Never Trust the Money Men (They get paid whatever happens!) or 1001 things you need to know (but won’t want to) before taking out a Mortgage.
In the old days if you wanted to buy a house you saved up (or begged or borrowed) the deposit then you spent several weeks going through a Mortgage interview where you and your partner’s credit history, wages, etc would all be examined carefully. If the lender felt you met their criteria then you would get a mortgage offer and could proceed to buy the house.
On the day that you took ownership your solicitor would transfer the deeds to the property to the Mortgage owner and there they would stay until you redeemed the mortgage in full. For the life of the mortgage you would make monthly payments to the company. If you had an issue you could go to them and talk about ways of resolving the situation, sometimes they would agree to ‘rollover’ a payment or two into the overall balance due to help you out, but in the main if you could not pay you would either have to sell or have a sale forced on you (repossession).
If you put money in a bank you expected that to be a secure if unspectacular investment unless something desperate happened to the bank in which case the govt and the Bank of England would hopefully help. If you had some spare money you could invest it in stocks and shares yourself or give the money to a fund to invest on your behalf. Investors are expected to be aware that this is inherently more risky and there is always the possibility that your investment could go down as well as up. You wouldnt expect the government to help out if this went wrong although there have been a number of cases where people have tried to persuade the govt to help.
Following the big Stock market crash in the US in the 1920’s the Glass–Steagall Act was enacted to legally enforce this split by banning deposit taking institutions from making more risky investments. This lead to the setup of separate Investment Banks to make riskier investments, a protection that has never been enacted in the UK but is under consideration at this time. The Glass-Stegall act was repealed in the late 90’s.
After the UK’s big bang (financial deregulation under the Conservative government in the 80’s), new ways of financing mortgages began to become popular.
There had always been a limit on the amount of money available for this kind of loan as the main lenders (Building societies) were quite deliberately rather safe institutions with strict, carefully observed lending practices. To fill this gap there was a growth in lending based not on traditional ‘face to face’ lending but on investment securities.
A security is simply where a financial institution repackages something into a product. An example might be where it takes 1000 mortgages and puts them together in a block then allows investors to buy a small or large part of that block until all of it is covered. This investment could come from anywhere or anyone – they don’t need to know the individual borrower. It meant that a small investor in Japan or America, a bank in Beijing, the New York Bus Driver’s retirement fund or even the Government of a country you had never heard of could all be contributing to your mortgage.
To help make this sort of investment predictable for the investor the Financial insitution creating the security would make available statistical data as to how secure the loan was with the use of credit ratings figures, which were used to rate applicants. We have all been scored when applying for credit – if you have enough ‘points’ (things like your credit history and wages are given a number) you get the loan, if you don’t then try somewhere else. For the investor knowing that say 80% of the mortgages in the fund met the highest calibre of rating was meant to be a reassurance of its integrity.
This influx of new money into the housing market from lending based on Securitised sources of money helped fuel the housing boom both sides of the Atlantic. It also fuelled Housing price rises as well – the ready supply of money and credit points based lending criteria meant that if I chose to bid £500,000 for a 1 bed flat in London there would be a lender to grant me the money provided I met those criteria, no matter how stupid the price was in reality.
There was also a new group of Mortgage salesmen both in the US and UK – the Mortgage Broker. Financial salesmen such as this were in the situation where on the one hand they could advise a customer to do something safe but get lower fees and on the other hand advise something risky for a fat commission (and meet the targets given by their employers). Many of them worked in Banks or closely with banks in the UK sometimes actually having desks next to the deposit desks.
The brokers who made up the securities up and sold them on made huge fees and their company’s made huge profits turning financial transactions into financial products.
In the UK the use of Endowment mortgages grew enormously in the 80’and 90’s.
The idea is a simple one. Instead of making a single payment to the mortgage owner that covers both the interest on the loan for that month and a contribution towards paying off the original amount, you make a payment to them to cover only the interest on the loan and at the same time make a payment into an investment fund (endowment) which would invest your money in the stock market until the time came to redeem the mortgage. In theory you would have paid the same amount over the life of the mortgage, but when the time came to redeem the mortgage your payments towards the original loan would have been invested for you and have been gaining interest all the time. Over a long period this kind of investment can produce big returns because of a sort of multiplier effect as the interest or profits begin to ‘compound’ and you get interest and then interest on the interest and then interest on interest on interest.
