My understanding of current economy #2

1. What happened?

Investment banks (or the so-called Wall Street banks, but actually it should include the I-Bank departments of universal banks too) have been taking care of people's money for years (about 150), that include different corporations, rich men, pension funds, and so on. By looking after their wealth and make good returns for people, they've gradually earned good reputations.

- Top graduates want to join I-Banks, because it's "cool" and more importantly they pay handsomely;

- they have been the biggest buyers of financial services and technology, and many other things (like cars, real estate, etc..);

- people in general pay more respects to bankers, compare to other professionals.

Fast forward to the 21st century, banks and investors rely on a lot of these investment banks to trade with and invest on. For example, when an investor want to invest on high return securities, a bond issued by Lehman Brothers would be a save and good option.

Inside the banks, traders would look for all possible ways to increase their rate of return with the massive capital they have, which in turns of course will give them higher bonuses.

I got this from a CNN article:

“Wall Street is a most unforgiving place to do business. Blood in the water will attract sharks, competitors will quickly build up trades against a debilitated foe, and a panic can accelerate a downward spiral. That's why institutions like E.F. Hutton, Barings, and Long-Term Capital--names that once conveyed soundness and permanence--vanished almost overnight.” (source: see here)

Different innovative financial products then started to appear in the market, and many of them are complicated derivatives and structured products which I can tell you, only a small group of people on the planet really know what they are, how they behave and most importantly what risks are involved. Still, every trading day billions of dollars are involved in trading of those.

Sub-prime mortgage and MBS

One of these structured products is called MBS, Mortgage Backed Securities. It’s still a general term for different varieties of MBS. But in short, mortgage companies (like building societies) and banks who lend mortgages, sell their mortgages to Bank A. Then Bank A put different mortgages together (structure and package) and sell them in the same way as a normal security (for example, the description would say it gives you quarterly coupons of 13%). It offers higher return than risk free products, and attracts a lot of buyers.

The arranger can bring the MBS that they package, to a credit rating agency e.g. Moody’s, Standard and Poor’s, pay them service fee and ask them to give their products a rating. The agencies are independent firms, so they won’t deliberately give good ratings. But they don’t actually have a good model to see the risks of these products. So many of these MBS have good ratings, even though the actual risks (which you only see after you are hurt by them) are high.

In the past few years, the house prices in the US have been rising dramatically, in the same time interest rates have been low. With very little control on mortgage application (unlike Hong Kong, where any mortgage more than 70% would need special application and addition insurance cost, thanks to 1997 local housing bubble), mortgage companies lend money to jobless homeowners to buy houses, sometimes even with cash backs. (Can you imagine that?! You walk into a mortgage company branch, 30 minutes after you walk away with a 3000 sq. feet house and cash to spend!) Because they see the house prices would rise and not afraid of the borrower failure to pay. That resulted in a massive amount of so-called “Sub-prime mortgage”.

Combine with many more reasons, such as the general spending habits of US people (last year, the total expenditure was about 6% more than US total GDP, where did they get the money from? Look at the trillions of US bonds and notes owned by Chinese and Japanese government), the price of these MBS and other similar products then rose and rose.

Big bubble -> big trouble

People seem to have forgotten one thing: these products offer higher return rate because they are risky. The most obvious risks are:

- Credit risk - underneath the security is a group of mortgages, with home owners who have to pay the mortgage company every month. If they default (go bankrupt, or fail to pay), it affects the coupon payments of the MBS, and hence the value of the MBS should go down.

- Interest rate risk - Interest rate may go up, which means the gap between risk free products and these MBS would become smaller, and therefore the value of the MBS should reduce.

- Counterparty risk – What if the bank who arranges the MBS go bankrupt itself? No one will pay any coupon anymore for these outstanding contracts.
Of course there are many more risks to these products, similar to any other investments.

The now-nationalised mortgage giants Fannie Mae and Freddie Mac were active players in the MBS market (see here). Originally they were not. They saw a lot of investment banks making profits from trading these products. But as market participants, they knew the risks. But in a Bull market, how can you justify to your management and shareholders of making such less profit compare to others?

So they were "forced" to play the game as well, even in their risk management system, everything is in red alert because of the high risk exposure. "Never mind, you make the money and you walk away with the bonus." Sounds like Homer, duh!

You can in fact buy or implement the best risk management software available, but if the management chooses to ignore it, due to human judgements, greeds, etc.., the results we see today are inevitable.

More to come...