niraj_hattangdi
Niraj Hattangdi
Part 1: INFLATING THE BUBBLE
First bubble element - sub prime mortgages
Every great bull market that turns into a bubble has similar characteristics. It starts with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats. These are obvious to anyone who has bought a house; like the need for a substantial down payment, the verification of income, an independent valuation, etc. But human nature is such that, given enough time and the right incentives, any endeavour will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. The problems with the US mortgage market (and to a lesser extent the UK as well) are now well documented. Loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate valuations.
The lending institutions in the USA have always been able to package their loans and sell them to a larger financial institution. The repayments are passed on to the buyer, as is the risk of default. Originally the biggest buyers of this debt were Fanny Mae & Freddy Mac who sold bonds to the public to raise the money to buy the mortgage debt. These companies collapsed recently under the weight of mortgage default and had to be bailed out by the US government.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into unsafe practices, or worse.
Second bubble element - selling the mortgages to banks
As lenders entered into the sub-prime area, they charged higher interest rates to borrowers to account for their risk. They made a higher profit on these and sold them on. With their newly replenished funds the lenders actively sought more high risk debt, as they made more profit. This was the first part of the problem as it sucked people into debt who obviously had no means of repayment. They even devised schemes with 3 - 6 months interest free period at the start, which gave more time for the loans to be sold on before there was any possibility of default.
The next step that started to make the problem more serious was that the banks became buyers of these debts and they created imaginative financial instruments with them. They created a collateralized debt obligation (CDO) by taking a package of high risk, but high yield debt and adding some low risk debt from "safer mortgages" and persuading the rating agencies to give the CDO a double-A or even triple-A rating on the basis that not everyone defaults on their mortgage payments at the same time. They conveniently forgot about the possibility of serious recession.
The banks then sold these instruments onto other banks to replenish their coffers, enabling them to repeat the process.
Getting carried away – the role of AIG in insuring the sub prime mortgages
Now the whole process starts to get out of hand. The banks that bought the rated instruments used these instruments as security to increase their capital base and borrow more money. This is where AIG comes into the story. Around the world, banks must comply with a set of internationally accepted banking rules known as the Basel II regulations. These regulations determine how much capital a bank must maintain in reserve and are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps (CDS)
To understand how it worked, assume you are a major European bank with a surplus of deposits (Europeans save more than Americans). You are under pressure to maximize the spread between what you pay for deposits and what you can earn by lending. You want something that is safe and reliable, but also pays the highest possible annual interest. You know you could buy a portfolio of high-yielding sub prime mortgages, but doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities (CDOs) in your portfolio, you simply call your friendly AIG broker and ask him to insure this sub prime security against default. The broker agrees to guarantee the sub prime security you're buying against default for five years for say, 2% of face value. This is on the basis that the historical loss rates on American mortgages are so low as to be close to nothing.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to "mark-to-market" accounting (which values an asset at the current market price), AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a portfolio of sub prime "toxic loans". The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to deposit billions in collateral.
Apparently, AIG did not have the capital to back up the insurance it sold as it did not expect a default and the profits it booked never materialised. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected and they continue to increase. In some cases, the securities the banks claimed were triple-A have ended up being worth less than $0.15 on the dollar.
The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (valued in March 2008 at $22 trillion, but has fallen a lot since) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market.
The credit bubble
The CDS market worked for over 10 years. Banks leveraged deposits to the hilt. Wall Street packaged and sold sub-prime mortgages as securities (CDOs). AIG sold credit default swaps without bothering to collateralize the risk and so an enormous amount of capital was created out of thin air. Nobody is really sure how far the contagion spread. Certainly we have seen the European banks write off tens of billions of dollars of this bad debt in the past year and it is by no means all written down even now. There are strong rumours around Geneva (where I am at present) that we have barely seen half the debt declared and written off.
The Middle Eastern banks have declared that they did not become involved in the CDO and CDS markets. It is not clear whether Asian, Russian, Chinese or South American banks were involved, however it does seem to have been more of a USA & European phenomenon.