Combine this with the housing price rises that were taking place pretty much consistently over this period and you have a situation where a large number of people were able to redeem mortgages early and the house that they now owned outright was worth a vast amount more than they paid for it. Instant security for many.
The market falls related to the Dot com bubble of the late 90’s lead to many of the funds that endowments were invested in suddenly looking much less attractive. Those borrowers who were faced with potentially not being able to pay back their Mortgages at the end of the term began to take a long hard look at what they had been sold. “We were not told that this could go down as well as up” they said and the financial regulator had his own long hard look at those who had sold the mortgages and realised that it was true – most of them had not been told of this possibility.
Some people complained and/or sued the endowment companies and were successful and then backed by the news that the regulator had officially censured several of these companies the few began to become many. In the main the companies only had one place to take these payments from – the fund itself – they were not going to take back the commission payments and bonuses they had paid themselves – so this process lead to several funds collapsing and even for the best run of them a disastrous loss in their value.
Most people who invested in Endowment Mortgages from the late 90’s until they fell out of favour ended up losing money and eventually having to renegotiate their mortgage. For these who held onto their property this was often not as bad as it sounds because their investment (the house) was still continuing to rise in value and whereas the original mortgage was for 80% or 90% of the value of the property it might now be only 40% or 50% of it – a much easier loan to obtain, if not always to pay back.
The lesson then is that moving boring traditional Mortgages into the investment field brought both benefits and issues but the thing that brought the whole project to its knees was the incompetence of the financial industry itself.
In America their traditionally rather flat housing market began to take off in the late 90’s also driven by new sources of funds and the recognition that investing in Property could be profitable.
AS menmtioned before the Glass Steigal Act meant that the US has number of large financial institutions called Investment Banks (eg JP Morgan, Goldman Sachs, Bear Stearns, Lehman Brothers) who specialise in making investments for customers often in sophisticated securitised products.
Another quirk of the US system is that if an Investment fund has only a limited number of investors it is not subject to the same regulation as other funds are. This lead to the set up of funds aimed at investing money for those who are already rich enough to be prepared to entrust a chunk of this wealth to a single fund manager (50 people investing $ million rather than 5,000,000 people investing $10).
They became known as Hedge funds because their primary method of making market profits was traditionally to buy stocks that they thought would go up, but at the same time hedge or offset this by selling the same shares short – basically borrowing the shares and selling them hoping to buy the same shares back at a cheaper price when they have to be returned. In all but the most extreme markets therefore a hedge fund would make money whichever way the market moved.
There was a huge influx into hedge fund management and some areas of Wall St of the ‘Quants’ (Quantitative Analyst) mostly very highly qualified Mathematicians, Engineers or Physics experts who were trying to use advanced mathematics such as chaos theory and a whole host of modern mathematical modelling tools to try and predict the market.
By the mid noughties these transactions were making consistent profits, but the profits were very small scale on each transaction because of the cost of the hedge and the fees involved. They therefore began to leverage their investments – basically borrow enough to buy a million shares rather than a thousand so as to multiply profits.
By the late noughties the Hedge funds were making unparalleled profits for their investors. For example Citadel Investment Group run by the strange and charismatic Ken Griffin was rumoured to be making unheard of returns of 20-60% per annum up to 2007.
The American housing market continued to rise and provide good returns on investments throughout the early noughties to such an extent that investment funds began to look at the ‘subprime’ mortgage category – basically those who were more of a risk to lend to. In return for this lending the investor claims a higher rate of return, but also bears a greater risk in that these mortgages are far more likely to go wrong.
The subprime sector in the US had begun back in the 90’s but had collapsed when the stock market ‘wobbled’ in the late 90’s amid accusations of Gross Incompetence and fraud.
In his dark and cynical book ‘The Big Short – Inside the Doomsday Machine’ Michael Lewis describes how the system was rebuilt in the Mid Noughties by corrupt and incompetent Brokers who knew the loans they were selling were not worth the paper they were written on, how they structured the loans to be unaffordable in the knowledge that they would then get a 2nd fee for re-organising it. Investment firms were then repackaging these loans and selling the resultant securities all over the world (taking hefty fees for themselves for doing so) based on information from ‘credit rating’ agencies who continued to insist that in their experience 80% of the loans in a sub-prime mortgage security were AAA (highest – the same rating as a govt bond) rated no matter what rubbish was actually included.
