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Liars’ loans

Robert Peston | 08:00 UK time, Monday, 20 August 2007


The underlying cause of the current global financial crisis is a system in which there’s little personal responsibility for lending decisions.

Here’s how it all works (or, as we now see, how it doesn’t work).

In the US, some half a million mortgage brokers have been incentivised to “sell” mortgages to potential homebuyers.

They don’t work for the providers of the loans. They are paid commissions for the volume of mortgages they arrange. So, of course, they try to arrange as many mortgages as they can, not minding the consequences.

If the customer wants to borrow more than he or she can really afford, then that’s no problem, thanks to a wonderful innovation called “stated income, stated assets” loans.

These allow US homebuyers to give a personal undertaking that their income is a certain level, even if they don’t provide any proof.

Such loans have been taken out by hundreds of thousands of US citizens who are pay-as-you-earn tax-payers and could therefore have easily provided proof of earnings, had they wanted to do so.

Surprise, surprise: studies have shown “discrepancies” between what such borrowers say they earn and what they actually earn, in 95 per cent of these loans.

These mortgages are now colloquially known as “liars’ loans”.

But liars’ loans are just the extreme manifestation of a US system for generating home loans which is predicated on turning a blind eye to economic reality.

When a borrower has difficulty making repayments on a loan, a mortgage broker would typically encourage them to pay off that loan by taking out a new one for an even greater amount! These are the infamous “rolling loans” which “gather no losses”.

When a loan is rolled over, no one need know that defaults loom – at least not for a while.

Wall Street’s sausage machine

What happens to all these hundreds of billions of dollars in home loans?

Well the paperwork and administration is usually done by specialist home loans companies, such as New Century Financial (which went into bankruptcy protection in the spring).

Then the debt itself goes into a giant mincing and mixing machine on Wall Street operated by the biggest US investment banks, led by Goldman Sachs, Morgan Stanley, Merrill Lynch and the like.

They take all this debt and they process it into asset-backed securities, or bonds.

Note that Goldman, Morgan et al have NO CONNECTION with the borrowers and NO IDEA whether an individual borrower is a good risk or a bad risk.

But they have historic data on default rates.

And this data allows them – or so they claim – to assess whether a bond is a good risk or a poor risk, and therefore to price it for consumption by international investors.

What’s more, verification of the riskiness of a bond is provided, for a fee, by the specialist credit-rating agencies, led by Moody’s and Standard & Poor’s (let’s for now ignore the obvious conflict-of-interest that as the market for these bonds expands, the rating agencies make bigger profits).

There’s a conspicuous problem here. An important part of the US home loans market, the sub-prime mortgages provided to those with poor credit histories, is a young market which has grown like topsy.

Or to put it another way, data gathered from past performance of loans in a small market may not be much of a guide to the future performance of a trillion dollar plus market.

But that hasn’t stopped the big investment banks citing this questionable data to convert sub-prime loans into bonds that they claim are risk-free and which have a so-called triple-A credit rating.

Here’s how they do the clever engineering.

For argument's sake, let’s say that they estimate that as many as one in two home loans will default and that on average there will be a 40 per cent loss on those defaulting loans. That, in turn, gives a maximum risk of 20 per cent losses on a portfolio of these loans.

Bad news? Not for creative investment bankers. Out of this portfolio of low-quality loans, they can create supposedly high quality bonds by putting in place covenants which stipulate that the first 20 per cent of losses would be attributed to one bunch of really poisonous bonds, usually called toxic waste, leaving the rest of the bonds almost as safe as US Treasury bonds (in theory).

Before we move on, it’s probably worth recapping the phoney assumptions made by the investment banks as they create these bonds:

1) That historic data on default rates is useful even though the market has exploded in size

2) That data of any sort is useful even though the system for originating the loans, with mortgage brokers paid by the volume of loans they make, actually encourages fraud.

So far, so disturbing. But it gets worse.

Because the demand for toxic waste isn’t as huge as all that (some purchasers of this poison have suffered horrendous losses), investment banks have looked for ways to slice and dice the toxic waste, to create something almost edible.

