Root of the problem? What Can Be Done To Make Banks Lend?

Refusal is not the only reason that someone might not have all the insurances (or is it assurances?). Take myself, for example. I tried to apply for such an insurance but, owing to a very minor health problem several years ago, the companies want to load my premium, thereby make it unaffordable and also poor value.

You have your income from these "failed" banks?

Looks like their website is kerplunked. Here's an earlier draft of that article:

WHEN MORTGAGES BUY THE FARM by Mike Holmes

Why did Northern Rock start to crumble? Is the credit crunch a new kind of breakfast cereal? And who blew the financial bubble? MIKE HOLMES follows the money in search of some answers.

If you've been resorting to the usually discarded business sections of the newspapers, you may be finding that the articles might as well be written in Klingon. What follows is for people who want the world of high finance explained in down-to-earth language..

Let's start with Frank Capra's 1946 movie It's a Wonderful Life, starring Jimmy Stewart as a small-town hero running a local bank known as a "Savings and Loan". Some of the bank's funds are stolen and the customers all queue up to demand their money back. Just when things are at their most desperate, the Ghost of Mortgages Past appears, shows Jimmy the difference he's made, and encourages him to explain that one person's deposit account had been loaned out as his neighbour's mortgage. The customers realize that the true safety of their money lies in the bonds of their community, the bank is saved and everyone thinks they finally understand mortgage finance.

A great number of people imagine that their own mortgage currently resides with their bank and hopefully has someone like Jimmy Stewart looking after it. In the US, this was largely true until the the Savings and Loan (S&L) Crisis in the 1980s caused many such banks to go under, unable to cover their debts. The S&L Crisis, which J. K. Galbraith called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time" ultimately cost US taxpayers close to $150 billion. The current President's uncle, Neil Bush, was Director of Silverado Savings and Loan, which alone lost $1.6 billion.

The problem started in the 1970s when, as a result of rocketing inflation, the S&Ls found themselves paying depositors higher rates than they could charge on fixed-rate mortgages--the only kind they could legally offer. This gradually eroded the solvency of the S&Ls. In a last-ditch attempt to save the system, they were deregulated. They then proceeded to enter new financial markets previously available only to the big banks. Crucially though, they were still exempt from the regulation which oversaw the larger banks and thus could undertake business without scrutiny. Through a combination of fierce competition for money, reckless incompetence, greed and peculation, the entire Savings and Loans system was undermined, and a large number of S&Ls collapsed.

Enter Fannie Mae and Freddie Mac. They sound like Elmer Fudd's cousins, but in fact, they're two giant financial companies formed by the US government to help poor people get mortgages. Because of the vacuum left after the S&L crisis, they shortly owned or guaranteed 90% of the

1400000000000 Dollar mortgage market in the US. They achieved this largely by taking advantage of the fact that investors assume that if such giant companies were to get in trouble, the US government will have to bail them out. Everyone gives them preferential rates on that basis and they used these beat their competitors on mortgage deals.

Fannie and Freddie generally deal in what are called "prime" mortgages. These are mortgages where people of good credit put down a deposit of

20% or more and agree to pay a fixed rate of interest for 25 or 30 years. Those people supply proof of their income which is duly checked, and a surveyor is sent out to confirm that the house is worth at least as much as the mortgage. So when a pal of Homer Simpson goes to a mortgage broker or a bank to get a mortgage, these checks are made, a deposit taken and a cheque written. The mortgage broker takes a fee and then immediately sells the mortgage to Fannie or Freddie, leaving him with the cash to make the next mortgage. The broker then receives further fees to handle the monthly payments and ensure these get to the eventual owner of the mortgage.

Once they've bought a few thousand mortgages, Fannie and Freddie package them up into asset-backed bonds known as "mortgage-backs". These are then sold to investors on the basis that those investors will collect the interest, and if the interest isn't paid, or the house is ever sold for less than the mortgage, Fannie and Freddie will make good the investors' losses. This left competitors to Fannie and Freddie looking for other ways to make money.

