Monday, April 14, 2008

How a couple with no money and a home can sink Bear Stearns

Raise your hand if you don't quite understand the whole financial crisis/recession/subprime writedowns/housing bubble/Bear Stearns bail out/insert any other financial term from the Wall Street Journal over the last quarter.

Since this is my first official post I thought I would cover a topic most are at least hearing about. The question some might ask is how subprime loans can bring down Bear Stearns. So I'll share my understanding of recent events (when I say "my understanding" it is because I've become acutely aware that even those in the closest circles on Wall Street don't really have any idea). Who's to blame? Where did it start? How bad is it? Are we in a recession? Well, if you only have thirty seconds, the answers are; us, late '90's, really bad, and "yes." If you have 15 minutes, read on.


Some of us don't remember, but the housing market was a mess in the early '90's. By the late 90's many investors, both domestic and foreign, thought Real Estate was still a bargain. In the U.S. there was plenty of liquidity from the beginning of the internet boom and foreign investors were enjoying higher commodity prices and, yes, even rising oil prices. All this extra money needed a place to be and U.S. Real Estate was relatively cheap. During the bust the Fed, recognizing that the fragile Real Estate market could not endure another recession drastically cut interest rates.

Problem #1 Incentives

Since Real Estate was fairly cheap and debt was easy to acquire, it became more competitive. It went from using regional banks as lenders to introducing national and international competition. Loans became more "creative." The Fed also enacted several regulations to make it easier for Banks to make loans to low and middle-income families. By 2003 the "subprime" market was in full swing. "Subprime" refers to loans where lenders require little to no documentation, or where the credit score is below 660. This was also the birth of the infamous 3/1 or 5/1 arm, where the borrower pays interest only for either 3 or 5 years, then the rate increases after that. At the same time, the mortgage business essentially "split," meaning, the company that originated the loan was not the end owner of the loan. It is a basic principle of economics that people or businesses do what they are incentivized to do. If the loan originator was not on the hook for the actual performance of the loan, then what incentive did they have to make quality loans? But this is exactly what happened. For example, you approach a mortgage broker for a loan, they complete the underwriting and grant you the loan. If you read the language in the loan docs you will see that they have the right to sell your loan to a third party. So they do and did, they sold them to banks. It is no surprise, when loan officers work on commission, and their company isn't on the hook for the performance of the loan, that many loans were just plain fraudulent. What does this have to do with Bear Stearns? I'm getting there.

Problem #2 Magic

Let's use Citigroup as an example. Citigroup purchases thousands of these subprime mortgages from various originators across the country. These subprime loans pay more because they have higher interest rates (because there is greater risk) . Citigroup realizes that if they keep all these loans on their books, they have to keep money in reserves. Rather, the Federal Government mandates they keep a certain percentage of cash on hand in the event of default, so the bank remains solvent. Well, Citigroup's finest gather in a room to figure out how to efficiently manage this obligation. Their conclusion is that they can package these loans together, say 1,000 at a time, and sell them in bulk. Whenever you sell "debt," like residential mortgages, you must have them rated by a rating agency (Standard and Poors, Moody's, etc.) as to the safety of the packages. Since Citigroup is smart, they recognize if they simply package all the subprime loans together they will receive a lower "rating" (AAA is the highest, then AA, and so one to CCC, which is junk). So Citigroup bundles subprime and conforming (high quality) loans together. This is called "magic," I mean, a CDO (collateralized debt obligation). These CDO's are also able to achieve a AAA rating. What?! If they are subprime how do they get AAA rated?! Remember, this is a new type of "borrower," they don't have a track record since it didn't emerge in earnest until 2003 (and there are also high quality loans bundled in the CDO).

Problem #3 Greed at Home and Abroad

Back to the international markets for a minute. Interest rates determine the extent of foreign investment that flows to a certain country. For example, if I'm the U.K. I can invest my money locally, or in an international institution. I'm going to invest wherever the interest rate is highest. So, if interest rates in the U.S. are 3% but they are 3.5% in Japan, then I might invest in Japan (assuming the same relative risk). And governments usually invest in the safest instruments. In the U.S., those are government treasury bills...and now, CDO's. Yes, CDO's were AAA rated and paying 6% (on average). Somebody (and by "somebody" I mean, Bernake, Greenspan, and thousands of PhD's on Wall Street) should have called "Bull Sh#@%" There is no free lunch! How can two securities, rated AAA have different returns (3% vs. 6%)?

Problem #4 Tremors

Enter Bear Stearns, stage right. Bear Stearns, and several other investment banks, purchase billions of dollars in CDO's because of their attractive risk/reward tradeoff from banks like Citigroup. Since, in our example, Citigroup sold the loans they are off the hook, right? Wrong! In order to attract buyers Citigroup also sold insurance policies against potential defaults within the CDO. They are essentially guaranteeing liquidity. So they are very much still on the hook. Housing prices in the U.S. have never declined. Banks figured the appreciation in the underlying homes would offset any negligible defaults in the CDO's. Especially with housing values increasing at a 50% clip in some markets. Now we have the end owner, Bear Stearns, and the seller/insurance provider Citigroup, on the line for the mortgages. Back to the homeowner.