They’ve mixed it up with other securities in collateralised debt obligations, which are bonds created out of other bonds – or sometimes they are bonds created out of bonds, that are in turn created out of other bonds (collateralised debt obligations squared, as if you wanted to know).

Even these bonds made of bonds rely to a worrying extent on all that dodgy historic data to determine their risk of default – the credit risk – or the risk that they’ll be vulnerable to interest-rate changes.

But notice too that once the original sub-prime loan is in a collateralised debt obligation, that loan could be one of perhaps a million different loans all mashed together to form this new bond.

What that means is that the eventual purchaser of the collateralised debt obligation has no more idea what’s in that bond than a sap eating a Turkey Twizzler knows what he or she is eating. Little wonder that when there’s a global scare about what may actually be in these bonds, no one wants to touch them.

That said, the investment banker will argue, on the basis of portfolio theory, if you put one load of toxic waste with another seemingly independent load of toxic waste, then the risk of holding them will fall. But for that to be true, each bunch of toxic waste would have to be uncorrelated to the other bunch – and that ain’t necessarily so.

Here’s the bottom line: for the past few years, Wall Street has operated a giant machine for turning mind-boggling amounts of US home loans – which are hugely vulnerable to losses from fraud and the inescapable cycles in interest rates and housing prices – into supposedly risk-free investments for risk-averse investors in Asia, the Middle East and (as it turns out) for Europe’s big banks.

Now if I worked for Goldman Sachs, Morgan Stanley, Merrill Lynch or the other big US investment banks, I might be considering my career options at the moment. It is inconceivable that they will escape unscathed from this debacle. Whatever the financial cost to these banks, which will not be trivial, there will also be significant damage to their reputations.

Europe’s shame

But Europe’s banks are hardly blameless either. If the underlying cause of the global financial crisis is fraud and greed in the US home loans system – from mortgage broker to investment bank – the trigger of the crisis was chronic folly by big international lending banks, notably some in Europe.

I am talking about banks’ use of “conduits” and “structured investment vehicles” (SIVs).

These are special off-balance sheet companies set up by banks for borrowing cheap short-term funds from the money markets in the form of securities known as asset-backed commercial paper.

Now, as their name implies, the commercial paper is secured against asset-backed securities, such as mortgage-backed securities and collateralised debt obligations. According to Citigroup, European conduits held more than $500bn of assets to back commercial paper at the end of March.

But there’s an intrinsic weakness to this funding: commercial paper of short duration has been sold by banks to finance their purchases of long-dated bonds whose assets include those dodgy sub-prime loans to US homeowners.

It’s a classic liquidity mismatch, except when there’s a reliable, active market for such bonds. To reiterate, European banks have been borrowing money that has to be repaid or rolled-over every 90 days to fund their ownership – direct or indirect – of 30-year US home loans.

They did this because they received more from the holdings of asset-backed bonds and collateralised debt obligations than they paid out in interest on the commercial paper. In theory, they made an attractive return.

Here’s the Catch 22: such funding schemes only work while the market has confidence in the value of the collateral backing the commercial paper.

When investors start to have qualms about asset-backed bonds and collateralised debt obligations, banks are squeezed in a vice: short-term funding disappears and there is a collapse in the value of the assets they hold.

So what happened over the past fortnight was a highly predictable – except by the big banks – double whammy.

Lenders to banks refused to repurchase commercial paper when it matured. And the banks that issued that paper faced a funding crisis, because they were unable to sell the collateral or raise new money against it.

Everyone had suddenly woken up to the idea that this allegedly safe collateral of mortgage-backed securities and collateralised debt obligations was the equivalent of a palace built on paper foundations.

That inability of major banks to raise short term finance is why the European Central Bank – and the US Federal Reserve and other central banks – recently pumped tens of billions of pounds of additional liquidity into the banking market at interest rates well below the new market rates (that had risen sharply).