Lewis’ fascinating book is actually written about those who recognised this House of Cards for what it was and eventually decided the only safe investment was to bet against the whole mess. While most of Wall Street and almost all investors were merrily pocketing huge fees and profits they were looking for ways to bet against it having recognised that this was the only safe bet.
To sustain these profits the Investment banks began to securitize these investments in ever more sophisticated ways to try and increase the profit and limit the risk. One example was to take all of the lowest rated (and hardest to sell) portions of a security and put them all together into a new security called a CDO (Collateralised Debt Obligation). The credit agencies obliged by applying their usual criteria and although the new security was made up of elements which previously been in the lowest portion of their previous securitised existence, 80% of them suddenly became AAA rated! The temptation to hide the really dodgy loans in this way and take more Fat fees for doing so must have been hard to resist.
For those who wanted to ‘bet against’ this increasingly fantastical process there was an easy option. If you wanted to hedge an investment it had always been possible to take out insurance against it defaulting. It was popular with hedge funds for obvious reasons. For the Subprime market this was the CDS (Credit Default Swap) basically insurance which would pay out if the level of ‘defaults’ on a subprime investment fund reached a certain level. It was supposed to be for these who owned the stock to offset their investment, but there was no technical limit on who could take them out.
Michael Eisman a Hedge fund manager with a bleak view of Wall St purchased over $50 billion worth of these for a few million a year and sat back to wait for the house of cards to fall. Despite explaining clearly over and over again he suffered an investor revolt in 2006 as his investors questioned why he was betting against a still rising market. The Wall Street securities firms then proceeded to package up the CDS’s into even more complex sub-prime securities (Synthetic CDO’s) which they sold onto investors. I can only assume neither they nor those who bought them were really sure what they were by this time!
In his book ‘The Greatest Trade Ever – How John Paulson Bet Against the Markets and Made $20 Billion’ Greg Zuckerman describes how a wealthy but secretive investment fund manager call John Paulson decided to short the subprime market in late 2008 and how he too looked to CDS’s to do so leading to one of the largest profits on a single trade ever in Wall St history. The regulator in the US is currently pursing legal activity against Paulson’s Investment banker (Goldman Sachs) for their part in this trade. Paulson is not hugely popular in the UK because of his role in betting against 4 of the 5 major UK banks in Sept 2008. He eventually realised over £250m for this trade after the government was forced to prop them up.
In late 2006 the housing market began to fall in the US. The impact of this on these on housing investments was dramatic and for sub-prime investments particularly spectacular and unexpected.
The first major issue was simply that in the morass of securitised mortgages lenders could not work out what proportion of their investment was still good so that they could work out how much of a loss they might take. The sale of sub-prime investment securities suddenly became almost impossible as everyone realised what a bad idea they were and that rather than spread the risk, they effectively contaminated all of the other loans that they had been securitised with. Because they could not be sold hundreds of billions of pounds worth of investment effectively became worthless overnight.
Two funds which were heavily invested in this market which belonged to Bear Stearns effectively ceased to be viable and were closed down with huge losses. These losses lead in the next few months to the collapse of the company (which had been the 5th largest investment bank in the US) and its sale to one of its rivals at a knocked down price. Another of these firms – Lehman Brothers was so heavily tied into this type of lending that it collapsed totally despite the govt and regulator trying to put together a sale or rescue package – the largest Bankruptcy in US history at the time.
The next shock came for those firms with less investment in this market but whose assets were very highly leveraged. Borrowing to multiply your investment would indeed multiply your profit but it also multiplied losses – the firms not only have to cover the original loss but a hundred or a thousand times that loss.
Hedge funds were then hit by the way that many of them were using sophisticated financial models to predict changes in stock prices and to predict a market that they essentially saw as rational enough to be analysed in a mechanical way. All of a sudden investors began to act irrationally – for example thousands of investors lost confidence and were suddenly charging out of housing investments in far greater numbers and far more rapidly than the potential losses might indicate, effectively destroying the whole market. Their computers suddenly became very bad at investing for a while which only helped to make things far far worse. One accusation levelled at Hedge funds is that they and their models were behind massive ‘shorting’ of stocks (borrowing them and selling them knowing that when the market went down you could buy them back for less). The impact of this was to drive down market prices to such an extent that for nearly a month in late 2008 the regulator stepped in and outlawed the practice.
Some Canny investors such as Michael Eisman had taken out CDS insurance on the losses but for the crisis the impact of this was to move a huge part of the losses into another field. It turned out that the giant American AIG held many of the CDS’s and had to pay out. The company had to be propped up twice with multi billion pound injections of cash during the crisis.
