Tuesday, October 07, 2008 Bautista: Understanding the US financial crisis (Part I) By Jun Bautista
WE MUST have heard by now the ongoing financial crisis in the United States with the unfolding drama of once thought to be financially impregnable, multimillion-dollar companies collapsing, such as investment giant Lehman Brothers, Bear Stearns, government-sponsored entities Fannie Mae and Freddie Mac, world’s biggest insurer AIG, Washington Mutual and recently, Wachovia.
To address this growing crisis, US President George W. Bush has just signed a modified bailout plan to the whopping tune of US$700 billion which his administration hopes will resuscitate the dying financial market and prevent the US economy from spiraling down.
Reading and listening to the news reports about this crisis could prove very dizzying, what with the complex concepts and jargons of the world of finance that played significant roles in this problem. Terms such as mortgage backed securities, collateralized debt obligations, asset backed securities, credit default swaps, etc., could prove very daunting for the unitiated like me to understand.
To understand the news is to understand the underlying issues. This is an attempt to explain the underlying causes of the U.S. financial crisis -- after an excruciating research and study of the financial gobbledygook -- which threatens not only the economy of the continental US but of the world as well, given the magnitude of the investments in US dollars of huge and several non-US companies including sovereign investors.
The problem started with the housing bubble in the US where thousands of new homes have been built over a span of a few years and many have acquired housing loans to buy new homes. Lower interest rates and the availability of cheap money have driven the mad rush to build more and more houses which resulted in the supply overwhelming demand.
In a typical housing loan a lender will provide the money that the homebuyer will use to purchase a house. To protect the lender against failure by the homebuyer in paying the loan a contract of mortgage will be created whereby the house will be foreclosed (sold to the highest bidder and the proceeds to go to the lender) in the event the homebuyer is unable to pay the loan.
Lenders have considerably relaxed lending requirements for housing loans and many extended credit even to those with spotty credit history or those with poor records of paying or questionable ability to pay their loans. These loans came to be known as subprime or junk mortgages because of the increased risk creditors face with these type of borrowers -- that of not being able to pay their loans or mortgages. MBS have much to do with this practice by lenders. More on this later.
An innovation of lending practice in the US is the adjustable rate mortgage or ARM. Under this scheme the interest rate is not fixed over the life of the loan and adjusts, either higher or lower, depending on the prevailing interest rate, unlike in a fixed mortgage loan where the interest rate is locked-in for the duration of the loan.
Many homebuyers with poor ability to pay have been enticed by lenders to take the ARM type of loans with so-called teaser rates where the introductory interest rate is low, thus resulting in lower monthly payments of their loans. Either these homebuyers did not appreciate the risk of interest rates increasing (which will increase their monthly loan payments) or were banking on the continuing rise of housing values that will enable them to refinance (getting a new loan on the house) to cover them against rate increases.
With rising home values homeowners could get loans against their houses over and above their purchase values. For example, if a homebuyer purchases a house worth US$200,000 and gets a loan for this amount to finance the purchase, after a year or two the house might be worth US$250,000 for which the homebuyer/homeowner could obtain another loan (refinance) over the same house for such an amount, thereby giving the homebuyer US$50,000 in the pocket. This increase in value is what is called an equity.
In essence the ARM type of loan is a gamble on the part of the homebuyer, because he or she is gambling on the possibility of a stabilizing or decreasing interest rate in the future that will maintain or decrease the monthly loan payments, as well as on the increasing value of houses.
What these types of homebuyers did not anticipate, however, is because the supply of new homes grew to a frenzy pace versus the demand for them home values also declined rapidly. From their peak in 2006, housing values have significantly dropped to 20 percent.
When interest rates increased known as a reset the monthly payments of ARM homebuyers ballooned. For most American households which are on fixed paychecks such sudden increase in monthly payments could hardly be afforded. What is sad is these distressed homebuyers could not get their houses refinanced, which is their last hope to get them through the crunch because of the drop in home values. Thus, begins the bubble burst in the housing market.
Now one might be asking, how is this housing problem related to the financial crisis? The answer lies in the structured finance instruments developed by finance-savvy investors.
