We all know how the Housing market started this great Recession. Some of us also know how “Adjustable Rate Mortgages” or ARM’s are seen to be responsible for this situation. However, what are ARM’s and how did they affect homeowners? This is what this article attempts to explain at a high level – in layman’s language.

Welcome to Countrywide Finance – the largest Home Lender in America in 2004.  By the summer of that year, the Housing and Mortgage boom had accelerated to phenomenal levels. Everyone you saw around you was involved. The easiest way to get rich was to buy a house, wait for it’s value to appreciate, then refinance the loan and presto – instant cash!!

So, let’s look a little bit closer at how this would work. In normal times, you buy a house that costs 200,000. You take a loan from Countrywide at a rate of  5% for say 20 years, so assuming Simple Interest, you will pay Countrywide 875 per month = (200,000 + (200,000*0.05))/240. In other words, each month you pay them an installment and more of the house becomes yours.

Now comes the Get-Rich-Quick part. Let’s say you are halfway through this process and in 10 years, you have paid Countrywide 875 * 12 *10 =  105000 when you realize that the value of your house has increased dramatically to (say) 300,000 – which is a 50% rise (wow). So, you decide to refinance your mortgage and talk to GU Bank instead.

GU Bank appraises your house, agrees that the value is indeed 300,000 and gives you a loan for the remainder 100,000 under more favorable terms. You pay off the remainder 95000 to Countrywide and use the rest of the money to improve the house by buying that new Plasma HDTV or put in that swimming pool. Since the terms of the new loan are more favorable, you have more money left over each month. If you have a lot more, you could even buy another house (and wait for it’s value to appreciate enough, of course).

This is the cycle that led to the Housing boom in America.

Now look at the the problem that Countrywide had: was, if you are already the largest fish out in the big pond, how will you grow? The answer is that you’ve got to come out with something revolutionary – something that none of your competitors have got. So you put your Marketing and Finance whizkids to work to design exactly that – a new and revolutionary product.

Some months later, the whizkids come back to you with the answer to what you asked them to create – a new revolutionary product called the ARM – which stands for the Adjustable Rate Mortgage. This new revolutionary scheme allowed the house buyer one of four options:

a.  The Normal Loan option – Described above where each month the creditor pays a normal monthly installment which remains fixed for the term of the loan. This installment contains both Principal and Interest.

b. The “Fast” option – Which allows the creditor to make larger payments than option a – thus allowing for a “prepayment” of the loan.

c. The “Minimum Payment” option – Which allows the creditor to make a payment of LESS THAN the normal payment. The effect of this is that at the end of the payment period, the creditor owes MORE than what he owed at the beginning of the period.

d. The “Interest only” option – Which allows the creditor to make a payment of only the “interest” on the loan (instead of interest and payment in a). In this case too, the creditor will owe more than what they did before the payment.

Additionally, after a preset time period (usually 2 years), options c and d would “reset” to option a above.

What Countrywide’s sales agents did was to push c and d on most people who could not afford it. In other words, if you earned 2500 a month, options c and d would allow you to go for a house that had an installment of 2000 a month  – which you would normally not afford. If you were a sub-prime borrower, this would be even worse.

To add to the misery of home borrowers, the market for houses tanked and went lower and lower. As a result, most people who had chosen c and d in their greed to buy what they could not afford were very badly hit because when their option c and d loans “reset” because their houses were LESSER in value and refinancing was not an option.

As a result, a very large number of home borrowers defaulted on their loans. This led home loan companies to raise their rates making the overall situation even worse and heralding the recession.

Below is an excellent reference on this article if you;d like to read more:

The Foreclosure of America – The inside Story of the Rise and Fall of Countrywide Home Loans, the Mortgage Crisis and the Default of the American Dream – by Adam Michaelson

Last week, we explored in some detail how the small time US Banks of the 1950s slowly grew into global International players. We saw how the small banks of yesteryear began to dip into their war-chests and started to use that money as well as floated shares on the exchanges to get the common man to invest money into themselves. Additionally, we realized the importance of the lifting of the Government 15:1 restriction which forced the banks’ Investment arms to stop lending at 15 times what they really had in their vaults.

Now let’s fast-forward into the year 2002 and beyond and look at our very own Growing Up Bank (aka GU Bank) to see what’s happening.  As we discussed earlier, the Bank has taken complete advantage of the easing of the 15:1 restriction and we’re in the stage where the Bank has 50 million in the vaults, but by wiping out our “rainy-day funds chest” and selling a large amount of stock, the Bank has successfully loaned out about 5 billion. In other words, GU Bank’s loan to deposit ratio is a cool 100:1 (compared to 15:1) as the Bank has managed to leverage it’s deposits to loan out 100 times that amount. You, the Chairman and CEO are at the zenith of glory and you spend a lot of time jet-setting around the globe as you strive to control and grow the Bank’s business. Everything’s going great.