In his book ‘On the Brink’ the Treasury secretary at the time Henry Paulson tells how he repeatedly underestimated how severe the crisis was and its effects because of these factors each of which just built on the other to make it worse.
Paulsen helped introduce a scheme to avoid the worst impact of Mortgage default, which helped many of those who struggled with their payments to refinance in affordable way, but he says that the hardest to help were those who had overfaced themselves, those whose financial situation had changed (eg unemployed) and those who had made the investment as a speculation. In the subprime category were many of what became known as NINJA mortgages – to those who had ‘No Income No Job or Assets’. Lewis tells the story of a Californian fruit picker with very little English and an annual income of $14,000 who was given a loan of $720,000 to buy a house and Eisman tells of his nanny approaching him to ask what she should do as her and her sister had ended up owning 5 houses in Brooklyn as they speculated and refinanced with the market, but were now unable to make the payments.
Much of the money that was invested in US Housing came from abroad and much money from abroad was invested in the devastated US markets, meaning that a ‘correction’ of overpriced housing in the US, the effects of which were hugely magnified in this way, spread to become a multi billion pound global catastrophe which will affect us all for some time to come.
I dont think anyone would disagree that this was a classic ‘bubble’ – housing prices in the US were clearly being pushed to unsustainable levels. The interesting question is why it was such a disatrous one with such widespread consequences – one way to look at it is to see it as a series of bubbles – all building one on top of each other to create a particularly massive pop when they burst.
The first bubble was that the investments themselves (in Sub Prime mortgages) were far more risky than the investors were told they were because of the silly and corrupt practices of the brokers.
The second bubble was that the financial institutions were making so much money on these deals that they began to apply pressure to the brokers to sell more (Effectively taking off almost any sane limits to the lending).
The third Bubble was that the financial intuitions repackaged the investments into increasingly complex forms which obscured the risk (with the knowing or unknowing connivance of the ratings agencies).
The Fourth Bubble was the new breed of investors whose computer models told them this was a good investment when good old fashioned investors like Warren Buffet steered clear.
The fifth Bubble was that in order to maximise profits investment funds in particular had started to use Leverage (borrowing) at an amazing level.
The sixth bubble was those who recognised that the huge bubble was about to pop and were now betting against it meaning that the risk was being spread across the economy.
The last bubble as always with investments was that there was only value in subprime mortgage securities as long as they could be sold – the market depended upon investor confidence that they were a good investment. When that collapsed the whole investment suddnly became worthless.
And what caused the issues – once again we have to put a tick by greed and incompetence by the Financial Industry – in this case those who sold the product without care and for their own profit, those who used it very unwisely as an investment vehicle and those who produced a product so complicated no one could see how tragic the downside might be.
One of the most worrying (and under reported) aspects of this that struck me is that in America you can make a reasonable bet that sub-prime actually means mostly Black, a group that has historically been denied both access to credit and the opportunity to own their own land or property. Suddenly along comes a way of owning your own home – it must have seemed a dream to millions and it is that dream that has been flushed down the toilet here. There is probably enough evidence to say for that this was a case of white educated salesman selling products to poorly educated blacks they knew they could not afford or understand – sign here and the house is yours – and walking away with the profits, and this disaster for whole communities is one of the darkest nastiest aspects of the whole mess.
This is the NYT on the impact in Atlanta:
For me though the enduring lesson is to always remember that whilst Bank Deposits are safe and go up albeit very slowly – they usually lose value in times of high inflation – Investments are inherently more risky and the people who sell them to you don’t always have your best interests at heart.
If a mortgage is the largest monetary decision most of us make in our lives it might be best to remember that investments can go wrong – maybe a safe boring building society mortgage is a good thing!
Appendices and further reading:
In its “Declaration of the Summit on Financial Markets and the World Economy,” dated 15 November 2008, leaders of the Group of 20 cited the following causes:
“During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions”
1: On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Henry M Paulsen
..and a reviews of the book
2: The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It by Scott Patterson
..and some reviews of the book
3: The Big Short – Inside the Doomsday Machine’ by Michael Lewis
This is an article based on the book:
..and some reviews of the book
4: The Greatest Trade Ever – How John Paulson Bet Against the Markets and Made $20 Billion by Greg Zuckerman
..and some reviews of the book