Part 2: BURSTING THE BUBBLE
Collapse of AIG
On September 15 2008, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company because of the soaring losses in its credit default swaps. The first big write-off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. However, the losses kept growing. The moment the downgrade came; AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
Collapse of Lehman Bros
The dominoes fell over immediately. Suddenly the banks were forced to downgrade the securities they were holding, which meant their capital requirements had to be raised. Worse, if AIG was bankrupt, the banks had no credit insurance and had to write down their CDOs. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity. That is how AIG became the linchpin to the entire system. However, the Fed decided not to rescue Lehman Brothers, America’s 5th biggest investment bank, and that was their big mistake as it immediately undermined confidence in the banks. If a major bank was allowed to go bust, then in the present circumstances, no bank could be trusted. Confidence in banks collapsed overnight.
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs. Goldman had avoided the huge mortgage-related write-downs that plagued all the other investment banks by hedging its exposure using credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. The moment AIG went bankrupt, Goldman lost $20 billion. Warren Buffet stepped in and invested $5 billion, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks had no way to borrow money, because no one would insure their obligations. To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. As at last week, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure.
Why the rescue?
I have gone into this detail because:
1. Without the government's actions, the collapse of AIG could have caused every major bank in the USA and Europe to fail, which would in turn bring down most banks in the world as they all lend to each other. However, letting Lehman Brothers go bankrupt was not such a good move and has been severely criticised.
2. Without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. The credit default swap market cannot provide cover anymore.
3. Most importantly, without the massive credit swap market initiated by AIG, the mortgage bubble could have never grown as large as it did. Other factors contributed, such as the role of Fannie Mae and Freddie Mac in buying subprime mortgages without questioning their quality, but the key to enabling the huge global growth in credit during the last decade can be tied directly to the sale of credit default swaps without underlying collateral. That was the stable door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine; the credit that existed in the world before September 15th should not have been there in the first place. The numbers are massive, as we have seen by the scale of the government bailout schemes announced by the US and UK governments followed by other major national governments.
Part 3: CONFIDENCE
The whole financial system is based on confidence. It starts with you and me. When we have our salary paid into a bank, we do so because we are confident the bank will honour our cheques and card payments and that their ATMs will deliver.
Banks earn money by lending our hard earned cash and that of our companies to other entities. They lend to home buyers, to businesses and to other banks and they do so in the confidence that they will receive interest and be able to get the money back, or in case of default, own an asset of equivalent value.
As we have seen above, banks can borrow more money than is deposited and lend that out as well. The majority of bank lending is long term. For the system to work, the banks have to be able to raise money to meet short term obligations. They can borrow from the Central Banks short term, but most of the borrowing is between banks.
Crisis of banking confidence
When Leman Brothers went bust, the banks realised they could not rely on the government to bail out a troubled bank and knowing that there were still huge unquantified losses on bank balance sheets and that the credit default insurance market had collapsed, no bank could be confident that even a big name bank would be able to return money it borrowed.
Immediately, the banks stopped lending to each other. Without the ability to raise capital, the banks stopped lending to the public and to businesses. So we saw panic amongst the banks that created an immediate credit crisis. There was no longer any confidence in the banking system and so governments have been forced to step in.
Crisis of business and stock market confidence
The next crisis of confidence came amongst corporations. Companies were having trouble obtaining loans and then suddenly found their banks reneging on commitments already made. Credit lines were withdrawn or called in. Companies could no longer be confident of being paid by their customers and were also finding some of their suppliers going out of business.
The stock market was quick to recognise the implications of this and confidence in share prices slumped. Most of the world's stock markets were down 20-30% over the past year and then panic set in last week. Markets dropped by another 25-30%. Most western markets are currently sitting some 40% below their highs of a year ago and the remerging markets have dropped up to 60%.
Iceland becomes bankrupt
In some cases, the market capitalisation (share value) is less than the asset value (buildings, stock, cash etc) of the company. The sudden drop in share value is causing problems for investment banks who have invested in corporations. This triggered the collapse of the Icelandic banks.
They had embarked on an ambitious program of raising money by offering interest rates in the region of 15% -16% and the UK government encouraged local authorities to deposit their money with Icelandic banks. The Icelandic banks invested this money in British and other overseas companies. They had taken on collective debt exceeding 4 times the Icelandic gross domestic product (GDP). When share prices collapsed, they became insolvent and the Icelandic government does not have nearly enough money to bail them out or to guarantee depositors. The country is bankrupt and the obvious place for it to turn is to the IMF.
So a vicious circle starts to build. The credit bubble burst and confidence has evaporated. Banks have no confidence in each other and so cannot lend and this has a knock-on effect to mortgages and property prices, to everyday business between companies and then on to all asset prices. We have seen it move from a loss of confidence to blind panic.
