Monday, January 11, 2016

The evil that bankers do — leveraging and the subprime mortgage crisis

joão pestana

I intend to continue on my previous article, but this time focus on the background gears that almost nobody noticed until it was too late. One might be tempted to ask such questions as why did people applied for loans they knew they couldn't repay? One might be equally tempted to blame the evil profit-seeking bankers for the whole crisis. Either way, only one thing is certain and that is the whole process involved millions of different individuals and possibly hundreds of different institutions.

We should start by understanding the concept of leveraging, which is a technique used to amplify gains — or losses, if things take a turn for the worst. Imagine that you have 100€ with you and while visiting your friend in another town you notice that the oranges there sell for just 0.5€ a piece while, back in your hometown, they sell for 1€. You seize the opportunity — a process called arbitrage — to buy all the oranges 100€ can get you — 200, if you're wondering. Back in your hometown, you go to the market and sell them for 200€ which, at the end of the day, represents a 100€ profit.

Having noticed what you have done, your friend also has 100€ with him and, since he's coming to visit you, he wants to make his trip profitable as well. Because he knows beforehand, he has time to go to the local bank and ask for a loan of 9 900€. Sum this up with the 100€ he already has and your friend has a total of 10 000€ to spend on oranges and he buys 20 000 units. He then arrives at your hometown and goes straight to the market where he sells the oranges for 20 000€. At the end of the day, he has paid back the 9 900€ to the bank plus interest — let's say 990€ at a 10% interest rate — and he's left with a total of 9 010€ profit — 100€ return from his own 100€ and 8 910€ return from the borrowed 9 900€.

As you can see, by using credit, your friend has amplified his gains compared to yours. This is the basic idea of leveraging and most institutions do this — including banks — in order to amplify their profits. Of course, this only works if what you get from the income exceeds the cost of borrowing the extra funds. In this example, you earn 2€ per every 1€ that you spend and, since each 1€ costs you 0.1€ to borrow, this translates into earnings of 0.9€ per 1€ borrowed.

Back to the main topic, the safest investment you can make is with the government. Believe it or not, it's even safer than banks' savings accounts due to the fact that even if the government lacks the funding needed to pay you back, it can just print more money and give it to you. Now, this doesn't hold true anymore for the individual governments of the euro-zone, but the European Central Bank will end up backing up those governments and it's true almost everywhere else in the world — including the U.S.A.

Because government bonds are a very low risk investment, it pays a very low rate of interest and it's not very attractive to serious investors that lust for riskier opportunities to earn more money in a shorter period of time. On the other hand, it's very attractive to banks and other credit institutions, because they can get money at a very low cost. That's precisely what banks did for two main reasons. The first reason is that it amplified their gains due to the leveraging effect. The second reason is that, with the extra funding, they could grant more loans. More loans translated into more cash flows from repayments and interest always amplified by the leverage.

Since everything is going so well and banks are enjoying large profits, other investors want to enter the deal as well — it has a greater and faster return on investment that government bons. This gave banks an opportunity to further increase their gains by letting these investors into the game and they did it with the mortgage loans — the ones you, your friend and many other people signed with the banks. Because you signed a contract with the bank promising to pay, for example, 10 000€ plus interest, that contract is worth at least 10 000€ to the bank. You can read more about how and why this works in my previous article what is money?

The investment banks started to buy the mortgages from the banks that granted the loans. The lenders received a good price for the mortgages and now the risk of default belongs to the investors. These investment banks applied for credit in order to increase their gains through leveraging and bought a huge amount of mortgages from the lenders. Every month, the investment banks would receive very large amounts of money in the form of payments from the homeowners. The cash flow was good, but what was not good was the associated risk of default. In order to dilute the risk, the investment banks created bundles of mortgages which they called collateralised debt obligations (CDOs).

Each of these CDOs had to be filled with payments from the homeowners. The investment banks split each CDO into three parts that would be filled in sequencial order. When the payments from the homeowners finished filling up the first part, the second would begin to fill and whatever remained would go into the third part. You can picture this as putting coins into three piggy banks and you could only start the next one if the previous was full. Investing on the first piggy bank is safer than the second and the second safer than the third one — which is the riskier and thus provides a higher return on investment.

If some homeowners default on their mortgage payments, only the third piggy bank gets affected. The last one to suffer from defaults is the first piggy bank and is considered to be the safest investment while still providing a better return than government bonds. To make this piggy band even safer, investment banks could include an insurance on the investment for a fee — called the credit default swap (CDS).

You may have heard about those swaps before and not know what those were and it's basically this. If there isn't enough money from the homeowners in the first piggy bank and you bought the CDS, the investment bank will compensate you. Because of all this, the rating agencies gave the first piggy bank the highest rating they could and it attracted many investors.

The investment banks are making large amounts of money in profits as well as the investors that bought the CDOs. These investors are so pleased that they want to invest in more and the investment banks try to buy even more mortgages. The problem is that there are no more mortgages, because the all the homeowners that were considered safe already have a house. This is the turning point, as you can imagine. Because houses have been increasing in value, even if the homeowners default, the bank sells the house and gets the money back and so banks that grant loans start to relax their requirements and everyone is entitled to credit.

By now, banks started to grant loans to people who possibly couldn't afford to repay them and they didn't care too much, because they would sell the mortgage to the investment banks and then the risk of default would be theirs. These guys were making so much money that they became reckless and eventually people did start defaulting on their payments. In time, more and more households defaulted and the investment banks ended up with a portfolio of houses that decreased in value with each additional house they received.