The mortgage meltdown business
In case you have been seeking (as I have) some lucid presentation of the ongoing financial meltdown triggered by the “sub-prime mortgage crisis”, I recommend the below from the LRB which starts with explaining the basics (not in the quoted text below) and goes on to describe the current problem:
LRB · John Lanchester: Cityphilia
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The Northern Rock crisis saw all these factors being brought together. The Rock is a bank with roots in the North-East. It had grown to be the fifth biggest mortgage lender in the UK by offering an attractive package of loans, many of them via accounts that are managed over the internet. Its rates are competitive and it used to have a good reputation in its dealings with customers, unlike the four main high street banks which are, as James Buchan once wrote, ‘mere burdens on the earth’. Not one saver in ten thousand would have been aware that the reason the Rock’s interest rates were so competitive was that it dealt on the global markets to fund itself. Only 27 per cent of its funds were ‘retail’, i.e. money deposited by savers: fully 70 per cent of the Rock’s funding was ‘wholesale’, i.e. came from international markets. So the Rock is lending long-term, in 25-year mortgages, but borrowing short-term to fund itself. That is a well-known recipe for trouble. In addition, the Rock uses offshore trusts to package its mortgages together into ‘asset-based securities’ – bundles of debt that could be sold on to other investment institutions. One thing worth bearing in mind is that in terms of its underlying assets, the Rock seems fine; there is no reason for thinking that its mortgage-payers are failing to cough up.
The Rock’s problem was that this business model depends on liquidity. Because it gets 70 per cent funding on the wholesale markets, if those markets aren’t working, it is instantly in deep shit. Over the summer, those markets seized up, and banks became reluctant to lend money to each other – and especially reluctant to lend money to anyone with an exposure to high-yield mortgages. Remember the interlocking nature of bank deposits, and how the system relies on liquidity? Over the summer, that liquidity dried up. The Rock had to turn to the Bank of England, ‘the lender of last resort’, to borrow the money to stay in business; when news got out, savers wanted their money back, but the bank’s website crashed, so they began turning up in person to withdraw their deposits, and lo and behold we had a genuine bank run. On 14 September, so many people turned up in person to withdraw money that the bank ended up paying out 5 per cent of its total assets, a cool £1 billion in cash.
The guilty party was the usual baroque financial instrument: in this case, a Collateralised Debt Obligation, or CDO. During boom times, banks lend money more and more freely, and begin to look for growth in places where they hadn’t before. In this case, the growth area for American financial institutions was in lending money to poor people whom they wouldn’t previously touch. The banks didn’t exactly go skipping around trailer parks handing out leaflets offering Buy One Get One Free mortgages – except that they did, sort of. The great thing about these poor people was that because their credit history was poor to non-existent they could be charged extravagantly high rates of interest.
There was a huge demand for these new mortgages, which in many cases allowed people to own their homes for the first time. By 2005, one in five American mortgages was of this new kind. The mortgages were then bundled together and turned into CDOs. These were packages of debt: some of it beautifully high-yielding, high-interest ‘sub-prime’ debt. (‘Prime’ debt refers to the people you’re sure will pay it back; with ‘sub-prime’ debt, you’re less sure, so you charge the borrower more for the privilege of borrowing.) The packages were structured to pay out different rates of interest based on different levels of risk; some of the debt rated AAA, the safest available, and some of it riskier and more lucrative. These were then sold as bonds on the international markets – this being a huge growth area in recent years. The market in mortgage-backed bonds currently stands at $6.8 trillion. It is the biggest component of the $27 trillion US bond market, bigger even than US Treasury bonds: $1.3 trillion of that is ‘sub-prime’ lending.
Then trouble struck. The problem was that interest rates in America went up, just as many of the sub-prime borrowers were coming off their first two years of fixed-rate mortgages, so their rates zoomed up, and many of them couldn’t afford to pay. The result has been a wave of home repossessions. A BBC report made a study of Cleveland, Ohio, where the banks lent heavily in poor black areas. It found that in Cleveland, one home in ten has now been repossessed, and the biggest landlord in the city is Deutsche Bank Trust.
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