From the Subprime to the Ridiculous

(not Charlton related)

Readers of New York Addick should not have been surprised by Thursday's aggressive sell-off in global financial markets. Back in March, I discussed the turmoil in the US 'subprime' mortgage market, and the potential implications thereof.

In short, the entire concept of 'subprime lending' (and its current implosion) reveals the very best and worst about American capitalism. It was the tragically beautiful meeting of Wall Street greed with the vulnerability of those seeking the 'American dream.'

The idea of the 'American dream' (which naturally includes home ownership) is fundamental to society here, and goes a long way to explaining how such extremes of wealth and poverty can co-exist relatively harmoniously. Taking a drive through New York City suburbs such as Greenwich, Connecticut or Summit, New Jersey allows one to witness levels of affluence that are simply not replicated to the same scale in the UK, even around London.

At the core of the 'subprime' problem here is the so-called 'teaser' loan which allowed even the most impoverished borrower to take out a 30-year mortgage, because the initial 2-year or 3-year payments were teasingly low. At the 'reset date', the loans would move onto the types of lofty interest rates usually reserved for store cards. However, whilst home prices were rising, the borrower would have built up enough equity during the 'teaser' period to successfully refinance into a new loan, and thus maintain the charade.

In the old days, if you wanted to take out a mortgage in the US, you would approach your local bank manager (who probably already knew you well), and you would be permitted to borrow only as much as you could afford. The mortgage would be taken onto the bank's own balance sheet, and the bank manager had an incentive to ensure not only that you could pay, but that you did pay. Today's subprime borrower was yesterday's renter (which with hindsight was how it should have remained).

However by the miracles of securitisation, loans today are increasingly originated by an unregulated lender (via an unscrupulous mortgage broker), which then pooled thousands of these mortgages into a trust. These trusts are sliced and diced into 'tranches' of varying credit risk and sold onto investors corresponding with their particular risk tolerance.

The 'ratings agencies' such as Moody's and S&P meanwhile, were somehow persuaded that these mortgages were sufficiently uncorrelated to one another to avoid a damaging wave of defaults within the trust. As a result upwards of 75% of the entire trust could be rated 'AAA' (a bullet-proof rating usually reserved for entities like GE or ExxonMobil). In fact, each mortgage-holder was highly correlated to a single factor (and thus to each other), namely house prices, undermining the entire (flawed) raison d'etre of the trust.

Risk-averse investors could take on the senior investment tranche, whilst risk-loving hedge funds could take on the subordinated 'equity' tranche. With interest rates (still) so low across the globe, yield-hungry investors such as insurance companies, happily bought into the senior tranches of these toxic structures because they offered slightly higher returns than cash accounts. The way that the ultimate risk is thus extremely diversified, is a source of comfort for regulators that subprime lending does not portend a generalised systemic risk.

Unlike the aforementioned bank manager, the lender no longer cares if you pay your mortgage or not because the risk now sits in the securitsation trust. However the lender was incentivised to originate as many such mortgages as possible because of the aforementioned irrational demand. Cue the innovative creation of ridiculous concepts such as the 'NINJA loan' (No Income, No Job, No Assets).

As discussed in my prior post, everything was fine until house prices stopped rising in late-2005. As they began to fall gradually on a national basis (and aggressively on a regional basis), subprime borrowers realised their 'refinancing window' was now closed, so they stopped paying thier mortgages. After all, given that it takes at least 90 days to begin foreclosure proceedings, it offered the chance to live for at least three months rent-free. Looked at this way, it seems that the only rational players in this game were the borrowers.

Over $1trillion of subprime mortgages were originated since 2005 alone. Approximately 15% of all subprime borrowers are at least 60 days 'delinquent' on their payments, and set to lose their property; sadly these figures are likely to rise sharply from here. Bailouts are almost impossible because of the moral hazard problem they would create (the 85% of subprime borrowers currently paying their mortgage would surely stop doing so). As a result, even conservative estimates of $100bn of total losses from the subprime meltdown may be on the low side. The current volatility in the markets reflects the impending reality of the losses (which of themselves are immaterial in a $13trillion economy), but more importantly the concern about who's ultimately on the hook for them, and a generalised unwinding of leverage.

Another factor panicking the markets is the potential contagion into other areas of lending. On paper, the fact that ignorant borrowers in Florida are defaulting on their mortgage, should not have an effect on whether the acquisition of Boots gets financed. But the fallout from the subprime meltdown is permeating all financial assets, particularly those that are debt-related. In short, the credit markets across the globe have temporarily shut down.

The rationale for lending money to purchase Boots is considerably stronger than that for a 'NINJA loan'. However the subprime lending explosion was coincidental with a relaxation of credit standards generally, but lenders have finally woken up to the fact that returns should be commensurate with risk. Football fans will recall that Manchester United was purchased with the help of so-called 'PIK' (payment-in-kind) loans, which will likely be AWOL for some considerable time.

Financial markets have shown amazing resilience in recent years, but they now potentially face their biggest test since the technology bubble burst in 2000. The very sophistication of today's markets (which have diversified the above subprime losses), creates new and immeasurable problems, because those same linkages between market participants has both increased overall leverage in the system, and thus the risk of contagion therein. Moreover, unlike in 2000 the Federal Reserve has little scope to reduce interest rates because of oil-driven inflation concerns and the weak dollar.

Anyone casually observing financial markets (as I have been) might reasonably have concluded that the mere concept of risk had been forgotten. It manifested itself in allegedly unconnected markets from football clubs to art, and from London property to private equity. If the phenomenon of the subprime borrower has brought the party to an end, it might just be the ultimate result for the 'little guy.'