We (Now) Love You

It wasn’t that long ago that voices in the US Treasury were telling the world that, as far as sub-prime mortgages were concerned, it was up to the borrowers and lenders to privately negotiate a settlement since government intervention would be counterproductive. The government would however, increase funding for debt counseling. Given that roughly 1.8 million happy debt-ridden families in the US with “teaser’ rate Adjustable Rate Mortgages stood to lose their homes pretty soon when rates were due to move up, the attitude was sanguine.

Now, deep into the Advent season when peace, love and compassion suffuse every crisis with a hazy glow, the US government has outlined a plan to freeze interest rates for 5 years for those holding Owner-Occupied sub-prime loans made between 1 January 2005 and 31 July 2007, the adjustable interest rates of which, were due to rise over the coming two and a half years. According to an online Reuters report dated December 6 2007, this covers US367 Billion worth of mortgages.

With foreclosures in the US at their highest levels since 1986, this avowedly “non-bailout” solution is intended to exclude those who have the financial means to pay as well as those real estate speculators who used a sub-prime mortgage as easy leverage into what was then a sizzling real estate market. In practice, it appears only 2 groups of borrowers will qualify:

• Borrowers who show themselves to be a decent credit risk but can’t afford the higher payment, will find it easier to qualify for a rate freeze;

• Borrowers who can afford the higher rate would be given help in re-financing;

Therefore those who were a lousy credit risk to begin with, who can’t afford their current payments and who definitely won’t be able to afford their future payments, will be excluded from this scheme. Presumably this means foreclosures will proceed and they will lose their homes. Not to sound crass, but aren’t the lousy credit risks the very people against whom sub-primes were aimed at in the first place? Factoring out the good credit risks, the speculators and the 2 groups listed above, SAW’s suspicion is that most sub-primers will be frozen out of this government scheme.

In an earlier post, entitled Town Planning By Default, November 8 2007, SAW suggested that sub-primes could be used as a method of social engineering, population clearance and land development. For the inner city areas of some major US cities, this scenario may be inevitable.

The government scheme has the potential to trigger some interesting displays of human behaviour. It’s widely acknowledged that people who ended up with sub-primes were lied to about the financial risks they were taking or who were downgraded in their credit rating to force them to take a sub-prime. SAW smells revenge here and suspects that many people through sheer anger will now lie about their financial condition to qualify for a rate freeze. And they’ll probably get away with it.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

A Stack Of Derivatives

Now that the media has been awash with the purported astronomical, catastrophic [add the doomsday superlative of your choice] consequences of the sub-prime mess, just finding out in simple terms how this lunacy was “structured” became an expedition in itself.

Perhaps the best explanation is contained in Jon Markman’s column for MSN Money. He correctly made the point that the commercial debt market is far larger than the stock market. It’s in the debt market that companies, governments and pension funds obtain financing, use credit instruments essentially backed by confidence i.e. an expectation that a debt will be repaid on time with requisite interest.

First, the debt forms a chain: banks borrow money from their depositors, pay them low interest rates, then turn around and lend that money at higher rates to companies. The difference between what the banks pay their depositors and what they charge to companies who want to borrow funds, is known as “the spread”. Banks make good profits when the spread is large.

Then, in comes the US Federal Reserve under Alan Greenspan which attempted to kickstart the US economy in late 2001 by cutting interest rates. The economy recovered but the Fed continued to cut interest rates and fell asleep at the wheel. The economy heated up, real estate prices went through the roof and the spread upon which banks relied to make their profits, narrowed.

The banks turned to their depositors, usually the low income ones, with a sales pitch to borrow more money from the banks to fund a consumer-driven lifestyle. It’s well known just how easy it is to hook the already over-indebted US consumer, so getting them to borrow more, wouldn’t have been difficult. At the same time, the banks employed an army of barely scrupulous mortgage brokers to dangle “teaser rate” home loans, a camouflage for the notorious Adjustable Rate Mortgages which trapped so many.

These shaky income streams were packaged and marketed to institutional investors as “asset backed securities”. These in turn were used as collateral to create the Collateralized Debt Obligations (“CDOs”) which were also re-sold to institutional investors. The banks pocketed huge fees.

The CDOs themselves were then used as collateral for “doubled” and “cubed” CDOs which were shoved into Structured Investment Vehicles, (“SIV”) purportedly managed at arm’s length and kept off the Balance Sheet.

Finally, in the ultimate act of over-confidence, the SIVs were used as collateral for the short-term commercial paper that forms the basis of the commercial debt market.

It all sounds so simple, yet jaw-droppingly reckless. The US Federal Reserve continued to cut interest rates in full knowledge of the burgeoning sub-prime market and of the imaginative shenanigans of Wall Street. The latter continued to stack their derivatives knowing fully well the Fed wouldn’t do anything. In fact the Fed is on record as saying it was not in the business of regulating asset-backed securities. Which begs the question…who was?

The irony is that following the massive loss of confidence in the commercial debt market, what does the Fed do? Cut interest rates of course. And apparently there’s more slashing to come.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved