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Why Wall Street quaked

We take a look at the reasons behind the latest turmoil in the US and its impact on global markets.

Narayan Krishnamurthy | Print Edition: October 16, 2008

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.

Henry M. Paulson
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

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

— Ben Bernanke, Federal Reserve Chairman

 

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