There’s one small problem. It’s called the law of “Supply and Demand”. No matter how high your connections, no matter how much money you have, this simple principle is something that’s out of your control. Here’s the problem: When money was tight, your Bank always ensured that before you granted loans, you looked at the credit-worthiness of the borrower. Which is why borrowers hardly ever defaulted. However with all of this excess cash available, the law of Supply and Demand has kicked in. The amount of cash in supply in the market has zoomed while the demand for it has not. Our Bank’s Executives have hence come up with two simple solutions:

1. GU Bank decides to lower the strict standards of evaluation to determine which borrowers are eligible to get loans from the Bank – in other words, GU Bank is about to increase it’s lending activity to subprime borrowers. In other words, the new mantra for GU Bank is: Need a Loan? No Problem
2. GU Bank’s Investment Management unit will use surplus cash to purchase mortgage-backed securities – in other words – the Bank will buy housing loans made by other banks as well. After all, the markets are going wild, GU Bank is just joining the flock.

Let’s now fast forward a little more to year 2008.

You’ve received an urgent call about a slight problem. You check your emails and the news on TV to hear a catastrophe – there’s a big subprime crisis going on. What’s worse – your bank is right in the middle of it. What the hell happened – you ask at the crisis meeting in the office? How did Growing Up Bank suddenly turn into Going Under Bank? Here are the answers you get:

1. Of the large number of subprime borrowers that GU Bank had provided loans to, a substantial number are defaulting on their loans. Worse, the effect of this has pushed a large number of others on the brink too, so they may be defaulting soon as well.
2. Of the large number of mortgage-backed securities that GU Bank had invested in, a substantial portion were related to subprime borrowers, so they are taking a toll as well.

As the crisis goes on outside, the Crisis Management Committee in the Bank is brainstorming for solutions. This is what’s on the table:

1. You authorize Bank officials to look at the “Rainy Day” accounts of GU Bank to provide some relief from this sudden lack of cash that has arisen. As expected, the officials come back to you with the bad news that while these “Rainy Day” accounts do exist, the contents are woefully inadequate since everything was raided long ago (at your own orders, they add).
2. The Bank tries to use stakeholders money, but there’s none left because the Bank loaned it out long ago. Worse, the shareholders are in a tight spot because all of their investments are in trouble (not just GU Bank – obviously, you were not their sole banking investment).
3. Officials look at the vault to see what’s available there, but there’ s not much left. Remember for every unit in the vault, the Bank made loans of 100 units to borrowers. The market is tight and new depositors are hard to find. Even worse, thanks to #2 above, depositors know GU Bank is in trouble and are not eager to invest more money.
4. Trying to get credit from the market is extremely difficult because every other financial institution out there is in the same fix and is struggling to find a means to stay afloat.

After all options have run out, the Crisis Committee decides to go to the Government for help. At this point, the crisis is so acute that if the Government backs out, the Bank will collapse and hundreds of employees jobs will be lost (not to mention the thousands of people who life savings will be wiped out too). From this point on, any financial news channel or news website will tell you what came next: The near collapse of several major banks and the subsequent bailout by the Government.

With the background in this (and the previous post), you should be well on your way to understanding how the subprime mortgage crisis affected today’s financial institutions. Feel free to look up references on the Internet – they exist in plenty. Below are some resources I found interesting that you might want to look up as well:

1. Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud and Ignorance – Richard Bitner (Amazon)
2. Subprime Lenders Gone Too Far – A Time Bomb Waiting to Explode – Article by Michael Dawson @ EZine Articles
3. How to stop the Banks’ Bleeding – No easy choices – Article in Time Magazine
4. Leverage by the numbers – Article @ Option Armageddon
5. Bank of America tops Leveraged-Loan Business – Article in CFO Magazine
   

Welcome to Part 4 of the Recession Series. While not exactly essential, I strongly suggest that you peruse Part 1, Part 2 and Part 3 before you read any further into this article.

I wanted to title this post “How the hell can a bank go Bust – when it was  worth billions such a short time ago?“, but that title sounded far too long, so I shortened it a bit. As you’ve guessed, in this post, we are going to try and understand how a large bank (such as WaMu, Bank of America or Lehman) can go bankrupt. We will start by understanding how a Bank works in it’s simplest form and then move into the complex scenarios, again in simplified form.

The business of Banking, in essence, is straightforward. Let’s assume for the sake of example that you are the CEO of GU Bank (which proudly stands for Growing Up Bank). GU Bank takes money from people as Deposits, on which it pays them a low interest rate, say 3%. Then, GU Bank finds someone who needs money and lends the depositors’ money to them at a sufficiently higher interest rate, say 7%. The Bank earns for itself the 4% difference generated between these two transaction percentages as profit. Once this is complete, the Bank repeat this process over and over – that’s it. Simple, isn’t it?

