A Plague of Subprimes
A new and unwelcome term—subprime mortgage—has intruded itself into the vocabulary of the financial world in the past year, appearing in headlines and nudging into conversations at water coolers and on putting greens from Sacramento to Sydney. These mortgage instruments—written by dubious lenders to even more dubious borrowers—are not new in kind, but in recent years they have appeared in a quantity that is quite new—three to four times that previously seen. Like the common locust in ancient Egypt or the Oriental Rat Flea in 14th Century Europe, or certain fissionable isotopes of uranium in more recent times, subprime mortgages have demonstrated the principle of critical mass: Gathered in sufficient concentration, relatively innocuous things can become very formidable. What we have here is the 21st Century’s Great Subprime Plague.
The Wall Street Journal reported finding no less than $2.5 trillion in subprime mortgages in a survey of loans issued from 2001 to 2006—nearly half of them issued in the last two years of the period studied (Wall Street Journal, December 3, 2007). Bundled into bonds and sold to yield-hungry investors, this Vesuvius of bad mortgages began to tremble ominously in April 2007, when the housing boom that had fed it—and fed from it—went bust.
Signs of serious trouble, says a panel of economists commissioned to study the fiasco (Greenlaw, Hatzius, Kashyap and Shin, 2008) were apparent no later than August, 2007, when certain bellwether interest rates began to rise with no obvious explanation. The “Ted” spread—the difference between the 3-month Eurodollar deposit rate and the yield on a 3-month Treasury bill—spiked to more than 200 basis points, about 10 times its baseline. This surge substantially surpassed those this same indicator made a decade before in the Long Term Capital Management crisis, and in 2001 after the 9/11 terrorist attacks. In October, the Wall Street Journal referred to the rapidly emerging situation as a “new age of uncertainty” brought on by murky pricing in subprime mortgages. “Large parts of American financial markets have become a hall of mirrors,” said the newspaper (Wall Street Journal, October 12, 2007).
This suggests a problem or problems extending well beyond a bust in the housing market. It is noteworthy, but hardly earth-shaking, when a boom goes bust. In this case, the sudden contraction in housing prices trapped some who bought late in the cycle in insupportable mortgages, and they defaulted. Some of the lenders stuck with these bad loans—generally highly aggressive firms that specialize in a marginal clientele (New Century Mortgage)—were forced into bankruptcy. That’s pretty much the baseline case, the generic model for any market contraction. This difference this time lay in the volume of money that had been put at risk, and the number of players involved, both of which were much larger than usual. When the game stopped, some very surprising players were left holding very large bags—bags full of dodgy mortgages. Thrust to center stage was a previously little-noticed network of conduits that connected an army of fly-by-night lenders and their equally suspect clients to some of the most the world’s most prestigious financial institutions. No less unusual was the fact that the lesser participants, who usually get all the worst of it in such head-on encounters, were not alone on the list of grievously injured. New Century Mortgage went bankrupt, but so did Bear Stearns, and a number of even more exalted names were scrambling literally across the globe looking for emergency cash.
It was as if Joe Fourflush, pouring a bucket of cement into the plumbing of his foreclosed home in Las Vegas, was backing up drains all over Wall Street. Along with Joe and thousands like him, the eviction list from the subprime entanglement included the chief executives of Citigroup, Merrill Lynch and UBS AG.
The story is very much one of “knock-on effects,” as the post mortem by the Greenlaw group phrased it (Greenlaw et al, Pg. 12.). And, once started, the effects knocked-on very quickly. Subprime mortgages had been the foundation of a multi-billion dollar bond marketing business, in which large Wall Street investment banks bought them, packaged them into complex securities called collateralized debt obligations (CDO’s), and sold them through special entities, usually trusts, called structured investment vehicles (SIV’s). These entities borrowed short term and relatively low rates and invested long term at higher rates. Subprime mortgages provided very attractive rates at what appeared to be relatively little risk.
