My quick understanding of what has been happening in the markets so far (Part 2)

At every stage of the process, from receiving the loans to buy inflated homes (consumers), to writing the loans (commercial banks), to collateralizing the loans (investment banks), to assigning dubious letter grades to assess risks (rating agencies), to insuring the loans (insurance companies), to trading the loan (traders), and to adding the loans as a lucrative part of an investment portfolio (investors and fund managers), there were profits to be made. This profit seeking, or greed, led to a speculative fever that gripped all that were involved. Homeowners were pushed into houses that they could barely afford hoping that they could sell the house at a lucrative price and recoup their initial investment plus a handsome profit in a few years. Commercial banks threw out all their risk management procedures and extended credit (sub-prime loans) to subprime borrowers above and beyond what they were reasonable expected to repay, often times turning a blind eye to inaccurate and/or missing information. Investment banks took the liberty to collateralize different grades of loans into a collective and complicated vehicle that they themselves might have found difficult to comprehend. The rating agencies, with no accurate procedure and no precedent to serve as a guide, assigned their letter grades that failed to predict the risk of the CDOs. Insurance companies were quick to insure these CDOs through credit default swap (CDS) without understanding the very assets they were insuring, settling instead for a short term gain from the premiums received rather than long term fundamentals. Traders held long and short positions with CDOs and magnified their bank’s gains and exposures through indulgent use of leverage in their proprietary trades. Investors and fund manager then snagged up all available CDOs pushing trading volumes to historic highs and neglecting the complexity of the CDOs.

But alas, the bubble was to be short lived. Soon, some sub-prime mortgage borrowers were having problems making their monthly mortgages payments, many of which were designed as ARMs. Simultaneously, the housing market started to correct itself and home prices and values started to decline. With decreasing home valuation, homeowners, especially those with little to more money down on their mortgage, were upside down in their homes (owing more on the mortgage than the house is worth). Struggling to pay the minimum on their mortgages and watching the value of their home equity declining, some homeowner chose to abandon their properties rather than continuing paying on a declining asset. Even when the homeowner, with the best of intentions, attempted to restructure their mortgage loans, it was impossible since the loans had been collateralized and were no longer the property of the bank, which now solely acted as an intermediary. Once these houses went into foreclosure, the banks had to settle for quick short sale to unload the houses at the best lowest price available in order to make payments on the CDOs. The huge supply of foreclosed home put an even greater downward pressure of the values of home that caused even prime borrowers to feel a bit of the systematic problems spreading through the housing industry. As defaults continued within the individual loans, havoc was being created in CDOs. It has hard to distinguish which CDOs were exposed to subprime mortgage and the market for CDOs stagnated. The holder of the CDOs suffering loses now looked at the insurance companies that insured the collateralized loans to pay for their losses. The insurance companies quickly found themselves singly attempting to hold back the floodgates. Still, the amount of losses that had to be insured soon outnumbered the available cash reserves to cover the redemptions and the most famous and biggest of them, AIG soon had to be rescued.

My quick understanding of what has been happening in the markets so far (Part 1)

Not a day goes by that the opportunity to discuss current market situations with someone new here at the University of Pennsylvania does not arise. Even with such a diverse population, I am at times aghast at all the different interpretations and beliefs as to the causes of the current credit crunch affecting the markets as well as exactly what role the federal government is playing or needs to play to mediate the effects. So below, I thought I should recap my own interpretation and understanding. After all, a little civil discourse never killed anyone (yet).

 

It all started with the Federal Reserve’s policy under the Greenspan era. To attempt to stimulate the stagnant economy post tech bubble, interest rates were cut to historic lows and held at these lows for some time. Concurrently, the federal government, under the Bush era, was actively pushing home ownership on families as one of the first steps towards financial security. Subject to these inputs, there was an influx of loans that were extended to consumers to purchase houses. Like any classic economic case of supply and demand, such spike in market demand for houses put an upward pressure on market price (both for new and existing houses). Yet with easy credit due to the federal government treatment of mortgage debt and interest rates at their historic lows, more funds kept chasing increasingly higher home valuations.

Meanwhile in a posh NYC office, the masters of the universe – or investment bankers in jargon-speak – decided the market for home loans was too lucrative to overlook. Now, the idea of collateralizing loans was by no means ingenious or new, but if the wheel was not broken, there was no real need to reinvent it – collateralized debt obligations (CDOs) had been in existence since the ’80s. As they had done numerous times before with other forms of debt, bankers began to collateralize these mortgages and market them as a new investment tool. Mortgage CDOs were touted as the new investment class with (very) generous returns but whose returns were uncorrelated to the market (S&P 500 used as a basis) and so could be used to diversify a portfolio and reduce overall non-systemic risk. The complexity and risk inherent in the CDOs were to be judged by the credit rating firms. Once rated, these mortgages CDOs would trade in the marketplace, as would any stock, bond, ETF or mutual fund would.