NOVEL NEXT Chapter : Subprime Mortgage Crisis
You can watch the Hollywood movie The Big Short, which is based on the Subprime Mortgage Crisis.
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Mortgage: A legal agreement by which a bank lends money at interest in exchange for taking the title of the debtor's property, with the condition that the conveyance of title becomes void upon the payment of the debt.
Example:
Dave takes a mortgage loan of $100,000 for 25 years at 7% interest, resulting in a monthly payment of $707. The total payable amount is $212,035.
-> If the tenure is 30 years, the monthly payment is reduced to $665.
-> If the loan amount increases to $250,000 for 25 years, the monthly payment will be $1,767.
The values vary when different parameters are adjusted, demonstrating the significance of choosing the right amount and length of time. The interest chosen should be within the borrower's paying capacity.
Note: Financial institutions determine the amount to be lent after estimating the property's market value.
In simple language: Mortgage = House loan.
]
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The subprime mortgage crisis started in 2007 and ended around 2010. But before we dive into what the crisis was all about, you need to understand why it occurred in the first place. It all began way before the 2000s.
< 1990 – 2002 >
Events =>
-> Dot-com bubble burst (I'll explain it in another chapter).
-> 9/11 terrorist attacks.
-> Sharp decline in the stock market.
-> The Nasdaq index peaked at 5,048 on March 10, 2000, then dropped to 1,114 by October 2002 (a 78% decrease).
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Investment Climate =>
-> People had money but limited investment options due to the declining stock market and low bank fixed deposit (FD) interest rates.
-> To boost the economy, the U.S. government encouraged banks to lend money for mortgages at very low interest rates (1% - 2%) for 3-4 years, expecting rates to rise as the economy improved.
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People buy houses for investment or living purposes. With the low mortgage interest rates, people had a new option for investment:
Real estate (houses, properties, land, etc.).
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Real Estate Investment =>
-> People began buying houses as investments due to low mortgage rates.
-> Banks received numerous loan applications and began lending money to those who could repay the loans. (Banks analyze credit history to assess repayment capability.) These borrowers are known as PRIME Borrowers.
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Banking Dynamics =>
-> Banks that provide mortgage loans to people are Savings and Loan Associations (S&Ls) type. Such as Wells Fargo, JPMorgan Chase, Bank of America, and Citigroup.
-> As banks lent money to PRIME borrowers, their liquidity decreased. (they had less money on hand because they lent it to prime borrowers).
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There are various types of Banks (explained at the end)
Savings and Loan Associations (S&Ls) Focus primarily on accepting savings deposits and making mortgage loans. They aim to promote home ownership.
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Debt Refinancing Concept => (don't need to go into details)
-> Banks sold loans to Investment Banks (IBs) to increase liquidity, earning commissions on these sales.
-> PRIME borrowers began repaying loans to the IBs instead of the banks.
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Investment Banks (IBs) =>
-> As the interest on mortgage loans was very low, the Investment Banks also want liquidity but they can not sell the loan like Banks do.
-> Investment Banks created CDOs (Collateralized Debt Obligations) by bundling loans into financial instruments.
[I've already explained what Financial Instrument is.]
Financial Instrument = CDO (collateralized debt obligation)
CDOs ---> Loans
The underlying asset for CDO is the Loans
Here comes the question why would people buy the CDOs (Financial Instrument)?
-> Investment Banks (IBs) provide high interest rates (4% - 6%) on CDO [these are similar to bonds, fixed deposits but with higher risk]
-> Credit Rating Agency rated the CDOs as AAA
People invest in any Financial Instrument after they look at its credit rating and this rating is given by a Credit Rating Agency, CRA.
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It's not like you'll buy any Financial Instrument (Shares, Bonds, Debentures, etc), you need to know whether there's any situation of defaults so the CRA rates all the Financial Instruments as AAA, AA, A, and so on.
AAA: Highest quality, lowest risk.
AA: Very high quality, low risk.
A: High quality, moderate risk.
]
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Risks of CDOs =>
When will the CDOs (Financial Instruments) default?
As the underlying asset for CDOs is the loan if the loan repayment stops then CDOs will default.
(default => the Investment Banks can't pay the interest to the people who bought CDOs from them)
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Earnings Structure =>
-> Banks earn commissions on loans sold.
-> Investment Banks earn money from selling CDOs.
-> CDO investors earn high interest.
Everyone is happy.
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Investment Banks (become greedier) want more CDOs due to high demand.
Investment Banks (IBs) can't sell more CDOs as they have no more loans to make more CDOs (Loans are the underlying asset for CDOs). They need more loans.
Investment Banks (IBs) pressure Banks to sell more loans to them. But there are no PRIME borrowers anymore.
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Shift in Lending Practices =>
-> Banks began granting loans to individuals whose applications had previously been rejected due to poor credit histories. These individuals are referred to as subprime borrowers.
-> Subprime borrowers typically lack repayment capability, making them riskier to lend to.
