Sub-prime Crisis and Financial Innovation

Back after a long hiatus! This time with a topic of world interest these days: Finance and Economy. Let us try to understand what exactly was the role of investment banks and financial institutions (and, if possible, the government) in bringing about the current economic crisis.

Financial innovation is a process of introduction of new financial products, for investors and for people seeking debt capital. If used in an apposite manner, they bring about increased efficiency and options to their users - ATMs and internet banking for example. Some financial innovation is specifically adopted to avoid or circumvent regulation. In the case of MBS (Mortage-backed Securities... Yes.. You have heard this term before), possibly that might be the case.

Let us take an example to understand what an MBS is. Suppose Kolya clears his MBA in two years [:)], gets a good job in the USA [:))] and gets an amazing salary [:D] (Highly unlikely given the current economic scenario). He gets married to his beautiful girlfriend [:O] and wants to purchase a home. He goes to a Government sponsored enterprise (GSE) like the Federal Home Loan Bank Corporation (Freddie Mac.. A famous name that went bust in the crisis - though it got bailed out by the US government, and is currently placed in conservatorship of the US government: US taxpayers' money used to bail out a privately owned institution - yes, it is a GSE but it is a private institution after all), and asks for a loan. Now what is the process through which these loans are generated? The general public (let us call them investors) deposit their money with Freddie Mac, to diversify their portfolio of investments, since Freddie Mac is a GSE and considered to expose investors to some (albeit very little) credit risk. So let us suppose Tarantula deposits a sum of 1 million dollars in Freddie Mac and gets some securities called Mortgage-backed Securities (There are many such investors who buy such securities from Freddie Mac, considering that it is considered quite a low-risk enterprise). And Kolya wants a bank loan of 1 million dollars for his home. So Kolya will go to Freddie Mac, show that he is employed and is capable enough of paying his mortgage dues, and will get the home loan. His job goes on well for two years and he keeps his promise. Monthly installments go to the Freddie Mac, which takes some portion of it and passes on the rest of the money to Tarantula as the return on his investment. Say, the loan period is 10 years. If everything goes well, then Tarantula will get his returns by this method each month, while Kolya will get his home loan. Amazing concept.

But this is where the assumptions that go behind this scenario become important. Suppose Kolya goes berserk, and no one wants to give him a job now. He can't pay his monthly bills and can't be expected to pay off his mortgage. Obviously, Freddie Mac would have already considered this scenario and can take possession of the house he bought if necessary and get their loan's worth. There are always some bad loans and this is one such scenario. However, the overall portfolio of Freddie Mac is still well-diversified because most of the people who have taken loans from it are still paying their installments. So all is well and fine. But then, where does the problem lie?

The problem lies in the assumption that Freddie Mac will be able to recover their money from the 1 million dollar house. For that, either its value has to increase over time or it has to remain constant. And this is one assumption that can be considered as the single biggest factor of the entire crisis. Suppose real estate prices come down and the house can only be sold for 500000 dollars. Then what about the rest of the money that is still left? It goes down into the "bad loans" account in the books of Freddie Mac and that is it.

Obviously, in normal days also, such things might happen. But that includes only a limited portion of the loan-takers. In the "sub-prime" case, the people who took the loans did not necessarily have the ability to pay off the loans and the number of such people was very high. The real estate prices go down simultaneously (because of so many defaulters). So Freddie Mac is left with many houses and no money to pay off its investors. The result is obvious.

The question arises: Was it only the assumption of stable real estate prices that was responsible for this crisis? Certainly not. The role of the government is a big issue. At the turn of the millenium, US was growing at a decent pace. Unemployment was quite low and the government wanted to ensure that everybody has a home. A good intention. Hence, the Federal Reserve Bank ensured that there is a lot of money in the system which can be given on credit to the people in need of homes. However, the assumptions mentioned above were not taken care of and the world economy has been brought to the brink of a recession. Somebody rightly said about the crisis: Good intentions do not necessarily give out good results.

While we are at it, let us also consider the role of investment banks. The fixed-income securities (because they give a fixed return every month) that Freddie Mac issues are sold in the market by the investment banks to its clients. So the process goes like this: An investor invests in Freddie Mac, who provides the securities to investment banks in return for funds, which it gives for loans, while the investment banks sell those securities. Investment banks significantly affect demand for these securities. (Let us not consider Structured Investment Vehicles, etc. here... I would like to keep this as simple as possible.. You can read more at http://subprimer.org/node/13). Investment banks, with their trading divisions, make bets using their own money too. Hence, eventually, investment banks also went down with the subprime crisis.

So what could have been done? Till now, everything was fact. What follows is personal opinion. The first thing that comes to my mind on reading everything above is the fact that if the amount of money supply in the market was limited, such that banks and financial institutions did not have as much money to invest as they had, possibly they would have shown a certain amount of restraint in giving money to people without pertinent checks on the ability of those people to repay the loans. This follows from a very fundamental behaviour principle: If I have too much of something, I would have a tendency of not caring too much. If I don't have as much of it, I would use it properly. That does not mean that the Federal Reserve Bank should have sucked all the excess liquidity in the system, but just that the amount of liquidity should have been limited.

The second thing is the role of investment banks and financial institutions. Because of lack of regulation on the activities of these financial insititutions, the money of general public is being played with. Loan providing institutions like banks did not check the credibility of people whom they gave loans to. The investment banks vehemently went on increasing the demand of the highly risk mortgage-backed securities without even looking at the risks involved. Even when a simple government bond is considered, a lot of risks are measured and then a decision on whether to invest or not is taken:
1. Interest rate risk: Effect of changes in prevailing market rate of interest
2. Yield curve risk: Risk according to the maturities of bonds
3. Call risk: Possibility of the application of call option when interest rates fall
4. Prepayment and reinvestment risk: When interest rates fall, prepayments increase which have to be reinvested at lower interest rates
5. Credit risk: Creditworthiness of the issuer
6. Liquidity risk: Whether sale is possible at fair price or not
7. Exchange rate risk: For overseas investors, the exchange rate is a factor
8. Inflation risk: When inflation is high, the returns in real terms might be lower
9. Volatility risk: For fixed-income securities with call/prepayment/put options
10. Event risk: Risk outside the risks of financial markets
11. Sovereign risk: Risk of governmental policies and attitudes towards repayment of debt

If this much is required to be thought of when considering the relatively low return and low risk government securities, it was the responsibility of the investment banks to be cautious about giving recommendations regarding such high-risk securities. Possibly, if there is sufficient regulation, these practices might give way to genuine research before recommending securities.

And last but not the least: Financial innovation. As I said earlier, financial innovation can be a boon by providing investors having different risk-taking aptitudes with different options. However, the effects of financial innovation can be extreme as we saw and hence, there should be a consideration of all scenarios that might result from a financial innovation before going forward with it. For that, possibly each financial institution might have a separate committee which does a scenario analysis and takes into account all complexities and assumptions before going forward with it (I don't know whether such committees exist but it is quite logical to have one). This is necessary because regulators might not have all the necessary information. It is necessary for the financial institutions to regulate themselves in the interest of the overall market and economy as well as in their own interests..

So that was all that comes to my mind about the sub-prime crisis.. It is late night and this is all that I can think of as of now... If there is something else that comes to my mind, I would edit this post.. Ciao..