There are some limitations to the above Banking methodology. We’ll talk a bit about them below:

1. You cannot lend what you don’t have – In other words, if the total deposits in your vaults is 1 million – that the maximum amount that you can lend out (minus government restrictions, CRR etc etc).
2. Your Bank and you are competing against the other Banks out there - some of who have more deposits than you and can outpace you easily. In other words, you need much more than what you have, if you want to grow against the tough competition.

So, from the 70’s, Banks that wanted to grow came up with two innovative ideas to generate money: Dipping into their own money chests and, Getting investor money – both of which we discuss below.

1. Over time, Banks had saved off a part of their profits for rainy days. With the competition in the market becoming more and more intense, Banks began to dip into this rainy-day fund to start getting money to increase their lending power.
2. Banks moved into Wall Street as institutions and started selling pieces of themselves as shares. Based on their reputation and marked standing, they were able to garner investor money by selling part of their ownership through Stocks. This provided even more money for lending.

Soon, things at GU Bank reached a point where the deposits in your vaults totaled 2 million. However, by dipping into your emergency funds and selling pieces of yourself in the Stock Market, you are able to raise capital that equals another 40 million. Hence, GU Bank now has 42 million available to lend. Compare this to your competitors who are still lending only what they have in Deposits – you soon realize that GU Bank is now firmly in the Big League.

The only thing that stops you is this (silly) Government law which stipulates that that maximum amount you can lend is 15 times the cash you have. Since you have 2 million in the vault, you can lend up to 30 million only. And you wonder – How old-fashioned – whoever heard of  loans being backed by deposits in this age?

However, what you have NOT realized (or blinded yourself to – same thing) is that a lot of the money you are lending out as Loans is now YOUR OWN and if the Lender fails to pay back the loan – YOU will be directly hit. Compare this with the traditional Banking business where you are lending out Depositor’s money, not your own.

But hold on a second – while you’ve grown your Lending Funds out of nowhere, your competitors have realized your trick and they’ve done it too. In other words, the entire Banking industry out there has now realized how to blur the line of distinction between a Bank and an Investment House,  everyone is dipping into their savings and selling pieces of themselves in the Stock Market and pretty much everyone out there has tons of moolah to lend and is looking for Borrowers. There’s a craze in the market to lend and every Bank out there is trying to get you to borrow more and more money from them.

Here are some samples of what Banks did with all this crazy money in the 00’s:

1. Industry leading salaries and record benefits to employees
2. Multi-million dollar bonuses to executives
3. Stock Buybacks – Buying back company stock from the open market
4. Sports Sponsorships
5. Private Jets for company executives

The list is long and crazy…

But even this was not enough, In 2007, Henry Paulson, the US Treasury Secretary and former CEO of Goldman Sachs pushed the US Lawmakers to lift the 1 deposit = 15X loans restriction as well. In other words, you were now free to lend everything you had.

Based on our example, Growing Up Bank has deposits of only 2 Million. It raised another 40 million but was able to lend out only 30 Million. Thanks to this new amendment, the Bank is now able to lend out the entire 42 Million.

Wow – you and Growing Up Bank are now at the top of the Big League. You’re having parties on your private yatch for your private guests, your wife is busy with buying those crocodile-skin designer bags, your Kids go to a private top-of-the-line school with their Nanny – in other words, you’ve got it all.

So what’s next? Next comes the Big Downturn, which we will talk about in the next post.

Welcome to part 2 of the Recession series.

In our last post, we talked about what a Recession is and how it occurs. We looked at a model of the Baby Sitters Co-op that gave us an understanding of how a recession actually occurs. We realized that a recession does not mean lack of resources, it just means lack of resolve to start using those resources. If you haven’t read my last post, please do so first.

We ended last week with a question: To counter the recession, the co-op managers forced a mandate that each couple would need to go out twice a month and have their child baby-sat by others. In other words, there would be some artificial demand created by this and there would be more babies being sat and consequently, more baby sitters. Do you think this will work?

Most of the readers who read the post reverted to me with the same answer – the above measure will NOT end the recession. And they were right. What the above measure will do is to force the couples to spend two (and only two) baby sitting coupons per month. Instead of increasing demand, this will only cause resentment in the couples because they are now being forced to spend coupons in a time-based manner instead of spending them at their own free will. Also, the number of coupons being circulated would be rather limited and fixed.  In the real world, since each couple will end up receiving coupons regardless of demand and supply, the incentive to perform better baby sitting would be taken away too.

So what is the solution? Luckily, one of the couples knew an Economist who suggested a solution. Here is how it worked: The Co-Op board went wild and printed a large number of coupons and provided a bunch of  ‘bonus’ coupons to each couple for use. Each couple was provided with a large number of coupons to spend. Couples soon realized that since they had so many coupons available to them now, there was no more need to hoard them and prepare a backup reserve.