One way was to create mortgages for the folks that Fannie and Freddie wouldn't touch because they couldn't put down a 20% deposit or because they'd defaulted on a credit card or car payment and had poor credit. Mortgages for such people are called "subprime". These companies used computer programmes to create "credit scores" for applicants which, it was claimed, could distinguish between subprime folks who would dutifully pay their mortgages and those deadbeats who wouldn't. The interest rates on the mortgages were graded in such a way that folks with lower credit scores paid higher interest rates. A basic rule of finance is that the more risky a deal, the higher the interest rate required to persuade an investor to finance it.

The people looking for subprime mortgages were often relatively poor. A typical couple with one child, let's call them Larry, Mo and Curly, had no savings but want to quit renting a flat. Their plan was to take a mortgage on a house for a couple of years and wait for house prices to rise, as they always had in the US since forever. Well, since the Great Depression of the 1930s, but to modern folks, that's as near "forever" as makes no difference. They hoped the house would rise in value by at least 20% because they could then sell and use that profit as the 20% deposit on their next house, obtaining a Fannie-approved prime mortgage at lower mortgage rates. They calculated that even if something went wrong and they went bankrupt, they couldn't be in any worse a position since they were basically starting from broke.

The mortgage broker who provided their loan, let's call him James, acts just like Fannie and Freddie and converts these mortgages into mortgage-backs and sells them to the big investment banks on Wall Street. This brings him money to make new loans and he gets a fee for every loan he makes. There's a crucial difference between Jimmy Stewart and James though: Jimmy had to watch out for bad loans because they'd undermine his bank while James will have sold on the loan and so he isn't at risk. James thus has an incentive to make as many loans, and gain as many fees, as he humanly can. Besides, he knows that since house prices always rise, if things go bad then the house will be sold to cover the loan. James also realises that if he doesn't make a particular loan, the competition down the road will, and they'll get the fee. James is thus ready to make a loan to anyone who can fog a mirror.

The Masters of the Universe on Wall Street then buy all these mortgage-backs based on subprime loans. They have a problem though: the folks they want to sell them to, the insurers, pension funds and hedge funds, can only buy investments which are rated "Safe" by the ratings agencies. By definition ,these subprime loans are not. This is where the financial engineers get to work and build a ?derivative? called a Collateralised Debt Obligation or CDO.

To make a CDO, they might take a number of mortgage-backs and bunch them together. Then they slice up that bunch into "tranches". They write a rule that says that when a mortgage from the CDO defaults, the lowest tranche must take the hit. Only when the lowest tranche has taken a large number of hits do defaults start to affect the next tranche up and so on. The lowest "equity" tranche, known affectionately in the business as "toxic waste", might be 10% of the whole CDO and will be sold paying a high interest rate to compensate for the extra risk. The next "mezzanine" tranche could be of a similar size and will be sold with a slightly lower interest rate. The other 80% is thus protected, unless there are a huge number of mortgage defaults, and these layers of protection get it rated "Safe" by the ratings companies. Thus it can be sold to the target market earning a nice fat fee for the Wall Street bank. This conveniently provides money make another CDO.

There are three main ratings agencies: Fitch, Moody's and Standard & Poor's. Their job is to analyse various forms of investment and give them a rating based on how likely they are to default. The top, most sought-after, rating is AAA, which is equivalent to bonds from the sort of governments who aren't likely to run off to Argentina the next morning. British and US government bonds, for example, are AAA. Large investors, such as pension funds are often legally bound to buy investments at or above a particular minimum rating. Rather than analyse all the sundry investment possibilities themselves, they'll instead just look at what the ratings agencies have stamped on the products. They only need to know the rating and the interest rate that the asset pays.

The top tranches of many subprime-based CDOs receive AAA ratings, making them supposedly as safe as government bonds. What happens to the toxic waste tranches is more exotic. These are of course difficult to sell since their owners are volunteering to take a hit whenever a subprime mortgage anywhere in the whole CDO goes into default. The large Wall Street banks would rather not keep these on their own books for obvious reasons. What they do is form their own hedge fund and put, say, a billion Dollars into it. Then the hedge fund buys the toxic waste from the parent bank.