This was subsidised lending by the ECB and the Fed. They have been bailing out silly behaviour by banks that should have known better. State-insured banks had no business engaging in such short-sighted financial engineering, which is a million miles from their core banking operations on behalf of Europe’s consumers and companies.

There is – contra the Economist – a serious moral hazard problem here. The Bank of England, by contrast, would only lend emergency funds to banks at a punitive interest rate, which seems a more prudent way to be the lender of last resort.

What horrors await

On Friday, in an attempt to shore up the US housing market, and by extension the value of all those crappy mortgage-backed bonds, the Fed signalled that interest rates would come down for all of us sooner rather than later.

But that’s to treat the symptoms rather than the disease itself. To avoid a repeat of this kind of crisis, there needs to be a return to lenders taking some responsibility for the loans they make.

Most bankers now think it’s quaint and absurd that once-upon-a time a bank manager actually managed a loan book and even talked to the individuals to whom he or she lent.

Our brave new world – in which a Parisian or Frankfurt bank doesn’t even know whether it’s exposed to the US housing market through its Turkey Twizzler collateralised debt obligations – is neither healthy or sustainable.

Paulson’s predicament

Robert Peston | 09:45 UK time, Thursday, 16 August 2007


hank_paulson.jpgWhen gales are blowing through global financial markets, as they are, in some ways it helps to have a former Goldman Sachs boss as US Treasury Secretary. Certainly Hank Paulson’s interview in today’s Wall Street Journal shows a grasp of market technicalities well beyond the knowledge and vocabulary of most of the world’s finance ministers.

His message can be boiled down as follows:

1) The gyrations of debt and equity markets will continue for some time
2) There will be a negative impact on economic growth from the market mayhem
3) But US and global growth is so strong currently that we won’t be tipped into recession
4) Some financial institutions will go out of business
5) A more robust system for lending to US homebuyers with poor credit histories has to be put in place.

As for the implications for the structure of financial markets, there he was a little less confident. He talked in fairly general terms of the need for the agencies that rate debt – and which underpin the way that markets price that debt – to show “a better understanding about the risk”.

You can say that again. The credit rating agencies are belatedly reviewing the quality of CDOs, CLOs and other specially manufactured debt securities, weeks after many financial institutions wouldn’t touch much of this stuff with a fifty-foot barge pole.

Paulson also paid lip service to the need to gather better information from banks and hedge funds about where financial risk actually sits in the global system.

But it’s not just locating the risk that is tricky to do. If you talk to three different regulators, as I have, about something as basic as how much leverage is in hedge funds – how much they’ve borrowed – you get three different answers. That’s not reassuring.

My favourite Paulson quote however came in response to the question whether what’s happening in markets is welcome. He said:

“I’m going to say it’s inevitable. When you have periods of benign markets, particularly in situations where parts of markets and the economy are growing at levels that are unsustainable, market participants aren’t going to be as vigilant as they should. You’re always going to have these events from time to time. When they come…it’s difficult to predict what might happen…what might be the precipitating cause. But as long as you have capital markets, there will be events like this…”

At the moment, it looks like it’s worth paying the price of “events like these” for the faster global growth that globalised financial markets have delivered over the past decade.

Paulson and his former Goldman colleagues will be hoping beyond hope that a fully-fledged recession does not set in, because that would create significant political pressure to increase regulation of these markets, and do something not very nice to their golden goose.

UPDATE 19:27 Well, the markets are convinced that global growth is set to slow sharply, which may imply that Mr Paulson and other politicians are whistling in the wind.

There were sharp falls in the price of oil and base metals. Copper and zinc are down around 8 per cent, lead and nickel are 6 per cent lower.

Some of that was a consequence of forced sales prompted by margin calls on leveraged investors. But much of it reflects the view that US consumer spending will slow, and that will feed through to lower demand for Chinese exports, and hence to lower demand for natural resources.

It is also worth noting that the mining-heavy London stock market has been led down by the international mining stocks: Anglo American, Lonmin and Antofagasta all fell more than 9 per cent; Rio Tinto, BHP and Xstrata were all about 7 per cent down.