First bubble element - sub prime mortgages
Every great bull market that turns into a bubble has similar characteristics. It starts with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats. These are obvious to anyone who has bought a house; like the need for a substantial down payment, the verification of income, an independent valuation, etc. But human nature is such that, given enough time and the right incentives, any endeavour will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. The problems with the US mortgage market (and to a lesser extent the UK as well) are now well documented. Loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate valuations.
The lending institutions in the USA have always been able to package their loans and sell them to a larger financial institution. The repayments are passed on to the buyer, as is the risk of default. Originally the biggest buyers of this debt were Fanny Mae & Freddy Mac who sold bonds to the public to raise the money to buy the mortgage debt. These companies collapsed recently under the weight of mortgage default and had to be bailed out by the US government.
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into unsafe practices, or worse.
Second bubble element - selling the mortgages to banks
As lenders entered into the sub-prime area, they charged higher interest rates to borrowers to account for their risk. They made a higher profit on these and sold them on. With their newly replenished funds the lenders actively sought more high risk debt, as they made more profit. This was the first part of the problem as it sucked people into debt who obviously had no means of repayment. They even devised schemes with 3 - 6 months interest free period at the start, which gave more time for the loans to be sold on before there was any possibility of default.
The next step that started to make the problem more serious was that the banks became buyers of these debts and they created imaginative financial instruments with them. They created a collateralized debt obligation (CDO) by taking a package of high risk, but high yield debt and adding some low risk debt from "safer mortgages" and persuading the rating agencies to give the CDO a double-A or even triple-A rating on the basis that not everyone defaults on their mortgage payments at the same time. They conveniently forgot about the possibility of serious recession.
The banks then sold these instruments onto other banks to replenish their coffers, enabling them to repeat the process.
Getting carried away – the role of AIG in insuring the sub prime mortgages
Now the whole process starts to get out of hand. The banks that bought the rated instruments used these instruments as security to increase their capital base and borrow more money. This is where AIG comes into the story. Around the world, banks must comply with a set of internationally accepted banking rules known as the Basel II regulations. These regulations determine how much capital a bank must maintain in reserve and are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps (CDS)
To understand how it worked, assume you are a major European bank with a surplus of deposits (Europeans save more than Americans). You are under pressure to maximize the spread between what you pay for deposits and what you can earn by lending. You want something that is safe and reliable, but also pays the highest possible annual interest. You know you could buy a portfolio of high-yielding sub prime mortgages, but doing so will limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities (CDOs) in your portfolio, you simply call your friendly AIG broker and ask him to insure this sub prime security against default. The broker agrees to guarantee the sub prime security you're buying against default for five years for say, 2% of face value. This is on the basis that the historical loss rates on American mortgages are so low as to be close to nothing.
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to "mark-to-market" accounting (which values an asset at the current market price), AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.
With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a portfolio of sub prime "toxic loans". The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to deposit billions in collateral.
Apparently, AIG did not have the capital to back up the insurance it sold as it did not expect a default and the profits it booked never materialised. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected and they continue to increase. In some cases, the securities the banks claimed were triple-A have ended up being worth less than $0.15 on the dollar.
The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (valued in March 2008 at $22 trillion, but has fallen a lot since) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market.
The credit bubble
The CDS market worked for over 10 years. Banks leveraged deposits to the hilt. Wall Street packaged and sold sub-prime mortgages as securities (CDOs). AIG sold credit default swaps without bothering to collateralize the risk and so an enormous amount of capital was created out of thin air. Nobody is really sure how far the contagion spread. Certainly we have seen the European banks write off tens of billions of dollars of this bad debt in the past year and it is by no means all written down even now. There are strong rumours around Geneva (where I am at present) that we have barely seen half the debt declared and written off.
The Middle Eastern banks have declared that they did not become involved in the CDO and CDS markets. It is not clear whether Asian, Russian, Chinese or South American banks were involved, however it does seem to have been more of a USA & European phenomenon.
Part 2: BURSTING THE BUBBLE
Collapse of AIG
On September 15 2008, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company because of the soaring losses in its credit default swaps. The first big write-off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. However, the losses kept growing. The moment the downgrade came; AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.