House prices rise and the toxic waste is now safer because, even if owners default, the house can be sold to pay off the mortgage, meaning no hit to the CDO. A safer product rises in price and so the hedge fund is now showing profit, which can attract investors. If global investors put in a billion Dollars, then the hedge fund now has two billion and a bit Dollars. The parent bank can then loan it 20 billion Dollars based on the collateral of whatever the hedge fund buys using the money. The fund now has 22 billion Dollars. It can use this to buy more toxic waste from the vaults of the bank.

This extra borrowing is known as "gearing" in financial circles. The way it works is very much the same as it does for a homebuyer. Let's say you put down a 10% deposit on a house, get a 90% mortgage, and house prices then go up 20%. You now own 30% of the value of the house and have tripled your deposit money on what?s quite a small rise. Hedge funds use gearing in exactly the same way to multiply profits. The trouble is that gearing also works in reverse: if your house instead falls in value by 20%, then you own minus 10% of your house. You've lost all your deposit and you now owe more than your house is worth. This doesn't work any differently for hedge funds.

This is how the first hole appeared in the global credit bubble. In June, two hedge funds owned by Bear Stearns, a large investment bank, got into trouble. Their worried lenders began grabbing the investments used as collateral and tried to sell them on the open market. This was highly unusual since these assets usually trade in-house and are valued by mathematical models rather than by what they would fetch in open sale. The prices at auction started at 80% of that mathematical value and falling. This caused a panic because, if they sold at such values, everyone everywhere with similar products would have to "write them down" and reduce the net worth of their portfolio, possibly causing them to show losses. For hedge funds, that's the sort of thing that makes investors unhappy enough to take out their cash, forcing more assets to be sold and a vicious circle to be created that ends in the classic run on the bank.

The sale was, under pressure from the big players, quickly pulled and a bailout for the two hedge funds arranged. Within a month, though, one of the hedge funds was declared "almost valueless" and the other so impaired that it refused investors access to their money. Warren Buffet, the world?s most successful investor, called derivatives ?Weapons of mass financial destruction?.

Not unnaturally, people who had their money invested in derivatives began to wonder how safe their cash was. They looked to the ratings agencies who were supposed to tell them how safe it was and discovered something unnerving: the ratings agencies were paid by the folks creating the CDOs to help them get the sorts of ratings they needed in order to sell them. They began to wonder if ratings agencies can be entirely fair and unbiased in such circumstances. After the Bear Stearns episode, there were clearly grounds for worry that CDO ratings might not be all they were cracked up to be. The ratings agencies then stated that they only rated the chances of assets going into default, not the chances of them falling in price. This was not what investors wanted to hear.

It dawned on many people at this point that their investments weren't in good hands and they began to retrieve them. Hedge funds around the world then had to sell assets to pay investors. When there's a lot of selling of something, that something tends to fall in price. This made lenders to hedge funds worried and start to try to call in their loans. Many hedge funds began to realize they were in trouble and cancelled the right of their investors to redeem their cash until the fund could be liquidated. The result is that substantial numbers of investors will lose at least some of their money.

It goes without saying that there aren't many people looking to buy CDOs right now. This means that the Masters of the Universe on Wall Street will be denied the giant fees they get for this work. Indeed, in the past week, several such banks have had to write off multiple billions of Dollars lost in the market turmoil of recent weeks. The Masters of the Universe are looking at no Christmas bonuses and the certainty that many of their number will soon be looking for other work.

No more CDOs means that nobody needs to buy the subprime mortgage-backs required to create them. This means that folks like James, our original mortgage broker, can't sell mortgages to get money to make more mortgages. And this means that he can't earn the fees that he needs to pay his own mortgage. Worse, it turns out that a clause in many mortgage-backs says that, if the mortgage defaults in the first six months, the onus is on the original broker to make good the investor. Some homebuyers only ever made their first payment, and they're required to make that one when they sign the mortgage forms.

