Thursday, October 09, 2008 Bautista: Understanding the US financial crisis (Part II) By Jun Bautista Straight Views
LAST time we discussed the problems in the US housing market, we learned that with the combined availability of money and relaxed, or should I say irresponsible, lending practices, the following factors led to the eventual bursting of the housing bubble: supply overwhelming demand, foreclosures, and sharp drops in home values.
In this segment we will correlate the collapse of the housing market with the ongoing financial crisis.
Let us backtrack on the mortgages originated by lending companies to homebuyers. In the past lending companies retain the risk of non-payment when they extend loans to borrowers. But with the emergence of certain finance instruments, which we will tackle shortly, lenders have learned how to distribute the risk while at the same time generating more money to lend to borrowers.
A lending institution that generated several mortgaged loans could now sell these loans (or the right to receive payments on them) to an investment company. The proceeds from the sale of these loans will then be used by the lending institution in extending more loans to borrowers, such as prospective homebuyers. At the same time the risk of default from the loans it previously originated is passed on to the investors of these loans.
When applied to mortgaged loans on houses these sold loans are called mortgage backed securities or MBS. The investment company that purchased these loans packages them for sale in the form of bonds (debt securities) to prospective investors. Unlike traditional bonds, however, the income from the MBS flows to the investors, which come from the mortgage payments of homeowners.
The ability of lending companies to transfer the credit risk to others through the instrumentality of MBS made it palatable for them to extend high risk loans to people with poor credit history, for after all they could easily dispose of these loans to willing investors.
Since holders of MBS rely on payments being made by homeowners to generate profit, the failure or inability of many such homeowners to pay the mortgages on their homes leading to foreclosures -- which became a nation-wide phenomenon in the US -- brought financial ruin to companies that invested heavily on MBSs.
According to former Federal Reserve Chairman Alan Greenspan, the creation of MBS based on subprime mortgages or high risk mortgages is the leading source of the current US financial crisis. Aside from MBS, however, there are still other species of structured finance that are being blamed for the crisis, such as the more complicated collateralized debt obligations (CDO) and credit default swaps (CDS).
The simplest definition of CDO that I came across the web is that it is an investment that is backed by debt. To better understand CDOs the mechanics of how they work must be understood. Typically an investment company raises money from several investors and issues corresponding bonds (securities) to represent the investors' interests. The money generated is invested in the purchase of loans, bonds or other assets with collateral, hence the term collateralized. This mixture of debts is called a portfolio.
The payments that the investment company receives from the portfolio are the source of income that is distributed to investors. A lot of CDOs have invested in MBS or securities in which the underlying assets are real estate mortgages.
A credit default swap (CDS), on the other hand, is an insurance against failure by a company in the payment of its obligations. For example, if you buy P100,000 worth of bonds from a company you can purchase a CDS that will pay you P100,000 -- after payment of an upfront fee and premiums at set intervals for the duration of the agreement, usually five years -- in the event the company that issued the bond fails to pay its obligation in what is called an event of default.
What differs a CDS from a real insurance is that one does not need to have an economic stake in the thing insured against (insurable interest) -- such as that which a homeowner has over his house in insuring it against fire or other losses. Anybody can insure another's investment in a company or in other words speculate on that company's gain or loss. Furthermore, CDSs are unregulated.
The problem with these CDSs is that so many companies invested and speculated on them (there are an estimated US$60 trillion -- yes in trillion! -- worth of unregualted CDSs lying around), and what exacerbated the problem is that these CDSs covered CDOs and MBSs that are based on subprime mortgages. Now if you do the math here you will see that since housing foreclosures have become so widespread the stream of income that is supposed to flow to the holders of these complicated, three-lettered investments (CDS, CDO and MBS) has been severely stemmed.
American International Group (AIG), which is the world's biggest insurance company, had invested heavily on these CDSs. It sold more than US$400 billion worth of CDS, which led to its calamitous fate.
These gigantic setbacks suffered by huge financial institutions led to a freeze in the credit markets. Lending companies, including banks, are now holding tight to their money and adamant to lend them -- even to each other.
To use a now famous cliché, this seizing of the financial market has trickled down from Wall Street to Main Street (to the common Americans). With banks and other financial institutions not lending money, companies are unable to re-supply their inventories that will enable them to produce or sell more with the net result of more people losing their jobs (already, the Department of Labor has reported about 159,000 Americans losing their jobs); investments are being stalled as the lack of capital holds investors from venturing or expanding their businesses; people cannot obtain loans to purchase cars, homes, get equity on their homes, and are holding tight on their cash by reining on spending resulting in a slowdown of the economy.
Indeed, the scenario for every American has become bleak. Although some experts express reservation on the effectiveness of simply pumping money back into the US economy in reviving its financial market, hopefully the newly-signed bailout plan of the Bush Administration will stem the tide of collapse of the U.S. economy.
As already mentioned the stakes here involve not only the US economy but of the world as well. Just recently in the news, European Union member-countries are working hard to come up with a consensus on how to protect their economies. The US financial or credit crisis has already affected huge banks and financial institutions in Iceland, Germany, and the U.K. Let us hope and pray that a viable solution will soon be found.