Collapse of Lehman Bros
The dominoes fell over immediately. Suddenly the banks were forced to downgrade the securities they were holding, which meant their capital requirements had to be raised. Worse, if AIG was bankrupt, the banks had no credit insurance and had to write down their CDOs. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity. That is how AIG became the linchpin to the entire system. However, the Fed decided not to rescue Lehman Brothers, America’s 5th biggest investment bank, and that was their big mistake as it immediately undermined confidence in the banks. If a major bank was allowed to go bust, then in the present circumstances, no bank could be trusted. Confidence in banks collapsed overnight.
AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs. Goldman had avoided the huge mortgage-related write-downs that plagued all the other investment banks by hedging its exposure using credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. The moment AIG went bankrupt, Goldman lost $20 billion. Warren Buffet stepped in and invested $5 billion, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks had no way to borrow money, because no one would insure their obligations. To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. As at last week, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure.
Why the rescue?
I have gone into this detail because:
1. Without the government's actions, the collapse of AIG could have caused every major bank in the USA and Europe to fail, which would in turn bring down most banks in the world as they all lend to each other. However, letting Lehman Brothers go bankrupt was not such a good move and has been severely criticised.
2. Without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. The credit default swap market cannot provide cover anymore.
3. Most importantly, without the massive credit swap market initiated by AIG, the mortgage bubble could have never grown as large as it did. Other factors contributed, such as the role of Fannie Mae and Freddie Mac in buying subprime mortgages without questioning their quality, but the key to enabling the huge global growth in credit during the last decade can be tied directly to the sale of credit default swaps without underlying collateral. That was the stable door. And it was left open for nearly a decade.
There's no way to replace this massive credit-building machine; the credit that existed in the world before September 15th should not have been there in the first place. The numbers are massive, as we have seen by the scale of the government bailout schemes announced by the US and UK governments followed by other major national governments.
Part 3: CONFIDENCE
The whole financial system is based on confidence. It starts with you and me. When we have our salary paid into a bank, we do so because we are confident the bank will honour our cheques and card payments and that their ATMs will deliver.
Banks earn money by lending our hard earned cash and that of our companies to other entities. They lend to home buyers, to businesses and to other banks and they do so in the confidence that they will receive interest and be able to get the money back, or in case of default, own an asset of equivalent value.
As we have seen above, banks can borrow more money than is deposited and lend that out as well. The majority of bank lending is long term. For the system to work, the banks have to be able to raise money to meet short term obligations. They can borrow from the Central Banks short term, but most of the borrowing is between banks.
Crisis of banking confidence
When Leman Brothers went bust, the banks realised they could not rely on the government to bail out a troubled bank and knowing that there were still huge unquantified losses on bank balance sheets and that the credit default insurance market had collapsed, no bank could be confident that even a big name bank would be able to return money it borrowed.
Immediately, the banks stopped lending to each other. Without the ability to raise capital, the banks stopped lending to the public and to businesses. So we saw panic amongst the banks that created an immediate credit crisis. There was no longer any confidence in the banking system and so governments have been forced to step in.
Crisis of business and stock market confidence
The next crisis of confidence came amongst corporations. Companies were having trouble obtaining loans and then suddenly found their banks reneging on commitments already made. Credit lines were withdrawn or called in. Companies could no longer be confident of being paid by their customers and were also finding some of their suppliers going out of business.
The stock market was quick to recognise the implications of this and confidence in share prices slumped. Most of the world's stock markets were down 20-30% over the past year and then panic set in last week. Markets dropped by another 25-30%. Most western markets are currently sitting some 40% below their highs of a year ago and the remerging markets have dropped up to 60%.
Iceland becomes bankrupt
In some cases, the market capitalisation (share value) is less than the asset value (buildings, stock, cash etc) of the company. The sudden drop in share value is causing problems for investment banks who have invested in corporations. This triggered the collapse of the Icelandic banks.
They had embarked on an ambitious program of raising money by offering interest rates in the region of 15% -16% and the UK government encouraged local authorities to deposit their money with Icelandic banks. The Icelandic banks invested this money in British and other overseas companies. They had taken on collective debt exceeding 4 times the Icelandic gross domestic product (GDP). When share prices collapsed, they became insolvent and the Icelandic government does not have nearly enough money to bail them out or to guarantee depositors. The country is bankrupt and the obvious place for it to turn is to the IMF.
So a vicious circle starts to build. The credit bubble burst and confidence has evaporated. Banks have no confidence in each other and so cannot lend and this has a knock-on effect to mortgages and property prices, to everyday business between companies and then on to all asset prices. We have seen it move from a loss of confidence to blind panic.