-> Banks did not inform borrowers about the impending increase in interest rates after the initial 3-4 years of low rates.
Example:
A case from the movie (The Big Short) illustrates a bargirl who was able to buy four houses due to low interest rates. Her credit history clearly indicated that she would struggle to repay the loans once interest rates rose.
-> Investment Banks (IBs) bundle both prime and subprime loans to create CDOs (Collateralized Debt Obligations)
Logically the Credit Rating Agency (CRA) should have lowered the credit rating for CDOs as now there are subprime loans are also involved. But the credit rating for CDOs was still AAA.
(I don't know whether the CRA doesn't know about the subprime loans or they were paid to keep the credit rating to AAA)
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A few investors, including Dr. Michael Burry, began to doubt the stability and sustainability of the housing market and the associated financial products, particularly CDOs.
Dr. Burry wanted to short (sell) CDOs, betting against them but faced challenges because there was no established platform for directly selling CDOs.
(You can imagine why investors were doubtful as even a bargirl had bought 4 houses and these subprime borrowers will definitely default when the interest rate rises.)
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Greed of Investment Banks =>
Recognizing the potential for profit, investment banks sought to create a new financial instrument to facilitate shorting and manage risk, leading to the development of Credit Default Swaps (CDS).
-> CDS were introduced as a way for investors to hedge (protect) against the risk of default on CDOs. They effectively acted as insurance against losses from these financial products.
-> Investment Banks (IBs) marketed CDS as a form of insurance for investors holding CDOs, assuring them that they could protect their investments against potential defaults.
(I've already explained the concept of Hedge and for CDS you can think of them as insurance on CDOs. What it means is that if CDOs default then CDS will protect your money.)
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Involvement of Insurance Companies =>
American International Group (AIG) was the largest insurance company in the U.S. and began selling Credit Default Swaps (CDS) as a form of insurance for Collateralized Debt Obligations (CDOs).
-> Investors who bought CDOs could purchase CDS from AIG, effectively insuring their investments against defaults.
-> Typically, insurance can only be purchased for something you own, which logically applies here: only CDO holders should buy CDS.
-> There were minimal regulations regarding these newly created financial instruments, leading to an environment where risks were not fully understood.
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Car Purchase and Insurance Scenario =>
You bought a car valued at 10 lakh rupees.
Insurance Policy:
You purchased an insurance policy for the car, paying a premium of 5,000 rupees per month.
Insurance Coverage:
The insurance policy covers damage to the car, meaning if the car is involved in an accident or sustains damage, you can file a claim.
Claim Process:
If an accident occurs:
-> You will contact the insurance company to report the incident.
-> After assessing the damage, the insurance company will approve the claim.
-> The company will then pay for the repairs to your car, up to the limits outlined in your policy.
Financial Protection:
This insurance provides financial protection, ensuring that you are not burdened with the full cost of repairs after an accident.
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Similarly, CDS protects your money if CDOs from default.
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Financial Crisis Unfolds =>
In 2007, bank interest rates rose to about 4%, leading to increased financial strain on subprime borrowers, many of whom began to default on their loans.
As subprime borrowers stopped making payments, investment banks (IBs) faced liquidity issues and were unable to pay CDO holders. This triggered claims on the CDS.
Investment banks found themselves in a precarious situation due to the rising defaults from subprime loans, leading to widespread financial distress.
(Lehman Brothers was the biggest Investment Bank that sold a large number of CDOs and due to default they were not able to pay CDO holders.)
AIG faced the biggest losses as it was obligated to pay out on the CDS contracts when defaults occurred, putting its financial stability at risk.
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Lehman Brothers' =>
In September 2008, as the financial situation worsened, Lehman Brothers sought a government bailout to stabilize its operations and avoid bankruptcy.
(A government bailout means that the government will give you money to stabilize the market and guess what from where will the money come, obviously from your pocket, which is taxes)
Lehman Brothers was denied a government bailout. The U.S. Treasury and Federal Reserve believed that allowing Lehman to fail would not pose the same systemic risk as other institutions.
(There were a lot of politics involved in whom to provide the bailout.)
On September 15, 2008, Lehman Brothers filed for bankruptcy, marking the largest bankruptcy filing in U.S. history at that time. This event sent shockwaves through global financial markets.
Lehman was operational for 158 years from its founding in 1850 until 2008.
The U.S. government intervened, providing bailout funds to save AIG, Bank of America, Citigroup, Morgan Stanley and Goldman Sachs
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Michael Burry's Strategy =>
Investing in CDS:
Dr. Michael Burry opted to buy only CDS, as he could not short CDOs directly.He stood to profit if defaults occurred on the CDOs, as the CDS would provide payouts.
Low Premiums:
The premiums for CDS were relatively low, making it an attractive option for investors seeking to hedge against risk.
He made a personal profit of $100 million and a profit for his remaining investors of more than $700 million.
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