rising assets. However, by 2005-6, house prices in the US began to plateau and then fall. Falling property prices coupled with the US Federal Reserve increasing the interest rates saw lenders scrambling to recoup some of their money. However, borrowers were unable to pay up and so the banks had to sell off the mortgaged property. Many properties are still on sale waiting for takers. As more and more property came into the market, real estate prices fell even lower. And that meant that the lenders were unable to get their money back. By February 2007, over 25 subprime lenders in the US declared bankruptcy, announced significant losses or had to be sold. By August 2007, even leading mortgage lenders had filed for bankruptcy, and some seven months later, one of the major players, Bear Stearns, collapsed. By September 2008, the two oldest and biggest mortgage players in the US, Fannie Mae and Freddie Mac, fell.

Compounding an already grave problem was the fact that the mortgages were engineered into complex securities such as collateralised debt obligations (CDOs), which became impossible to value once house prices started to fall. Financial institutions had been trading these CDOs and so, even those institutions that had no direct exposure to mortgages ended up as victims of the subprime crisis. Selling exposures has been increasingly difficult except at very low prices, which did not look attractive to many institutions. Merrill Lynch, for example, was able to sell some CDO exposures recently at only about 22 cents on the dollar.

Lehman Brothers, AIG and Merrill Lynch aren’t subprime mortgage lenders. So why have these institutions fallen?

While none of these institutions might have dealt directly in subprime lending, they all had significant exposure to this segment.

Lehman Brothers was a leading underwriter of mortgage-backed securities. The combination of a bad market and an uncertain management led to Lehman declaring huge losses. The institution had also refused earlier bids from prospective buyers, as it considered the offers too low for consideration. The Fed and the Treasury both indicated that the government would not step in to prop up the giant, and on September 15, Lehman filed for bankruptcy.

Merrill Lynch put itself up for sale amid fears that it could be the next Wall Street giant to crumble. Bank of America has agreed to buy Merrill for $50 billion. Meanwhile, insurance biggie, AIG tottered as it had a significant exposure to real estate and the credit default swap market—the two segments hardest hit by the decline in asset prices.

The events leading us here began years ago and this is all about the American taxpayer. That’s all we care about. — Henry M. Paulson, US Treasury Secretary

The failure of Lehman posed risks. But its troubles had been known for a while and investors recognised it. — Ben Bernanke, Federal Reserve Chairman

  

Why did the US government step in to help even though it prides itself on having an independent financial system?

Both the Fed and the government know that if big banks are allowed to collapse without any care to their creditors, as was the case in 1930, the results could be disastrous. It could lead to a major recession or depression, something that neither the US nor other countries can afford to get into.

The government bailed out Bear Sterns because of the hedge fund’s heavy involvement in the credit default swap market and the high level of fear in the markets at the time. It has now intervened in Fannie and Freddie to save senior debt (bonds). If the holders of the $5.4 trillion of senior debt had not been given reassurance, then Fannie and Freddie would have needed to pay such high interest rates for funding that they would have been forced to scale back their new mortgage lending or charge higher interest rates. With other banks becoming reluctant to lend, Fannie- and Freddie-backed mortgages have accounted for 80% of all new mortgages. To ensure that the housing market does not get worse, the US government needs this to continue.

In the case of Lehman Brothers, the government has not intervened because Lehman’s business is less intertwined with other banks. However, the government did encourage the takeover of Merrill Lynch by Bank of America to remove one of the potential weak links. There remain a number of other weak financial institutions, but only time will tell if the government sees fit to step in again.

How the Mighty Fell The losses incurred by some of the biggest US financial institutions
Total Subprime losses $512 billion	Lehman Brothers $210 billion	Bear Stearns $90 billion	Merrill Lynch $51.8 billion	AIG $41 billion	Washington Mutual $14.8 billion

 

What is the worst-case scenario for the global banking system?

That would be a repeat of the Great Depression of the 1930s in the US, when the entire financial system broke down after a number of banks failed. Thankfully, the situation does not seem as grim yet. There is still plenty of room for the central banks, including the Fed, to cut interest rates.

For instance, Japan took rates down to 0% during its financial crisis. The ECB and the Bank of England have even more room to cut. There is also the potential, if necessary, for governments to step in with guarantees for creditors or to directly buy assets. Of course, inflation experts might worry about these actions, but the point is that these are steps that can be taken in the event of imminent depression.

The big fear at this point in time is deflation. Despite recent actions by the US Treasury to counter systemic risks arising from the seizing up of key intermediaries, financial market conditions continue to deteriorate, and liquidity is not sufficient for normal economic activity to take place.

Is there any good news at all?

If you look only at the economy, the news is not as bad as it could be. The US government intervention has saved the sliding economy. Banks and financial institutions are cutting back on borrowing and risk taking, and this can only be good. However, this de-leveraging has a long way to go before it can make a substantial difference.

The other good news is that credit rating and credit history will be taken far more seriously from now. Borrowers and lenders will learn to curb their greed and, at least in the foreseeable future, will try and live within their means far more seriously from now.

COMING TO THE RESCUE The US Fed has planned a $700 billion rescue package to bail out the entire Wall Street mess. This is still being debated by the Congress as several deals are being probed into. The Fed will give $110 billion to help banks that need cash inflows to maintain credit in the markets. Divided across the US population, it would amount to more than $2,000 per person. The Bank of England has injected £4.4 billion into the credit markets, and has committed to more such inflows if the crisis continues. Financial institutions in the UK have also stepped in; Lloyds TSB bought over the Halifax Bank of Scotland for £12 billion, while Barclays has bought some core assets of Lehman Brothers for $1.75 billion. The Swiss National Bank has entered into currency swap arrangements of up to $40 billion with the US Federal Reserve and is looking at ways to increase liquidity in the Eurozone. The European Central Bank has injected €30 billion into the system to improve liquidity and is looking at infusing more capital into the money markets if the stagnation in the Eurozone continues. Meanwhile, the central banks of Japan and Australia have pumped in $28 billion to tide over liquidity concerns. Japanese companies are also looking at acquiring some of the Asian divisions of Lehman Brothers and Merrill Lynch.