Couples who realized this fact eagerly started to go out and have their kids baby-sat by other couples. The other couples in turn had a surplus of coupons and started to spend them liberally by going out more and spending more coupons and on and on it went. The end result was that there was a healthy circulation of coupons and the Baby Sitters Co-Op came out of recession.

Although this is a simple example, we can immediately draw some parallels with the real world. First, the Baby Sitters Co-Op is the entire USA and the Board of the Co-Op is the Federal Reserve Board. The “coupons” is our currency. Now you can complete the analogy and realize why the Fed is pumping billions of dollars into the economy.

In simple terms – the Fed is trying to:

• Get those of us who are hoarding and saving money in bad times to go out and start spending some of it in the stores.
• This will lead to the stores having more money and selling more
• This will lead to a need for more employees i.e. more jobs and more employed people
• The newly employed people will get paid salaries, some of which they will spend in the stores

and the above cycle will repeat till the economy comes out of the current recession.

Credits: The complete credit for the example goes to Paul Krugman and his book – The return of Depression Economics – and the Crisis of 2008 from W. W. Norton. I strongly recommend reading it, if you can.

If you stand outside and stop the first person you see walking on the street and ask them: “What do you think about the economy today?” – the answer will almost certainly be – “The economy is in a recession. Don’t you know that?” – and most will follow up with – “What hole have you been living in? Don’t you know that the entire world is in the grip of a severe recession?” – and the person will probably walk away disgusted and angry with you. It does not matter if the person is man or woman, old or young, the answer will always be the same. Make no mistake, as of January of 2009, most of the world is in the grip of a severe recession. Most major stock markets are at all time lows and a large number of jobs have been lost across the world.

I have often wondered and the question has been asked to me by so many friends and acquaintances – We know what a recession is, but what causes it? What is the solution to a recession? The truthful answer is: I didn’t know either. Of course, I knew what a recession was and it’s deadly effects. But I had no idea about what caused it and how to get rid of the problem. That is till I read an amazing book titled The Return of Depression Economics – and the  crisis of 2008 by Paul Krugman – Winner of the Nobel Prize in Economics. I was deeply impressed by the author’s ideas and explanations. I haven’t finished the book yet, but when I am done, I will try and do a review of the book as well.

But on to recessions – what are they? To understand this, let’s consider the example given by Paul Krugman from his book. Krugman talks about a Baby-Sitting Cooperative, an association of young couples with kids who were willing to baby sit each others children.

This co-op was large with about 150 couples, so there were plenty of couples ready to baby-sit and managing the association was a non-trivial task.

Like many such associations, the co-op issued it’s own scrip or currency -  a coupon. Each coupon entitled the holder to one hour of baby-sitting. In other words, when a couple went out for the evening, they would leave their baby to be sat with another couple and for each hour, the sitter would receive one coupon from the baby’s parents for this service. The system was shirk-proof: it automatically ensured that over time, if a couple wanted to use the baby-sitting service, they would have to also contribute and baby-sit other babies to earn their coupons.

However, the system was not as simple as this sounds – for smooth running of the system, there was a need for a sufficiently large number of coupons to always be in circulation. Couples who had several free evenings would attempt to “hoard” coupons by trying to baby sit as many babies as they could and build up a “saving” of coupons. Obviously, this hoarding was matched by a depletion in the savings of other couples.

This kept on happening till one fine day, there were relatively too few coupons in circulation. The cause is not very important, but the effect is.

Couples who felt that their “savings” of coupons were insufficient became anxious to babysit other couples babies. However,  one couple’s decision to go out was another couple’s opportunity to earn a coupon, so opportunities to baby-sit became harder to find. This made couples even more reluctant to go out and to use their “reserves” except on special occasions, which made baby-sitting opportunities even more scarce, which made couples even more reluctant to use their “reserves” and so on and on it went until…

The Baby Sitters Co-Op went into a recession. No couple was ready to go out and spend their hoarded coupons and consequently, no one was available to baby-sit a baby because of the total lack of demand.

If you are with me so far, then let’s go ahead. If you are feeling a little lost, go back and read the paragraphs again. I had to read them more than once to grasp the complete concept – but when you have done so, you’ll realize that it is really a brilliant example.

Now, let’s conduct our own analysis and try to visualize the effects of the same. Let’s assume that to counter the recession, the co-op managers forced a mandate that each couple would need to go out twice a month and have their child baby-sat by others. In other words, there would be some artificial demand created by this and there would be more babies being sat and consequently, more baby sitters. Do you think this will work? If yes, how and if not, why not?

Let’s continue this discussion next week.

Credits: The complete credit for this example goes to Paul Krugman and his book – The return of Depression Economics – and the Crisis of 2008 from W. W. Norton. I strongly recommend reading it, if you can.