The Financial Fundemental of the Sub-prime Mess
Sub-prime is making much noise in the media now, but the threat has been anticipated since almost the middle of 2006. I remember reading article in Economic times back in Dec 2006 about the rate hikes done by Fed (Alan Greespan then) would result in a sub-prime meltdown.
The media talks about the social side of the housing market collapse, that people were given loans recklessly and that the borrowers don’t bother to pay back and why they don’t. For the media, this makes more sensational news than the fundamental mistakes which lead to this predicament. Here I just want to talk about the fundamental mistakes made by the economic policy makers, in other words the Fed.
The problem started when Alan Greenspan was still Chairman of the fed. In a effort to keep Wall street happy, kept the interest rate as low as 1%. Wall street is always happy because people would spend more on borrowed money when interest rates are low and this would boost consumption meaning more money at Wall Street.
But everything has side effects. When interest rates go down so do yield on bonds and financial corporations were not getting enough returns on investments (ROI) so they started looking for ways to get more rate of interest. At this point the idea of easily repackaging the loan collaterals into CDO (Collateralized Debt Obligation) came in handy. This promised higher interest when compared with the banks and so the finance biggies were quick to jump in on this opportunity. It’s very interesting how CDOs work but that is out of scope here ;)
Now, this is where the problem came, such CDO (based on loan repayments) should not have been given AAA rating by risk assessment agencies, but they were. So many here was aware of risks involved and they poured money into this opportunity to get more returns. This corporate need (to get more ROI) made credit easily available and consequently the 'criteria' to lend loans was being lowered. The 'middle-man' was given a billion dollars to be lent quickly so that it could be repackaged into CDOs and sold off quickly to address the market need which is to get more ROI.
This was one route for investors get ROI (return on investment) more than the market's Fed rate of 1%. There was another route invest in emerging markets. FIIs were taking this route they invested heavily in Asian stock markets. This had a side effect, which was the depreciation of dollar against other currencies. Initially this was seen as something good, because this was lowering US fiscal deficit and making US goods cheaper abroad again keeping wall street happy.
But this artificial lowering of interest rate cannot go on for ever because, with the dollar consequently going down, that would mean the dollar loosing its place as the standard currency for all international transactions. The OPEC was looking to shift from dollar to Euro. So Fed had to raise the interest rate steadily when interest rates kept going up quarter by quarter upto 7% way back in 2006, financial analysts were already worried that the housing market would collapse and bring he economy spiraling down.
What we see now is just their prediction coming true. The problem was not that the interests were suddenly spiked, the problem was Fed wanted to please Wall Street with some quick-fixes and kept the interest rate too low. This leads to many side effects one of which is the housing fiasco.
But still financial corporations were irresponsibly continuing their affair with CDOs. It should be remembered that when Stanley O’Neal CEO of Citibank was questioned about continued investments in CDOs he replies ‘as long as the music goes on so will the dancing’, a few months later when Citibank came up with billion dollar write downs and Stanley O’Neal was asked to step down, the press was quick to remind him ‘the music most certainly will stop sometime and so will you’.
The media talks about the social side of the housing market collapse, that people were given loans recklessly and that the borrowers don’t bother to pay back and why they don’t. For the media, this makes more sensational news than the fundamental mistakes which lead to this predicament. Here I just want to talk about the fundamental mistakes made by the economic policy makers, in other words the Fed.
The problem started when Alan Greenspan was still Chairman of the fed. In a effort to keep Wall street happy, kept the interest rate as low as 1%. Wall street is always happy because people would spend more on borrowed money when interest rates are low and this would boost consumption meaning more money at Wall Street.
But everything has side effects. When interest rates go down so do yield on bonds and financial corporations were not getting enough returns on investments (ROI) so they started looking for ways to get more rate of interest. At this point the idea of easily repackaging the loan collaterals into CDO (Collateralized Debt Obligation) came in handy. This promised higher interest when compared with the banks and so the finance biggies were quick to jump in on this opportunity. It’s very interesting how CDOs work but that is out of scope here ;)
Now, this is where the problem came, such CDO (based on loan repayments) should not have been given AAA rating by risk assessment agencies, but they were. So many here was aware of risks involved and they poured money into this opportunity to get more returns. This corporate need (to get more ROI) made credit easily available and consequently the 'criteria' to lend loans was being lowered. The 'middle-man' was given a billion dollars to be lent quickly so that it could be repackaged into CDOs and sold off quickly to address the market need which is to get more ROI.
This was one route for investors get ROI (return on investment) more than the market's Fed rate of 1%. There was another route invest in emerging markets. FIIs were taking this route they invested heavily in Asian stock markets. This had a side effect, which was the depreciation of dollar against other currencies. Initially this was seen as something good, because this was lowering US fiscal deficit and making US goods cheaper abroad again keeping wall street happy.
But this artificial lowering of interest rate cannot go on for ever because, with the dollar consequently going down, that would mean the dollar loosing its place as the standard currency for all international transactions. The OPEC was looking to shift from dollar to Euro. So Fed had to raise the interest rate steadily when interest rates kept going up quarter by quarter upto 7% way back in 2006, financial analysts were already worried that the housing market would collapse and bring he economy spiraling down.
What we see now is just their prediction coming true. The problem was not that the interests were suddenly spiked, the problem was Fed wanted to please Wall Street with some quick-fixes and kept the interest rate too low. This leads to many side effects one of which is the housing fiasco.
But still financial corporations were irresponsibly continuing their affair with CDOs. It should be remembered that when Stanley O’Neal CEO of Citibank was questioned about continued investments in CDOs he replies ‘as long as the music goes on so will the dancing’, a few months later when Citibank came up with billion dollar write downs and Stanley O’Neal was asked to step down, the press was quick to remind him ‘the music most certainly will stop sometime and so will you’.