It's Called Discipline

In this weeks edition of The Economist (May 17 -23, 2008) the "Special Report" section talks about the future of banking. But the first two articles deal a lot with the history of banking - especially the past 8 years.

The recent "Subprime crisis" seemed to pretty much pop up overnight. One day shows like "Flip This House" (and its knock-off cousin shows) were all the rage, making people think that all you needed to do in order to make $80,000 was a short-term bank loan, 4 friends, and 3 months to fix up a house.

Then reality hit.

But did it really just pop up overnight? Were there some signs that were pointing towards this?

In the opening article in the Special Report section (Paradise Lost) the chief risk officer at Credit Suisse, Wilson Ervin, apparently saw the "signs of the gathering subprime storm in America...in late 2006." But what brought about these warning signs?

The second article (Ruptured Credit) sheds a little more light on this question:

The value of subprime mortgages originated in America shot up from $190 billion in 2001 to $600 billion in 2006.

That is an over 300% increase in 5 years. But this begs another question: Why would banks and financial institutions underwrite these loans to begin with?

Let's start with an understanding of how banking has worked for a long time, in regards to mortgages. In a nutshell, a person would come to a bank in order to get a loan to buy a house. The banks would check the credit history of the applicants, and if they met a certain criteria (credit score) the bank would see them as a fit to give a loan. If they did not meet the criteria, they wouldn't give them a loan. The reason? The bank would hold onto these loans on their balance sheets, and if the person defaulted on the loan, the bank's only way to get back the money that they lent was to repo the house and either sell it or auction it off.

But a good idea started to crop up with the bankers: why not bundle the loans into something similar to bonds - in short, make loans tradeable on the secondary market as securities. Securitization is the process of turning the cashflows from a pool of underlying assets (such as a mortgage) into bonds. Simpler still, it lets the bank take that loan off the balance sheet and record cash inflows on their statements of cash flows.

Now comes the interesting part. What was meant to be a good thing - put more liquidity into banks and lending institutes in order to make borrowing easier for people needing a loan- was corrupted by greed and careless risk-management.

Securitisation...degrades credit quality by weakening lenders' incentives to monitor the quality of the loans they write. If loans were even less likely to come back to their originators, this monitoring problem would only get worse...Many mortgage brokers and originators were concentrating on writing as many loans as possible and passing them on to arrangers who would parcel them into securities.

But it gets worse:

Higher volumes went hand-in-hand with lower standards...Standards weakened most where the risks were highest...A series of academic papers has shown that lending standards slipped farthest when loans were securitised.

So this crisis, that seems to have blindsided a lot of banks and lending institutions (Northern Rock, UBS, Bear Stearns, Citigroup to name a few) should have been very obvious - in hindsight. There seems to always be parts to every story that makes things seem a bit more gray.

Many blame the central banks: tougher monetary policy would have encouraged investors to steer towards more liquid products. Others blame the investors themselves, many of whom relied on AAA ratings without questioning why they were delivering such high yields.

One thing to keep in mind is that, in credit ratings, the higher the rating the lower the return on investment. So a AAA-rated bond (which are suppose to be the safest investments you can make) should have a lower return than a AA-rated bond - and so forth down the list. So why were these highly-rated mortgage-back security bonds delivering such high returns?

Loans in a securitised pool of mortgages are divided into bands based on their credit risk. The safest, "senior" ones at the top have first claim on the cashflows from the underlying assets; the riskier, "subordinated" ones below are next in line. Buying senior tranches offers protection against losses up to a certain level, which was fine until losses exceeded expectations. Investment-grade credit ratings for the senior tranches suggested they were safe even when the underlying collateral was all subprime.

Well, there seems to be the problem.

With large players, such as Merrill Lynch, UBS, Bear Stearnes and others wanting in on these super-safe (remember, A - AAA-rated securities), high yield investments, greed took the place of common sense.

Deals were being placed within three weeks of being announced, sometimes giving credit committees as little as two days to make a decision, at a time when there were lots of other offerings to review as well. "Some investors did their homework, sending pages and pages of questions in writing," says the head of securitisation at one bank. "Others just asked for the price."

Therein lies the reason why many of these banks and financial institutions have now become shells of their former selves. They invested billions - if not trillions of dollars - into pools of mortgage backed securities without ever doing any of their homework.

Securitisation may have given this boom and bust its own distinctive flavour, but the core ingredients are drearily familiar: over-eager lending, careless investing and a widespread failure of risk management.