by David Kazakov
In recent news reports, sub-prime mortgages have dragged down the names and balance sheets of illustrious banks such as the Bank of America, Wachovia and JP Morgan Chase, just to name a few. These banks were forced to announce enormous losses stemming from their mortgage business and write-downs of entire business segments. But what is a sub-prime mortgage and why is it such a deadly beast, both in the United States and in Europe? In short, this financial animal evolved from a cross-breeding between greed and over-confidence, the two emotions driving Wall Street. However, what Wall Street does not know, or is unwilling to admit, is depth of the problem and how long it will persist.
In the 1950’s and 60’s, when the mortgage business first began to thrive, banks only gave mortgages to credit worthy customers with families, jobs and credit histories. These mortgages were usually short-term, for ten years or less, leading families to hold mortgage-burning events when the debt was paid-off. As the American government began to favor home ownership via favorable interest deduction, Americans took the hint and began to invest in residential real estate. This was all and well while there were enough customers to feed all major banks vying for their business. After a while, however, the pool of credit-worthy customers dried up and banks found themselves starved for people to whom they could lend money (and expect to get it back). Thus, banks began to target less and less desirable segments, which had higher rates of default and non-payment. Nonetheless, banks are still risk-averse creatures and the only way they could accept greater risk is by demanding greater return. Using complex models bank gurus calculated that the percentage of defaults compared to the high interest rates charged on these mortgages would offset each other in the long run. Actually, more than break even was achieved because banks also managed to turn a healthy profit. This analysis, however, hinged on one crucial assumption, that real estate prices would be on the rise (O’Brien).
This assumption was very plausible until recently when real estate prices leveled and even declined a bit, depending on the region. According to the Center for Responsible Lending, 7.2 million households have sub-prime mortgages and more than fourteen percent of those are in default. It projects that one of every five of those loans issued in 2005 and 2006 will end in foreclosure, with 2.2 million families losing their homes (Economist). Before the downturn, sub-prime mortgages were good for banks and good for borrowers. For example, a family of four earning $40,000 could purchase a house for a low introductory mortgage rate. The house was purchased for $200,000 with no money down and payments were being made on time for three years. Once the introductory rate wore off and the prevailing market rate was charged, the family of four was no longer able to afford the mortgage payments and the bank foreclosed on their home. However, due to the skyrocketing price of real estate, the same house was worth $250,000 rather than $200,000. As a result, the bank made money on the appreciation and the destitute family was not required to pay anything out of pocket. For them it was as if they had rented the house cheaply for three years. Nowadays, however, when houses foreclose, there is usually no gain cushion. In fact, the poor resident is usually left liable for the foreclosure costs. When these costs are not paid and the bank fails to collect, the U.S government treats this as “forgiveness of debt”, which is considered taxable income. Thus, both the bank and the homeowner lose due to the transaction.
The story gets more complicated because these mortgages are then sold in bulk and traded as asset-backed securities. However, the underlying microcosm of the problem rests with the individual and the mortgage broker. The repercussions of this phenomenon are evident in the U.S and overseas. In Great Britain, Barclays Bank will provide information about their finances on November 27th, information that most analysts speculate will be negative (Dash and Werdigier). In an attempt to salvage its falling stock price, Barclays initiated a four million share buyback program, which only raised analysts’ concerns. Other European banks like UBS and Deutschebank have also announced multi-billion dollar write-downs of mortgage-backed securities (Landler). Commenting on the situation, the Bank of England deputy governor acknowledged the need to work on “liquidity risk management, valuation of complex instruments, disclosure of risk positions and on crisis management” (Landler). This uniform market shake down has led experts to believe that the economies of Europe and America are more closely linked than they care to admit. The global flow of capital produced its benefits: cheap investment funds, and its detriments: global recessions.
However, the best hidden secret in the world of finance today is not the cause of the crisis but its ultimate resolution. Most investment bankers, brokers, Investor Relations personnel and other company officials pretend as if the crisis is a quarter-specific event reflected in the earnings of one quarter. But as long as sub-prime mortgages remain on the balance sheets, a percentage of residents will continue to default every quarter as their introductory interest rates expire. Unfortunately, in this situation banks can do nothing but bite the bullet in the short-term and curb their greed in the long-run. Both difficult lessons to swallow for banks, investors and home owners around the world.
Bricks and Slaughter. (London: The Economist, November 8, 2007)
Dash, Eric and Werdigier, Julia. Three Banks See Troubles; Barclays Falls on Rumors. (New York: The New York Times, November 10, 2007)
Landler, Mark. Credit Crisis Spreading New Jitters in Europe. (New York: The New York Times, October 26, 2007)
O’Brien, Timothy L. The Nation; Giving Credit Where Debt is Due. (New York: The New York Times, December 14, 1997)