Standard Chartered was the worst performing bank, because of its dependence on Asian growth. Man was the worst performing financial stock – because it rode the hedge-fund phenomenon up and up, and now is riding it in the other direction.

The stock to watch, however, is Northern Rock. As one of the most aggressive lenders in the UK housing market, and heavily dependent on funding from the bond market, its shares have fallen almost 50 per cent from their peak of the past 12 months: a pretty soft rock.

Central banks’ hazards

Robert Peston | 09:30 UK time, Wednesday, 15 August 2007


The oldest dilemma for regulators is how to prevent their actions in protecting the integrity of the financial system from affecting the behaviour of those they regulate in the opposite ways to those intended.

It’s called “moral hazard”. The classic and legitimate fear is that regulators actually encourage banks and other financial players to take silly risks, by showing that they’ll always intervene to reduce the costs for the market of such imprudent behaviour.

Those concerns about moral hazard lay behind my uneasiness about how much cash the European Central Bank has been pumping into the banking system.

ECB_tower.jpgOf course, I understand that the ECB has a target for overnight interest rates. So in one sense it was rational for it to provide tens of billions of pounds of incremental short-term lending to Europe’s banks, to prevent that overnight rate from settling too far above its target of 4 per cent.

But the reason for the rise in those short-term interest rates was nervousness among lenders about which of them might be holding something very explosive and nasty in the frenzied game of pass-the-parcel of horrible financial risk – which stems ultimately from sub-prime lending in the US.

Or to put it another way, in providing all that cash or liquidity to the market, the ECB (and to a lesser extent, other central banks too) was bailing out banks – and, indirectly, hedge funds – who should have known better.

The danger inherent in the ECB bailing them out is that when this particular market storm is over, those banks and hedge funds will take on even greater risks and do even sillier and more opaque deals, safe in the knowledge that when it all goes wrong again – as it will – the ECB will always prevent drama turning into crisis.

On the other hand, there is a separate imperative for the ECB. There are growing signs of softness in the eurozone economy. And the sudden reduction in liquidity in the banking system and rise in short-term rates could have turned that softness into a more serious slowdown in economic growth.

It would have been unfair for Europe’s consumers and businesses to pay a big price in the form of slower growth in their income for the imprudence of those who lent to US homebuyers with poor credit histories.

Understandably, the ECB – and to a greater extent, Europe’s politicians – would want to avoid that.

Unfortunately, we are not out of the woods in terms of the impact on the real economic world from the financial mayhem. There’s a continued flight to quality going on, with the more marginal markets in Asia being hit hard overnight. That has prompted fresh falls in the larger, more liquid stock markets like London’s. Underlying all this is the continued reluctance of lenders to provide credit to all but the safest borrowers.

So eurozone consumers and businesses – and British ones – may yet pay a real economic price for the excesses of players in financial markets.

Panic at the ECB?

Robert Peston | 11:30 UK time, Monday, 13 August 2007


From Far Faraway Land, I hear that the Asian markets were up overnight, share prices in London have bounced this morning and Morgan Stanley has this morning put out a recommendation that it’s time to buy equities again.

So that’s alright then: panic over; normal service can be resumed for global financial capitalism.

Not quite.

The European Central Bank has today made its third consecutive daily injection of cash into the European banking system, bringing to almost £140bn its aggregated support for eurozone banks (though today’s injection can be seen as a slight reduction in ECB support). And lesser amounts of cash have been provided to financial institutions in the US and Japan.

Even if Morgan Stanley is right and this bull market has another couple of years to run, globalised capitalism will change a bit.

Here’s how and why.

As I wrote last Thursday, the ECB’s intervention was designed to stem contagion from a US debacle, viz imprudent lending to American housebuyers with poor credit histories, known as sub-prime lending.

European institutions are exposed to losses on these sub-prime loans in a whole variety of ways. Here are just some:

1) They might be owners of mortgage-backed securities, or bonds created out of the repackaging of these sub-prime loans for consumption by investors.

2) Or they might be owners of collateralised debt obligations, bonds created by another process of deconstructing and re-engineering the mortgage-backed securities.

