Bicolano magic in a can - Planters Development Bank

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Making Sense of the U.S. Financial Crisis 20 SME.COMmunity.PHilippines What funded Sub-Prime Lending? Subprime lending was developed in the late 1990s in the United States and became popular in the past five years. Subprime lending simply means lending to people who have questionable capability to repay the loan. Banks, generally, lend to prime clients or those who have a good credit rating. A good credit rating is earned by showing the capacity to pay back loans, no history of late or non-payments, acceptable property for mortgage etc. Those who do not pass the bank checklist are below prime or “subprime”. In any transaction, the higher the risk, the higher the rate. Subprime loans carry very high risks for the lender and thus, have very high interest rates. Photo from dreamstime.com The subprime market was an opportunity for financial institutions to generate more profit by developing securities (tradable investment instruments) related to subprime loans. With aggressive global investment banking, these investment instruments with high returns reached financial markets all over the world and were snapped up by all kinds of funds. As demand increased, the U.S. financial institutions granted more and more Subprime loans. Over the past 10 years, the world saw massive inflow of capital to the U.S. Savings from Asia and Europe were seeking investment venues to fund their social overhead and sustain positive economic growth. Only the U.S. had the capacity to absorb these funds. Housing-related investment instruments, subprime lending included, offered a unique opportunity to the entire world. Meanwhile, the culture of credit spending was pushing the American public to consume more. With credit cards, liberal consumption and now liberal housing loans, America increased its importation thus sending its dollars to China, Europe and Asia. Awash with U.S. dollars, these countries were snapping up U.S. Treasury Bills and Bonds and mortgage notes. It was and continues to be a vicious cycle. On the other hand, the U.S. housing sector, was going wild. Lenders having cheap funds from the world gave out loans right and left mostly based on perceived increasing value of houses. Mortgage brokers wanting to earn more commissions pushed borrowers to cash in on their “home equities” or to borrow more using their now higher valued homes as collateral. With additional loans, they could fund everything from consumer goods such as toys, plasma TVs (from China and Asia), cars, vacations, second and even third homes. Freddie Mac and Fannie Mae, two Government Supported Enterprises (GSEs) accelerated its massive purchases of mortgage papers from U.S. domestic lenders and issuances of credit guarantees to U.S. as well as global investors. Investment Bankers and Insurers became more creative to fuel more credit. More money was made available as investment bankers and insurers became even more creative issuing asset-backed securities and forms of complicated debt instruments. They are not restricted by strict capital requirements as commercial and savings banks. They bundled individual mortgage notes valued based on the increasing housing prices and sold them off to domestic and foreign investors as high yielding instruments. These are the securities referred to as Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs) and other similar structured products. No real attention was given to the fact that a good number of these mortgages were loans given to borrowers with no real capacity to pay. The commission-driven mortgage brokers aggressively sought out borrowers and arranged housing loans with banks. Banks were eager to lend since they could sell these same mortgages to Freddie Mac and Fannie Mae very quickly. There was just too
MONEY MATTERS much money available and too much money to be made in giving out housing loans. These CDOs and CLOs became even more saleable when Wall Street players included something like an insurance policy in the package (Credit Default Swap or CDS). With the insurance guarantee, rating agencies (like Standard and Poors, and others) gave AAA ratings to these structured products. Thus, even top banks like UBS, and Citicorp invested substantial amounts. Eventually, Citicorp and UBS covered their huge losses of $62Billion and $42Billion with new capital right away. Latest information from the IMF is that subprime losses of banks have reached over $500Billion. More and more investment instruments based on the value of other assets or financial instruments called Derivatives, took over the financial markets providing instant margins to traders, brokers, investment bankers and insurers. These Wall Street operations were producing sustained profits out of buy and sell transactions of CDOs and the growing liabilities were not reflected in formal records (kept off-books). All eyes were on the margins and profits as if there were no real risks and as if the increasing price of housing which was the fundamental basis for the asset value would never stop. The fact is, it did. In summary… 1. What funded Subprime? Too much capital from foreign investors looking for yields higher than what their own countries could offer. 2. Where did these funds come from? In the case of China and Asia, their exports to the U.S. mostly made up of consumer goods. In the case of the Middle East, oil proceeds from global energy imports. 3. How did Subprime get to grow to such high levels? a. Wall street’s creativity in developing securities without adequate regulation; b. the failure of the established rating agencies to properly assess the true credit risks and; c. the unmitigated insurance cover (CDS) on payment defaults sold over-the-counter. Neither the Insurance nor Securities Regulators regulated them. The U.S. Credit Crisis in Perspective Here are a few statistics cited from the presentation of Mr. Helmut Schnabel, Chairman of the International Association of Financial Executives Institutes (IAFEI) in its summit on September 5, 2008. 1. Total Subprime mortgage loans in U.S. in 2007 was $1.2 Trillion. 2. Total private mortgage loans in U.S. today is about $12 Trillion 3. Total non-mortgage debt of private households (i.e. credit card, auto loans and other consumer credits) is $2.5 Trillion 4. Total U.S. private household debt is thus $14.5 Trillion 5. Net worth of private households in U.S. in 2007 (i.e. their total assets less their total debt) amounts to $58 Trillion. 6. Private household assets to their total debt ratio is a healthy 5:1 7. Actual losses of banks and intermediaries from Subprime loans are in the magnitude of $512 Billion. This represents approximately 3.5% of private debt and less than 1% of private household net worth. 8. In the last two weeks, new capital infusion of almost $400 Billion was raised to offset the above losses of the affected financial institutions. These numbers indicate that it is more fear and panic that is causing the present credit and thus liquidity crisis to further drive financial markets down. More than anything, it is clear that the U.S. consumer and the economy remain viable and nowhere near being in the brink of collapse. In the Philippines, we have the opportunity to turn this global crisis to grow our economy in our own way. FRANCISCO J. COLAYCO is an entrepreneur, a venture developer and financial advisor. He is the Chairman of the Colayco Foundation for Education (CFE) and the Author of Bestsellers: Wealth Within Your Reach (2004 Book of the Year for Business and Economics, National Book Awards), Making Your Money Work (Nominated for 2005 Book of the Year for Business and Economics, National Book Awards), Pera Palaguin Workbook and Money for Kids. The books are available at National Bookstore, Power Books and other bookstores. CFE conducts talks, seminars, and workshops. Learn more about our advocacy at www.colaycofoundation.com, email info colaycofoundation.com, via SMS 0917- 8537333 or through 637-3741. 21 VOL. NO. 03 / ISSUE NO. 05
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