Housing values increased beyond what would be considered a financially healthy rate. Interest rates were low, debt was cheap, interest-only payments were easy, and originators weren't asking any questions. Demand exceeded supply for a couple of years. As housing values increased, home owners took out second mortgages to capitalize on the value of their home. With the second mortgages borrowers bought cars, purchased other homes, remodeled, and basically pumped a lot of money into the economy. Supply eventually exceeded demand as the Fed started raising interest rates. Housing prices started to "revert" back to the mean. Here's an example:

I buy a home in 2003 for $150k, no money down, with an interest only loan for three years, my payment is $800/mo. The value of my home over the next three years goes from $150k to $250k (Arizona, Nevada, California, Florida, New Mexico, Texas, etc.). During that time, I take out a second loan to purchase a T.V., two cars, a family trip, and to remodel a room, life is good. Since my three years interest only term is up, my payment turns in to principle and interest, $1200/mo. So I try to refinance. But instead of owing $150K, because of my second I owe $230k. And, because easy loans are no longer available, and my housing prices has fallen from 250 to 230K in six months, I can't get a loan for 100% of the value of the home. I can't make the monthly payment so I default.

This played out at the start of 2007 in certain markets and slowly, as these interest only loans came due, made it's way across the country.

Bloody Hell!

Mortgages started to default, Bear Stearns, and others, got the "willies." The rating agencies came back to the investment banks and essentially said, "That bundle of loans we rated AAA is really rated CCC, you have to write the value of the loans down." That's why you see all the banks writing down billions of dollars worth of loans. And they have no idea how bad it really is. The insurance providers are also getting kicked in the teeth because the defaults are much higher than forecasted. Making matters worse, banks like Bear Stearns purchased these CDO's with borrowed money. Now lenders aren't lending and they want their money back. No buyers, no lenders, out of luck.

JPMorgan Bailout

Bear Stearns was going to declare bankruptcy. That would have been devastating to our economy. Experts are pretty unanimous in their opinion that something of that magnitude could have started a Depression. Shareholders moaned when JPMorgan offered $2/share, which, in my opinion, was $2 more that what it was worth. Then JPMorgan offered to increase the share price to $10, just to help the shareholders. The additional $8/share came, in part, from the Federal Government! The Fed hasn't intervened to this extent since the Great Depression! This was huge! Here's the caveat; JPMorgan stands ahead of the Fed in Seniority. Meaning, if Bear Stearns doesn't get its act together and declares bankruptcy, JPMorgan will collect first and then the Fed (i.e. taxpayers). But, that is the lesser of two evils. If Bear Stearns would have declared Bankruptcy there would have been massive global panic. Everyone should send a personal thank you to Jamie Dimon at JPMorgan for his generous offer.

Not Over Yet

This is a long post. Banks did the same thing with credit card debt, auto loans and home equity lines of credit that they did with mortgages. These haven't hit the market yet. Logic is, if someone defaults on their mortgage, they will probably soon default on their auto loans and credit cards. If someone loses a job, which happens in a recession, then they will probably default on their auto loan or credit card. When, not if, this hits our economy it could plunge it into a deep recession. The answer must come from a correction in the housing market. The fed is on the right track with some of the adjustments they've made in addition to the interest rate cuts. However, this is really the fault of every American. We turn anything into an ATM that we can. We don't save and we demand cheap credit. Lowering interest rates is only a band-aid.

...More thoughts later


Nate said...

Good stuff. A couple of good questions. When you say:
"the birth of the infamous 3/1 or 5/1 arm, where the borrower pays interest only for either 3 or 5 years, then the rate increases after that." This doesn't mean that all 3/1 or 5/1 ARMS are like this correct? I mean, there are a lot of ARMs that function like a traditional mortgage in that you're paying both principal and interest each month.

So, if we need to ride it out with the housing market correcting itself first, wouldn't the current proposals by the government to freeze foreclosures just delay the market correction you see we need? It seems we need to take the band-aid removal method and just rip it off quick, by letting people declare bankruptcy and abandon their homes - the sooner the better. Would you agree?

PS. This is your brother

Jenga said...

Yes, you are right on both assumptions. However, most 3/1 or 5/1 ARMs are interest only, although not all.

Yes, the current moratorium on foreclosures is not the preferred method. It is worth mentioning that the Fed has asked for a two month extension on potential foreclosures and are encouraging banks to cut more deals with borrowers. By this they are hoping to minimize losses (if banks reposes, they can't sell the home in this market), decrease supply (more people staying in their homes), and save the value of some CDO's. Yes, letting people declare bankruptcy would correct the supply/demand issue quicker. But that solution is not politically expedient as constituents want action from their legislators, who are hoping to be re-elected.

Jessica said...

Your example sounds strangely familiar, almost like real life ;)
Thanks for explaining that. I've heard "credit crisis' on NPR, but they've never explained it in such detail. The CDO's sound crazy. AAA instead of CCC? That's nuts.
One thing, though.
Who/what is Bear Stearns and why would they have such a great affect on the market?

Jenga said...

Bear Stearns was either the fourth or fifth largest investment bank in the world. Major players.

Allie Cat said...

Really great. I think you should find someone to publish this article. I feel educated, but also feel like crapping my pants.

Tacy said...

So, because im a financial idiot, i caught about three percent of that post.

i dont know bear sterns.
i dont really know the role of the fed.

and to the extent that i understand your post, what do I do now??

thanks for your info, definitely publish this stuff.

= )

Jenga said...

Here's what you do. If you're an investor, now is a good time to pick up some really cheap stock in banks. Every bank has taken a huge hit. They'll recover and you'll have bought at the bottom of the market.

If you're not an investor, that probably means you don't have any money which also means you'll probably be getting a rebate check from the IRS in a couple months. You probably have two choices, pay off debt, or spend it. If you want to help our economy, spend it. Don't pay off debt, that wouldn't be patriotic.