The real story behind the world’s financial crisis…
Once, when I was just getting my start in global finance, a very clever corporate finance lawyer explained to me what happens when you default on a loan contract. I thought of him this week.
“The damages you pay are to repay the loan, plus interest,” he explained, “but that’s what your contract says you have to do anyway.” He paused, and then he added, “I suppose that’s why everyone lies to the banks.”
We are in the midst of a global financial crisis. It is not clear what proportion of a crisis comprises its ‘midst’, but it is clearly significant, since our presence in the crisis’ midst is now well-established and it appears we’ll be stuck here for some time to come.
Global terms of credit are tightening, as banks seek to reduce risk. Corporate borrowers, many of whom require financing at specific and pre-determined times in the year (when bonds are falling due or are reaching the end of existing credit facilities), face increased costs. Perceptions of risky loan portfolios coupled with falling revenues drive down the price of bank stocks, making it harder to source capital to fund fresh loans. As a result, global terms of credit get tighter. Lather, rinse, repeat.
This cycle was triggered (we now know) by over-excited lending into the ‘sub-prime’ mortgage market in the US. Typical sub-prime loan terms include the ‘2-28’ loan, so-named because it offers an initial low interest rate that is fixed for two years and that then shifts to a higher rate (for example, five percent over standard variable rates) for the remaining 28 years.
Financially, this reflects well on the ability of markets to incorporate a risk premium properly. In previous centuries – before the clever bank marketing departments had come up with the catchy and friendly term ‘second-chance lending!’ – the technical term for this sort of arrangement was ‘indentured servitude’.
It may help to clarify the sensible and socially responsible nature of this market if we reflect on the fact that the worse the likelihood of a loan ever being repaid, the greater the return on the mortgage demanded by the lender and, hence, the more attractive the investment prospect. In principle (according to the economist who I have trapped in my basement and to whom I throw toast crusts and food scraps when it pleases me) these factors cancel out, with the perfectly rational market pricing risk according to expected returns.
In fact, the bank takes the prospect of the higher repayments and uses it to talk up the value of their own shares now, whereas the risk of default is accrued when the loan is issued. In short, they bank the profit and forget about the extra risk. This is one of the reasons why I’ve stopped feeding the economist, at least until he comes up with a better theory.
In the last few years, up to one in five loans issued in the US were sub-prime – a real measure of the generosity of spirit of the banking industry. Although it is hard to source precise figures, this also implies that the effects are just beginning. Many more future loan-defaulters are likely to be still in the initial low-interest rate phase of their loan. Which is good news, if you are looking for a straightforward way to sound clever by explaining to others why this is going to get worse, not better. But, it does have the important collateral implication that we’re all doomed.
Of course, the global business press would not leave us to face such a crisis armed with only our own puny critical facilities.
As soon as the crisis broke, a vast wave of commentary from the world’s business columnists swept around the world, like a great, big, huge, tasteless and inappropriate tsunami metaphor, unstoppable in its bigness and lethal in its effects – if by ‘lethal’, we mean moderately impoverishing to a small number of very rich people, and perhaps – having a very small effect on the wealth of a very large number of other people over the next few years. Not classical lethal, but ‘lethal’ – in the sense I mean it here – nonetheless.
But from this oceanic wall of punditry, there is still a chance to save a few plucky insights, tenacious nuggets of fact that have clung to the palm-trees of perception while the swirling vortex of hysteria has washed away their kin.
It turns out that those very smart people in investment banks are, on occasion, slightly wrong. “The people at Goldman Sachs,” the Economist dryly noted, “lost a packet when something happened that their computers told them should occur only once every 100 millennia.” Good call, that computer. It isn’t clear whether a call was put into Goldman’s IT support help-desk – and did no-one think to switch it off, then wait a few minutes and switch it on again to see if it came up with the right answer?
More importantly, it is now clear that the poor are to blame. For several centuries now, modern principles of debt and credit have established that if you own nothing, you aren’t merely poor, you’re squandering important opportunities to own considerably less than nothing. Sub-prime borrowing was designed to assist those who were unable to obtain regular mortgage finance to achieve the American dream, by assisting their bank to own their own home.
Many of these loans are backed up by full and detailed information, to enable a borrower to consider carefully the questions of financial probity and risk assessment before they borrow (but take care, many of the more important points are often on the back of the pamphlet).
Now that the dust is settling, it is clear that despite this willingness by banks to meet lenders on their own terms, something totally unforeseen has gone badly wrong amongst the poor. We all know that the poor are likely to under-perform the average Joe on a variety of measures but I don’t think that anyone could have imagined that they would prove to be so irresponsible when it came to money. And who could have guessed that so many of them can’t seem to hold down a regular job?
It isn’t easy being a bank. But who could have possibly imagined that on top of it all, people would lie to you about whether they would repay their loans?
Name Withheld is a London-based global financier and lawyer, who wishes to remain anonymous so that he can continue to make far more money than he is actually worth. You can assume Name Withheld holds stock in pretty much every company he mentions.