Tuesday, April 01, 2008

Understanding the subprime crisis and its real victims

Here's your chance to be the only on your block who understands the subprime loan crisis, what it
means for the average Canadian and why it's so alarming.
The crisis has driven down stocks and sent U.S. real estate values plunging. As a result, among other things,
demand for B.C. lumber has plummeted.
Canadian banks have lost billions. Thousands of families have lost their homes. The U.S. government, the
supposed free-market champion, has used taxpayers' money to bail out banks and investment companies that
recklessly lost money.
And some individual Canadians have seen their life savings vanish.
Here's what happened.
Once, banks lent people money to buy homes and then collected the mortgage payments for 25 years. They made
money as long as the payments kept coming. So naturally they were careful to loan to people who looked able to
pay them back. The banks also made sure the houses were worth enough that they could always foreclose.
About 30 years ago, very clever investment bankers had a good thought. They went to the banks and pitched the
idea of bundling hundreds of these mortgages together, calling them asset-backed securities and selling them as
investments, promising annual payments to the security holder.
The investors got a good return; the banks gave up some revenue but got all their money up front, instead of
waiting for 25 years; the middlemen got a big commission.
It was a success. A rising real estate market gave everyone comfort; even if a few borrowers did quit making
payments, the increase in value in their homes would ensure they could be sold for more than the debt. The
investors felt safe.
People and funds flocked to buy the securities. The banks and financial institutions needed to start writing a lot
more mortgages so they would have something to sell.
But now they weren't thinking much about whether the homeowner could keep making mortgage payments for
25 years. They were looking to find a buyer to take the debt off their hands within six months.
Subprime loans, they called them. Homeowners paid higher interest - which investors liked.
But they put nothing down, or got big mortgages they couldn't really afford. Lenders offered low payments for
the first two years - long enough to bundle the loans and flog them as asset-backed securities to investors.
And people rushed to get the mortgages and buy houses. We're optimistic. We figure we'll find a way to make the
payments. If not, our houses will have risen in value. We'll sell, pay off the mortgages and come out ahead.
Everybody was keen.
So imagine you're in charge of this business for a hot investment bank, pulling in $7 million a year. You have to
sell more secutiries this year than last, or you're toast.
Everybody got a little loose about quality. Banks make bad loans to new homeowners. Investment houses grabbed
dubious mortgages. Some were shifted on to unsophisticated investors, or they couldn't be sold and banks were
stuck with them.
Then it collapsed. Mortgage holders defaulted. Lenders seized homes but couldn't sell them, as property values
fell. Individuals found their savings had vanished.
The public corporations stuck with the securities on their books had to admit they weren't worth what the
managers had claimed - not even close. One big company, Bear Stearns, was worth $20 billion a year ago. Last
week, it was bought for $1.2 billion.
Shareholders and securities' owners got creamed.
And a lot of people made a lot of money along the way.
It's remarkable on one level. This was a business worth hundreds of billions of dollars that produced nothing. It
made money by persuading people to take increasingly greater risks in the hope of reward.
The lesson is that you can't really trust anyone. And the big guys don't pay a big price for their sins.
Footnote: Hearings have started on a proposed plan to settle with Canadian investors, including about 2,000
individuals who are being offered a fraction of the value of the securities. In return, they will have to give up their
right to sue the banks, investment houses and individuals who sold them the bad investments. The early reaction
has been fiercely negative.


Anonymous said...

Nobody can take advantage of you unless you let them. I have little sympathy for people who got burned in the subprime mortgage crash. If you can't afford to take a risk, then it's not a risk but a gamble.

My sympathy for those who lost their homes to foreclosure is also limited. They were given a chance to own a home despite a poor credit history, and they blew it again. People have to live somewhere, so their actual losses should be adjusted for what would've been paid in rent otherwise. In many cases, there's not much of a difference.

The bail-out of the investment sector seems unfair, and it is unfair. However, it's pragmatic. If the investment sector melts down, the economy loses liquidity. It becomes hard to obtain financing for new projects, people have less to spend, and we sink into an economic depression. Some problems are just so big that blame is pointless - you just have to fix the problem.

Anonymous said...

Keep in mind that a few farsighted US states saw the subprime debacle coming and enacted lending laws to protect people from themselves.

The GW Bush administration nullified the state laws after being lobbied by banks... The Bushies stated that federal law prevailed and would be enough to protect people.

Bernard von Schulmann said...

The sub prime crisis on the US shows that there are two things government should do differently.

1) Introduce better regulation of consumer lending with legislated limits to debt and interest rates. Also monitor closely the financial institutions lending.

2) Education of the public - have courses in grades 11 and 12 dealing managing your money for your life. Also require a weekend course to be taken by the public before they can take out their first credit card, loan and mortgage. The general public is generally rather unknowledgeable about money and finances. An example of course is http://www.moneyminding.com/default.php