Chief Investment Officer, J P Morgan Chase lashes out on US investors calling them "predictably irrational" and "stupid". This he did in an interview given to Forbes magazine few days back. What cheek!! Calling majority of 95 million US investors as "stupid" and "predictably irrational"? This is after what the Wall Street bankers did to willfully defraud common investors? We all know what happened to investors in 2008 sub prime mortgage crisis in US. Who were the actual brains behind the global meltdown that followed? To arrive at an answer let us analyse the sub prime crisis step by step that brought the world dangerously close to the Great Depression era. By the way, what we see today as turmoil in financial world across nations is majorly gifted by the sub prime crisis. And Lord knows how much more pain world has to endure before the venom of sub prime crisis gets thrown out completely from the system! But first let us focus on the genesis of sub prime crisis.
Sub prime crisis started with mortgage companies giving loans to American public at near zero interest and with no due diligence and no collateral. This led to a boom in economic activity as homes were sold like hot cakes. The mortgage companies were fully aware that most of these loans were going to default because these loans were mostly given to people with little or no repaying capability. That is why it has been exotically termed as loans to Sub Prime (below Prime) borrowers, meaning borrowers with very poor credit history and below par repaying capacity. They went so far as to having no document check for the sub prime borrowers, with computer generated automated approvals given to loan applications within 30 seconds. In this format you can declare anything as your income and there will be no questions asked.
The mortgage companies therefore knew that there will be payment defaults. Initially when the default started, the housing market in US was booming. So the mortgage companies gave away mortgage loans for second time to defaulting borrowers against their homes to pay off their first mortgage. It was a win-win-situation for all since the property prices were rising fast and furious. The exponential rise in property prices was forming a housing bubble, and any bubble has to burst sometime or the other. This fact was known to financial wizards in the mortgage companies.
Time was running out. So to wriggle out of this imbroglio, these mortgage companies went to the omnipotent and omniscient investment bankers of Wall Street to bail them out of their impending doom. And thus a devious and intricate plot was hatched by big daddys of Wall Street.
Mortgage Backed Securities(MBS) : The investment bankers were quick to securitize the mortgage loans and pass on the risk to the buyers of these securities. Simply put they bought the mortgage loans, made a pool of these loans, and issued out bonds against the pool. The mortgage companies got their money back, and again went back to give out more loans to more undeserving borrowers.
Credit Default Swap(CDS) : Not content with passing on the risk to bond holders of MBS plan, they further wanted to make big bucks out of the situation of rising property prices. Thus they thought of exercising the financial instrument of CDS to make a killing. If you are a bond holder you would like to insure yourself against the huge investment you have made in these bonds. So you get advised to buy CDS as an insurance. Suppose you have bought $1 million as mortgage bonds and then you buy CDS as insurance, you are required to pay annual premium of $10000(say) for such an insurance. By doing so you are insured to get your $1million in case the bond fails. CDS also allows that even if you are not the bond holder or property holder you can still participate in the housing market through CDS by speculating. Supposing you have an opinion that property prices will fall and by extension the MBS bonds will fail, then you buy CDS against these bonds, pay the yearly premium of $10000 and make a killing of $1 million as and when the bonds fail.
Collateralized Debt Obligation(CDO) : Still not content with raising mega bucks through MBS and CDS, these investment bankers devised more hideous plans to spread the risk right across the globe. They invoked CDO, a name that now sends shivers through millions of hapless investors on planet earth. All MBS and CDS were grouped into a pool, divided into tranches and sold as bonds of CDO. The tranches with least risk were given highest investment rating of AAA through rating agencies like S&P, Fitch and Moody's. The riskier tranches were given lower ratings in steps starting with AA, A, BBB, BB and B. Riskier the tranche, higher was the promised return and vice-versa. These were then sold to all financial institutions and big investors across continents as financial products, with investment grade stamp and authority of the most hallowed names in financial world.
CDO Squared : Yet not satisfied that they have done enough, the investment bankers this time made a pool of CDOs itself as underlying asset and issued out CDO Squared. In doing this, slices were taken from CDO proper and mixed so horribly that the riskier tranches got thoroughly mixed with healthy tranches. Now the credit rating agencies had no problems giving AAA ratings to CDO Squared. Further, CDO Squared were put into a pool and made CDO Cubed and bonds issued against them. They have even gone further and sold derivatives of CDO Cubed and so on. No one really knows how far these investment bankers have gone in this game of deceit. All that one knows is that these financial products were manufactured in the factories of Wall Street and sold across the globe with investment grade ratings from the most venerable names in the rating business. Who will not buy these products, made in USA?!!
Synthetic CDO : One step further into the quagmire, Synthetic CDOs were sold which had no asset backing at all. This was the last nail in the coffin, as investment bankers on Wall Street sold Credit Default Swaps(CDS) of the already complex CDOs, terming them as Synthetic CDO.
When the housing bubble finally did burst in US, everything got complicated. The credit unworthy or sub prime borrowers defaulted and this time with their property prices plummeting, no one was ready to
re-mortgage their property. Not being able to pay the loans they vacated their homes. The banks had deluge of foreclosures, but there were no buyers for foreclosed homes. Hence there was distress selling from bankers. This led to further fall in property prices and the malaise slowly spread across to the prime mortgage market.
With such huge defaults from sub prime borrowers all derivative instruments starting with MBS and all hues of CDOs crumpled. Anyone having exposure to these toxic assets had to book huge losses. Even those who did not have any exposure to such toxic assets were also hit. They were the pensioners in US who found out to their horror that the pension funds had exposure to these toxic assets.
All that is known to all of us. Now the question that begs an answer is this: "If derivatives is a zero sum game then how come the whole financial world is crying fowl?" If majority has lost billions of dollars ( last estimate of loss by IMF was about a trillion dollars) then who are the minority gainers. If the investment banks like Bear Stearns, Goldman Sachs, Lehman Brothers and mortgage companies like Countrywide Financial have all lost billions of dollars and had applied for bankruptcy, then who have profited those lost billions? Surely not the poor sub prime borrowers who are on the street with their homes foreclosed. I would like to provide a clue to the answer. Investment bankers working for these investment banks had in their internal emails described all these derivative instruments like MBS, CDO as worthless papers. And yet they were wilfully selling these worthless papers with gusto and guise to all investors. Before the sub prime crisis all you needed to do was to take credit default swaps(CDS) of all these exotic mortgage derivatives and you would have made billions before you could say Jack Robinson. But for that you have to be an Insider and part of a Cartel !!
I have tried to explain a very complex phenomenon of sub prime crisis in a very simplified manner. Each financial instrument has many degrees of complexity attached, which I have conveniently left out so that it is easy to understand. As sequel to this understanding, I shall be discussing about the ramifications of sub prime crisis on world economy in my next post. We shall also try to evaluate as to how much more pain is left in the system. Till then trade with caution!