3) Or they might be exposed to hedge funds suffering losses on direct or indirect exposure to sub-prime loans.

In fact, the most plausible way in which most European institutions have been hurt is through the transmission and amplification of sub-prime problems to other financial markets.

Here are a variety of ways in which that would have happened, most of them due to “leverage”, or the fact that hedge funds take out loans to finance part of their investments:

a) When a hedge fund suffers losses on sub-prime loans, for example, the collateral backing its borrowings falls in value. Under the terms of the borrowing agreement, the hedge fund would then be forced to sell assets. But if there is insufficient liquidity in markets, as there was last week, the forced sale of these assets would lead to a downward spiral in asset prices – which in turn would force the hedge fund, and possibly other hedge funds, to sell yet more assets. And so on and so on, until we’re all bust.

b) Investors caught in this vicious spiral of declining prices would not just sell the sub-prime and related products, they would sell anything that could be sold. Which is why share prices have been pummelled.

c) Finally, when liquidity dries up in this way, all sorts of “normal” relationships between different classes of assets change. And that can lead to unexpected losses for many different institutions, especially those which trade on the basis of computer models created from processing past inter-relationships between markets or securities. Just this morning Bloomberg has reported just such losses for funds managed by Goldman Sachs.

If you want to see how market-turmoil can generate losses in the strangest of places, just look at poor old Mitchells & Butlers, the FTSE100 company which owns pubs and bars. It recently announced it was sitting on a £60m post-tax loss relating to a complex financial transaction or hedge. It had taken out this hedge to facilitate a £4.5bn deal transferring its properties to a special new company that would be jointly owned with Robbie Tchenguiz, the billionaire financier.

That deal has been suspended, because the cost of raising the necessary £4bn of debt has become too expensive. Unfortunately, M&B had already taken out the hedge – probably a foolish thing to do – against inflation and rises in the price of debt.

Foolish or not, the hedge should not have cost it money if the traditional linkage between inflation expectations and government bond yields had held. Usually, when investors expect inflation to be on a rising trend, the price of long-term government bonds falls. But in the past few weeks, investors have sought the safety of government bonds, because of their fear that everything else – from sub-prime securities to equities – was vulnerable. So long-term government bond yields have actually fallen, at the same time as inflation expectations have risen.

After the mayhem of last Thursday and Friday, M&B’s notional loss on the hedge will be even greater than £60m.

The point is that if there is a loss of this sort at somewhere as unexpected as M&B, who knows where the next splurge of red ink will be found?

But let’s say, for the sake of argument, that systemic crisis has been averted. What then follows?

Well there are big implications for the eurozone, the European Central Bank and Brussels.

The big fact is that the Bank of England dispensed precisely zero pounds on propping up the City through the turmoil, compared with spectacular sums made available to banks by the ECB.

That means one of two things.

Either the problems at continental banks are significantly greater than for British based ones. Or the ECB simply did not have enough hard fact on the health of European institutions and panicked.

Whichever turns out to be the case, it suggests that risk-controls at continental banks are inadequate and regulatory oversight is lamentable.

And here’s what should really turn the ECB red with shame. Just possibly it has needlessly bailed out the global hedge-fund industry.

It has signalled to the hedge funds and the giant investment banks servicing them that they can take all the mindless risk they like – because if they suffer a dose of the sniffles, the ECB will turn up quick-as-a-shot with the medicine.

What worries me is that ECB and Brussels politicians will become so embarrassed by their neurotic intervention that they’ll learn the wrong lessons.

The correct response would be to improve information-gathering on the hedge-fund and associated banking industries.

The wrong, futile and more likely response would be to attempt to shut down the hedge-fund industry in the eurozone.

US exports poison

Robert Peston | 18:00 UK time, Thursday, 9 August 2007


I am a long way from a properly functioning computer screen. But thanks to the miracle of mobile telephony I have been able to read BNP Paribas's explanation for prohibiting investors from cashing in more than a billion pounds of funds linked to the US subprime market.

bnp_paribas.jpgBNP's statement is scary, to put it mildly. The giant French bank says that it cannot value the assets in these funds due to the "complete evaporation of liquidity in certain market segments of the US securitization market".

