BIGGER THE SIZE, GREATER THE FALL
Are you one of those who are wondering how the woes of a handful of companies can create a global
financial crisis? Perhaps you should for starters consider just how huge they are. The total revenue of Freddie Mac, Fannie Mae, AIG, Lehman Brothers and Merrill Lynch added up to nearly $322 billion in 2007. There are 185 countries, including fairly developed economies like Denmark or Greece, whose GDP cannot match that size.
In fact, even the combined GDP of the 96 smallest economies doesn’t add up to the aggregate revenues of these Wall Street giants, which were often considered too big to collapse. Between them, the CEOs running these firms had an annual compensation package of close to $118 million last year. In the past decade, which was considered the golden era of the financial industry, most of these companies made pots of money, particularly through real estate loans. Increasing property values were only adding to the profits of these companies who experienced an exponential surge in their revenues.
Things started going sour towards the end of 2006, with the bursting of the housing bubble in the US. Fannie Mae was the first to feel the heat, incurring a whopping $2.3 billion or 26% drop in net income. However, net incomes of the others were still surging.
Freddie Mac even witnessed a recovery after a slowdown in 2005. But, by 2007-end the decrease in inco
mes turned into real losses. Freddie Mac, Fannie Mae and Merrill Lynch started incurring loss from the third quarter of 2007. In the calendar year, Merrill Lynch lost $7.8 billion, which was more the $7.5 billion it has earned as net income in 2006.
The losses of Freddie Mac and Fannie Mae were respectively $3.1 billion and $2.1 billion.Although AIG still made profits for the year as a whole, it had also started incurring losses from the last quarter of 2007. As a result its net income over the year fell 56% from the $14 bn it made in 2006.
Lehman Brothers was the only exception, because it did not incur any loss in 2007. In fact, there was a
slight increase in the yearly profits from $4 billion to $4.2 billion. But it also joined the loss makers league when it lost $2.8 billion in the first quarter of 2008, a loss which was more than half the net income generated in all of 2007.
This dramatic roller coaster of profits and losses is perhaps best summed up by a quote of former Morgan Stanley MD Anson Beard: “If you’re betting with other people’s money, you’re more willing to take risk than if it’s your own.”
Given that mindset, it’s also easy to see why some have characterized what’s happened as ‘privatisation of profits and nationalization of losses’.
To Americans who were already debating the waste of taxpayer’s money in waging wars in Iraq and Afghanistan, the $900 billion and more of taxpayer money used for bailing out some of America’s largest financial giants is a staggering burden. This amount is nearly five times the $182.2 billion estimated as the expenditure for the war on terror for FY 2008. (TOI)
US mortgage crisis: A subprimer
This article was published in TOI on 16/09/2008 which is being reproduced because it very nicely explained that I thought it should be published. What is a sub-prime loan?
In the US, borrowers are rated either as ‘prime’ indicating that they have a good credit rating based on their track record or as ‘sub-prime’, meaning their track record in repaying loans has been below par. Loans given to sub-prime borrowers, something banks would normally be reluctant to do, are categorized as subprime loans. Typically, it is the poor and the young who form the bulk of sub-prime borrowers.
Why were sub-prime loans given?
In roughly five years leading up to 2007, many banks started giving loans to sub-prime borrowers, typically through subsidiaries. They did so because they believed that the real estate boom, which had more than doubled home prices in the US since 1997, would allow even people with dodgy credit backgrounds to repay on the loans they were taking to buy or build homes. The government also encouraged lenders to lend to subprime borrowers, arguing that this would help even the poor and young to buy houses. With stock markets booming and the system flush with liquidity, many big fund investors like hedge funds and mutual funds saw sub-prime loan portfolios as attractive investment opportunities. Hence, they bought such portfolios from the original lenders. This in turn meant the lenders had fresh funds to lend. The subprime loan market thus became a fast growing segment.
What was the interest rate on sub-prime loans?
Since the risk of default on such loans was higher, the interest rate charged on subprime loans was typically about two percentage points higher than the interest on prime loans. This, of course, only added to the risk of subprime borrowers defaulting. The repayment capacity of sub-prime borrowers was in any case doubtful. The higher interest rate additionally meant substantially higher EMIs than for prime borrowers, further raising the risk of default. Further, lenders devised new instruments to reach out to more sub-prime borrowers. Being flush with funds they were willing to compromise on prudential norms. In one of the instruments they devised, they asked the borrowers to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years.
How did this turn into a crisis?
The housing boom in the US started petering out in 2007. One major reason was that the boom had led to a massive increase in the supply of housing. Thus house prices started falling. This increased the default rate among sub-prime borrowers, many of whom were no longer able or willing to pay through their nose to buy a house that was declining in value. Since in home loans in the US, the collateral is typically the home being bought, this increased the supply of houses for sale while lowering the demand, thereby lowering prices even further and setting off a vicious cycle. That this coincided with a slowdown in the US economy only made matters worse. Estimates are that US housing prices have dropped by almost 50% from their peak in 2006 in some cases. The declining value of the collateral means that lenders are left with less than the value of their loans and hence have to book losses.
How did this become a systemic crisis?
One major reason is that the original lenders had further sold their portfolios to other players in the market. There were also complex derivatives developed based on the loan portfolios, which were also sold to other players, some of whom then sold it on further and so on. As a result, nobody is absolutely sure what the size of the losses will be when the dust ultimately settles down. Nobody is also very sure exactly who will take how much of a hit. It is also important to realise that the crisis has not affected only reckless lenders. For instance, Freddie Mac and Fannie Mae, which owned or guaranteed more than half of the roughly $12 trillion outstanding in home mortgages in the US, were widely perceived as being more prudent than most in their lending practices. However, the housing bust meant that they too had to suffer losses — $14 billion combined in the last four quarters – because of declining prices for their collateral and increased default rates. The forced retreat of these two mortgage giants from the market, of course, only adds to every other player’s woes.
What has been the impact of the crisis?
Global banks and brokerages have had to write off an estimated $512 billion in subprime losses so far, with the largest hits taken by Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half of these losses, or $260 bn, have been suffered by US based firms, $227 billion by European firms and a relatively modest $24 bn by Asian ones. Despite efforts by the US Federal Reserve to offer some financial assistance to the beleaguered financial sector, it has led to the collapse of Bear Sterns, one of the world’s largest investment banks and securities trading firm. Bear Sterns was bought out by JP Morgan Chase with some help from the Fed. The crisis has also seen Lehman Brothers – the fourth largest investment bank in the US – file for bankruptcy. Merrill Lynch has been bought out by Bank of America. Freddie Mac and Fannie Mae have effectively been nationalized to prevent them from going under. Reports suggest that insurance major AIG (American Insurance Group) is also under severe pressure and has asked for a $40 bn bridge loan to tide over the crisis. If AIG also collapses, that would really test the entire financial sector.
How is the rest of the world affected?
Apart from the fact that banks based in other parts of the world also suffered losses from the sub-prime market, there are two major ways in which the effect is felt across the globe. First, the US is the biggest borrower in the world since most countries hold their foreign exchange reserves in dollars and invest them in US securities. Thus, any crisis in the US has a direct bearing on other countries, particularly those with large reserves like Japan, China and – to a lesser extent – India. Also, since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world.