Why would anyone want to buy subprime debt?
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The big financial houses in the City and on Wall Street are downgrading their own paper. Merrill Lynch analysts have cut their recommendations on shares in Goldman, Lehman and Bear Stearns, as well as those of Deutsche Bank and Credit Suisse Group, from ‘buy’ to ‘neutral’. As for the bonds of the three biggest securities firms – bond traders (many of whom are employed by these same three biggest securities firms) are buying and selling them at prices more suitable for junk bonds than to masters of the universe. On Tuesday, Goldman Sachs astonished analysts with higher earnings than any had seen coming; still, investors sold off the stock.
How subprime debt tripped up the big banks?
The banana skin on which they have slipped up was sub-prime mortgage lending – and a special kind of mortgage in particular, known institutionally as ‘low documentation’ loans, and colloquially as ‘liars’ loans’. As to their ability to pay, and perhaps even as to their name and address, lenders took the borrowers at their word. With no solid incomes, nor any real assets to wave as collateral before the lenders’ turned-up noses, the poor borrowers had to fib a little. Anyone but a financial genius could see that ‘liars’ loans’ would be a disaster for someone. But it took a near-meltdown in the mortgage market to bring the point home to investors.
It began on 7 February, when HSBC said it had fired its head of North American operations, after its bad debt – much from subprime ‘piggyback’ loans – rose to $6.8bn. It continued when New Century Financial, America’s second-biggest subprime lender, carrying $23bn in debt, came crashing down. The stock fell from $66 down to near zero, losing 43% in just three days in February, and most of the rest when the New York Stock Exchange halted trading last week.
And what of the nation’s Numero Uno in the subprime market? In 2006, Wells Fargo leaped ahead of Ameriquest Mortgage and New Century Financial to become the biggest funder of so-called subprime mortgages. In December, when other lenders were in retreat, Wells Fargo was increasing its lending to the least creditworthy buyers. It has been accused of ‘predatory lending’. Maybe so. But subprime lenders and the people who lent them money now look more like fools than knaves. Even the smartest lenders – including Britain’s number-one bank – were providing money to these subprime salesmen, all of them presumably aware that their collateral rested on white lies.
Until a few months ago, rising house prices gave them some traction. When a subprime buyer gave up and defaulted, the lenders, or the lenders to the lenders, could still tread confidently, secure in the knowledge that they could sell the house and get their money back – and more. What they hadn’t seemed to realise was what was most obvious – that house prices wouldn’t go up forever. Indeed, some day they might even go down. What bothered New Century Financial was that the people they lent money to could not pay them back. What bothers Goldman, Merrill and the rest of the elite smarty-pants is no different. Their credits are going bad. They applied the same standards to the mortgage-backed securities business as New Century applied to the mortgage itself.
Subprime debt and mortgage-backed securities
Readers may be as unfamiliar with mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) as we are. It may help to imagine the entire mortgage market as a giant pig and the financial industry as a rendering plant. After the prime lenders have taken the hams and ribs, there remain many less appetising body parts. In the mortgage industry, as in the slaughterhouses, those cuts do not get the ‘prime’ label. In lending, they’re known as ‘subprime’.
The low-priced stuff is too disgusting for most people to put directly on the table, so the unidentified pieces are typically run through the grinder. Then they are packaged into old-fashioned, pure pork, mortgage-backed sausages, whose buyers never met the borrowers (and often not even the lenders) and were never privy to the particular lies that coaxed the animal into the abbatoir in the first place. But markets are familiar with these things, know more or less what is in them, and have some idea of what they are worth.
But then the tranches are repackaged – mixing the parts together ever-so-carefully so they don’t go bad – and resold as CDOs, either of the regular or synthetic variety. The whole is better than the sum of its parts, it’s claimed – and the ratings agencies go along. The buyers, with neither time nor competence to double-check assumptions or carefully inspect the sausages – tend to go along too. And thus it is that the cream of the financial industry finds itself in the same position as the subprime lenders – taking liars at their word. The big difference is that the original liars – who bought houses with money they didn’t have – could leave as they came in. The CDO buyers – who bought the subprime debt – put in billions. They will almost certainly leave poorer, but wiser.
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