So long as things went as planned, the SIV’s could be excluded permissibly from the balance sheets of their sponsoring banks. When things did not go as planned, however, the problem became one of rolling over the short-term debt required to keep the operation afloat. The alternatives would be to liquidate much (or all) of the long-term portfolio, or seek an infusion of cash from the sponsoring bank. The latter course would require the bank to acknowledge ownership of the SIV, and bring the rescued assets onto its own balance sheet, valued at the current market price. This is problematic at any time, but particularly so in the case of subprime mortgage bonds, as the absence of a functioning market was the cause of the problem to begin with. The few bids to be found were disastrously discounted. The investment banks were therefore faced with the prospect of recognizing a number of large and conspicuously dead losses in their next financial statements. Those who had subprime mortgage bonds therefore were stuck with them, much like the occupants of a quarantined house in time of plague. Help would not be on the way any time soon.
In November, as rumors of these events spread through the capital markets, nervous investors began to sell off assets across all categories, financial stocks appropriately taking the worst of it. By December, hard numbers for damages began to emerge as big investment banks issued pre-announcements of big losses deriving from subprime mortgages. Scuttlebutt had it that Merrill Lynch, Citigroup, UBS AG, Morgan Stanley and perhaps others would send envoys to foreign capitals, offering large chunks of themselves in exchange for emergency infusions of cash.
January earnings announcements for the last quarter of 2007 more than sustained the earlier warnings (and rumors) as an increasingly aggravated situation came to be called the “subprime crisis.” Merrill Lynch and Citigroup, Inc. reported write-downs on assets summing to $40 billion as a result of fourth-quarter losses in subprime and “Alt-A” (not quite prime) mortgage securities, and at the same time revealed that their chief executives had been replaced. (Three months later, Merrill would announce an additional $6.6 billion, and Citigroup an additional $7.6 billion, in subprime losses for the first quarter of 2008.)
The two giant firms also confirmed in January that they would indeed dispatch emissaries to foreign capitals, with palms extended. Merrill reportedly sought $5-billion from the sovereign investment fund of Singapore; Citigroup circled the bases in the Middle East, soliciting help from Abu Dhabi, Kuwait and Saudi Arabia, raising $20 billion (The Wall Street Journal, March 5, 2008). Also mounting road shows were Morgan Stanley, which sought help from China after writing down $12.9 billion in subprime mortgages. UBS AG ($37+ billion in write-downs) went to Singapore. Later, after a third round of write-down announcements, UBS joined Merrill and Citigroup in replacing its CEO.
Ominously, Bear Stearns had gone hat-in-hand to China, and was rebuffed. Later the firm became the poster child for the subprime meltdown, as it was taken over by J.P. Morgan Chase on March 16, at an announced price of $2 a share. This was later raised to $10, but it was nevertheless a long fall from the $87 price the firm’s shares had touched a mere 14 trading days before, or the $172 at which they had traded just 14 months before. So low had the stock fallen that even J.P. Morgan’s fire-sale offer was contingent upon the Federal Reserve taking the unprecedented step of financing the deal with a $29-billion loan against Bear’s troubled and illiquid assets (though Fed officials later reported to Congress that they expect ultimately to see a profit from the deal). The boost in offer price to $10 was financed with a second loan of $25 billion to Bear Stearns itself, through the Fed’s discount window, which had recently been opened to non-depository banks. J.P. Morgan’s guarantee was required to seal the deal.
As the trouble escalated, so too did the urgency of the language used by the financial press to describe it. As mentioned, the “hall of mirrors” characterization came early on in the process, soon giving way to “subprime mess,” then to “credit crunch.” By January, weightier adjectives were deployed: “crisis,” then “debacle” and finally to the ominous nuclear-age metaphor, “meltdown.” As the Bear Stearns takeover was announced, The Economist invoked the oldest and most dreaded epithet, declaring “Panic is in the air.” The Wall Street Journal editorial page took up the cry—perhaps tellingly—on April 1, announcing that its namesake thoroughfare was in the throes of a “credit panic” remediable only by an thorough application of what it called the Glasgow curative prescribed by (the original) Adam Smith: market discipline.