The terrifying bit is not BNP's citing of the disappearance of two-way trade in bonds and derivatives linked to poor quality US home loans, or what it calls the "evaporation of liquidity". That's just a statement of the obvious, bad news we've known about for some weeks.

No. What gives the game away is that BNP, the pride of France and one of Europe's biggest banks, doesn't dare take the long view and offer to buy these illiquid investments from investors who want to sell.

In theory, BNP should be able to ascribe an economic value to the assets in the funds, independent of their market price. And as a well-capitalised bank, it ought to be able to buy these assets at this fair value from investors and hold them to maturity or until normal conditions return to credit markets.

So why won't BNP do this? Could it be that it fears that the assets in the fund are toxic garbage that defy rational valuation?

Is there reason to believe that many of the securities manufactured out of subprime loans are worse than ordure?

I'm afraid so. Here are just three reasons:

1) As the FT pointed out this morning, many of the underlying subprime loans were taken out by fraudsters and will therefore never be repaid in full.

2) When repackaged as mortgage-backed bonds, they were given ratings by the credit rating agencies based on delinquency experience during the benign conditions of the past few years - which almost certainly means that the ratings flattered their innate (poor) quality. Or to put it another way, investors have bought the financial equivalent of poisoned mutton dressed as prime lamb.

3) Hundreds of billions of dollars of these mortgage backed bonds have been re-engineered as collateralised debt obligations. These CDOs are customised bonds of varying quality and varying yields. There is nothing intrinsically noxious about them. However there are CDOs made out of other CDOs, called CDOs squared, which are marketed as high quality investments - and they've been bought by the "one-born-every-minute" brigade. What's more, there's accumulating evidence that even the simpler CDOs have been bought by naïve investors, who had no idea what they were buying.

It is wonderfully ironic that a disproportionate share of losses from America's dodgy mortgages should be borne by financial institutions in France and Germany - and that the European Central Bank is pumping cash into the banking system to avert a possible crisis.

The incongruity is that the Anglo-American model of financial markets is despised in many European capitals; it is droll that their banks were seduced by Wall Street.

But although I allow myself a chuckle, it is a hollow one. I fear there'll be plenty more damage to come from America's exports of subprime poison.

Where's Branson's apology?

Robert Peston | 09:05 UK time, Wednesday, 1 August 2007


For a business nerd like me, it’s much more gripping than a blockbusting summer novel. I’m talking about BA’s “summary statement of facts” published today about its unlawful conversations with Virgin Atlantic about changes to fuel surcharges levied on long-haul passengers

Virgin and British Airways planesSecret talks took place in a systematic way over 17 months between BA and Virgin executives about the plans of their respective airlines to change this important element in the price of airline tickets.

This was not a careless accident. The two big birds – which have a huge share of business on important routes – were not competing properly on price over an extended period: they were giving each other comfort that they would not undercut each other on the fuel surcharge.

It is about as blatant a breach of competition law as it’s possible to imagine.

BA is paying quite a price for its wrongdoing: £350m in fines from regulators and related costs.

By contrast, Virgin won’t pay a penny in fines and actually emerges as a winner, since all the opprobrium of the rule-breach has been heaped on BA.

Virgin escapes any penalties because it was the whistleblower.

Experience indicates that providing immunity to whistleblowers is the sine qua non of enforcing competition law.

But it makes for quite rough justice, since – on BA’s account – Virgin was a willing participant in this shameful attempt to rig the market.

In other words, Virgin’s behaviour was well below the standards expected of it by customers.

Which begs only one question, if it’s not going to dispute BA’s narrative: where is the public apology from Sir Richard Branson?

UPDATE: 22:35 A spokesman for Virgin Atlantic has telephoned to tell me that le patron has now apologised. But the statement he then emailed is not actually in Sir Richard's name. However, here it is: "Virgin Atlantic is sorry that the events took place and apologises to customers."

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