James now has no money coming in and investors chasing him for recompense for the deadbeat mortgages he originated. James, and a lot of others like him, is going bankrupt, and nobody is going to send an angel. In the US, more than 150 national mortgage brokers have gone under since the Bear Stearns episode, with the biggest broker, Countrywide, on life-support. Needless to say, this makes it very much harder to get a subprime mortgage at all. Those few who can still get them will pay interest rates closer to 11.5% than the 8.5% they'd have obtained in May. This is because the risk of making subprime loans has clearly risen and the investors require higher rates to compensate them for the extra risk. The US Central Bank, trying to help, cut the US interest rate by half-a-percent last week. The investors however, concluded that this might lead to higher US inflation and promptly raised the mortgage rate to compensate themselves for that risk too. In the days of Jimmy Stewart, the Central Bank controlled mortgage rates. Now it's international investors who call the shots.

This means trouble for our homebuyers Larry and Mo. They got a mortgage at a "teaser rate" of 4% for two years. The 4% wasn't enough to pay even all of the interest, and the rest has been added to the capital due. When their two years are up, they'll move to that 11.5% rate and they'll also start paying capital. Thus they'll see their monthly payments almost quadruple when already they can barely afford to pay the teaser rate. Their plan to sell and raise the 20% deposit on another house is in tatters because house prices haven't risen in the US in the past two years and they're now going down. They can't even quit the house because the sale price would be lower than the mortgage as a result of their two-year period where the missing interest got added to their loan. Then there's the several thousand Dollars they'd need to pay off the various fees involved in selling.

Most likely Larry and Mo will, over a period of a year or so, see their house foreclosed (repossessed) as they fall behind with the mortgage. Then the house will be sold for less than the mortgage and they'll be looking for somewhere to rent while still owing some money. Their defaulted mortgage means that a toxic waste CDO somewhere will take another hit, adding to the credit crunch. The good news for Mary and Moe is that the rest of the debt will probably be written off. The bad news is that this is seen as income by the taxmen and they'll be due an immediate payment of taxes on what's written off. Currently the US government are trying to change that.

US houses are going into foreclosure at a rate of two million per year. This is likely to increase in the next year as more and more subprime mortgages come to their two-year resets. Each foreclosure is another property heaped onto a market already in a glut. If no more properties came onto the market in the US, it would take ten months at current rates of sales to clear those already looking for a buyer. Each house foreclosed means another family which can't buy a house and their credit will probably be ruined such that they never will.

The omens for house prices falling considerably further are worrying, and each further fall will mean more mortgages in trouble and another turn of the screw for CDOs. Even the supposedly safe AAA tranches of CDOs are taking hits. The toxic waste and mezzanine tranches are often nearly worthless. Worse, the carnage is spreading outside subprime mortgages.

"Alt-A" mortgages, which lie between prime and subprime are in almost as much trouble. "Jumbo" mortgages, made for people buying houses too large to be insured by Freddie and Fannie, are seeing more and more defaults. There are even some prime mortgages going into default. This means that Freddie and Fannie are being called upon to make good investor losses on the mortgages they guarantee. Given that between them they insure 1.4 trillion Dollars of mortgages while having capital of around 3% of that total, it's possible that they themselves could run into trouble if US housing markets continue to get worse.

The UD central bank says that there is no guarantee of a taxpayer bailout, but if this did happen, there would be almost nothing left of US mortgage markets -- it's hard to imagine what would happen to US housing if it was difficult for everyone to get a mortgage. There may now be other holes appearing in the bubble: CDOs based on credit cards and car loans in the US are now also running into trouble. As the debt from mortgages spread to banks and hedge funds around the world, it meant that the problems caused by their collapse has also affected economies everywhere. As these financial instruments went global, they created debt to feed housing bubbles in the Britain, Ireland, Northern Ireland, France, Spain, Belgium, Holland, Italy, Australia and New Zealand. Currently, the bubble has burst in Ireland, Spain and France; and is bursting in Northern Ireland Australia and New Zealand.

US subprime mortgages have been blamed for the global credit crunch. There's no doubt however that the credit bubble itself was global and it may be that US subprime is simply where the first leak appeared. These problems are not unique to the US and it remains to be seen where the next holes in the bubble will appear. In Hamlet, Polonius advised his son to "Neither a borrower nor a lender be". This never looks more wise than in the denoument of a credit bubble. Let's hope the stage doesn't end up littered with bodies when this tragedy ends.