If market discipline can be defined by its opposite, the WSJ editorial board would cite (and often has) the Fed’s massive intervention in the Bear Stearns sale, coupled with its earlier—and also unprecedented—open-ended offer to all investment banks to shore up their balance sheets by putting up shaky mortgage bonds as collateral for short-term loans of Treasury securities. Complementing this was a striking series of rate cuts that almost completely unwound the 2004-06 rate hikes, setting the Fed Funds target rate back to 2.0% by April 2008.
The Bank of England followed the Fed’s suit in April, but with a measure of characteristic British restraint. The BOE offered to take AAA-quality mortgage loans as collateral for up to $100 billion in loans paid with British sovereign debt instruments. American mortgages were specifically excluded from the offer. Neither the central bank of England nor the European Central Bank has followed the Fed’s aggressive rate-cutting policy.
The Fed’s willingness to stand alone on interest rates has exposed it to criticism as the value of the dollar has shrunk versus other currencies, particularly the Euro. With the price of oil and food commodities soaring, the decline of the dollar has been doubly embarrassing. However, even critics of the Fed’s historic moves concede they appear to have been effective, at least in the short term, in restoring some order to the markets. At the very least, the word Panic has disappeared from headlines. There even have been occasional upwellings of investor optimism, as stock traders pounced greedily on good (or relatively good) news from one or another troubled financial firm, betting it signaled a rebound, or at the very least a technical (“dead cat”) bounce.
For example, when Goldman Sachs Group and Lehman Brothers Holdings reported quarterly profits (a happier “p” word), investors pumped Lehman’s stock up 46% and Goldman’s 16%—even though the profits were reported in the context of drastic year-over-year declines.
Likewise, traders greeted UBS’ announcement of a new write-down in early April—raising its total subprime losses from $18 to $37.7 billion—with a buying flurry that pushed the stock up 4.4 percent. Investors were gleeful that news of the additional losses had evoked cries for a break-up. When Merrill Lynch announced its first-quarter loss of $1.96 billion, its shares, which had opened down, bobbed up by more than $3 to gain $1.72 for the day. Citigroup announced a $5.11 billion loss, and gained $1.08 for the day.
Bear Stearns stock was the most remarkable of all in executing a “U” turn in the charts, as J.P. Morgan increased its bid by 500% in response to shareholder outrage at the original $2-a-share offer. Those who bought the stock on the four trading days between the two announcements had cause to be happy (though longer-standing share owners did not).
It is not likely that many speculators (and still fewer investors) thought the subprime problem was over, but clearly many were eager to bet that the worst of it was over.
However, the big questions—how much long-term damage has been done (or is still to be done), and what will be the ultimate cost of repair—are matters of conjecture. The most rigorously derived estimate (that of the Greenlaw group) projects $400 billion in direct losses, and an enduring 1½ percentage-point drag on the Gross Domestic Product, due to curtailed lending by stricken banks. Directly measured losses declared by corporations measured $150 billion in the fourth quarter of 2007 through the first quarter of 2008, according to the Wall Street Journal. Analysts at Standard & Poor’s, said the newspaper, project tangible losses ultimately will reach $285 billion. If so, the impact on the GDP forecast by Greenlaw et al could prove optimistic.
When the smoke at last clears, and the damage redressed, a central mystery likely will remain of exactly how the largest and presumably shrewdest investment firms in the world—firms that literally form the bedrock of our investing apparatus—came to be skewered on junk mortgage bonds. How did they come to stake their very lives on packets of dodgy mortgages that they had themselves assembled, and understood better than anyone else could have?
Bibliography:
Leveraged Losses: Lessons from the Mortgage Market Meltdown, David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (University of Chicago Graduate School of Business; National Bureau of Economic Research; Federal Reserve Bank, Chicago) and Hyun Song Shin (Princeton), U.S. Monetary Policy Forum Conference Draft, 2008.