Why did mortgage banks ever think subprime was a good idea?

If house prices only ever went up, then lending to subprime borrowers could be considered relatively foolproof. But as the ongoing bad news from the credit markets has shown, it's anything but.

Imagine that you worked for a mortgage bank in America and a few years ago you were called to a presentation by the Chief Executive.

He started by explaining that the mortgage business had become very competitive and margins were pared back. However, the bank could steal a march on its competitors'. Increased profits would be to everyone's benefit, generating higher bonuses and higher wages. His great plan was to lend to subprime borrowers who would, for the first time, be able to buy a house. This would increase housing activity, driving prices higher. Higher prices would give further security to the bank.

One of the reasons subprime borrowers had previously been unable to afford mortgages was that market driven interest rates made them unaffordable. To overcome this, the bank would offer them an especially low, artificial rate of interest for say three years. The underpaid interest would accrue as additional debt. At the end of the teaser' interest rate period, a proper market rate would then apply to the whole of the increased loan. The increased debt level would be more than covered by the presumed appreciated value of the house. However, the borrower would yet again be faced with an unaffordability issue.

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The Chief Executive explained that the solution to that was simple, the borrower could go to one of their competitors and refinance on a favourable basis, presumably by utilising a new teaser rate plan. The crazy and doomed scheme was thought foolproof because everyone stupidly believed that the rate by which the unpaid interest accumulated would be less than the rate by which the property would appreciate - a process that would continue indefinitely.

The other trick that made it all seem to work so beautifully was that these loans, once completed, could be diced and sliced with other loans, add a bit of leverage to spice up returns and then be sold on as high yielding bonds. Investors, he explained, in an era of low interest rates, would clamour to buy these bonds which the rating agencies conveniently rated higher than that which would apply to much of the diced and sliced contents. The mortgage bank, with the funds received following the sale of these bonds, could then re-lend to another group of no-hopers, etc., etc.

It's hard to believe that such a concept prospered because to work, the smartest people in the business had to play a part. The brightest minds at global investment banks and hedge fund managers of immaculate investment pedigree, all participated and, of course, financially benefited the whole process was finally justified by the fact that the risk, instead of resting entirely with the original lending bank was instead spread amongst many investors. This, they said, would ensure no banking crisis. One can hear them saying to each other at the time "If it doesn't go wrong we will all make bundles of money and if it does go wrong the pain will be spread amongst many and we will still make bundles of money!"

This past fortnight has been dominated by news dealing with the deteriorating credit market. The following are just a few of the news items in the order that they have been reported:

1. The Man Group raised $2.9 billion versus a target of $3.5 $3.8 billion when floating its broking arm MF Global it blames concerns about the impact on the financial sector.

2. Basis, an Australian hedge fund, warned investors of potential 50% losses.

3. Manchester United's £600 million re-finance deal was put on ice.

4. KKR forced to renegotiate deal for Alliance Boots mergers.

5. Morgan Stanley report that the cost of credit for mid-tier companies rose from 6.9% to 8.3% in one month.

6. Expedia slash buy-back plan, the Chairman and CEO, Brady Diller, said that the terms available in the current debt market environment were simply unacceptable.

7. Banks in US and Europe have been forced to retain $40 billion worth of high yield debt that they had intended to sell in recent weeks.

8. IKB, a German specialist bank, only two weeks ago issued a statement to reassure the markets that it would not be significantly impaired by weakening property loans. However, on the 31st July the Financial Times reported that IKB now faced a crisis from the fall-out from the subprime mortgage market. But then on 2nd August the Financial Times said that a government sponsored rescue is under way. Germany's Head of Financial Regulation, Jochen Sanio, said it was the worst banking crisis since 1931.

More worrying news will come soon because many hedge funds issue monthly valuations which, this time, are causing huge difficulty. Gillian Tett wrote in the Financial Times on 2nd August of bitter disputes developing behind the scenes about the way funds are valuing some assets for their end of month performance reports. Amongst those hedge funds are bound to be a further slew of skinny dippers scrambling to justify previous valuations, based on model, which have lulled investors into a false sense of comfort and justified payment of fees based on investment growth which now looks very dodgy. Fertile ground for generating lawyers fees as embittered investors start a blame game and look for compensation.

From the point of view of RHAM managed portfolios, we think these are appropriately deployed and the reported action taken so far is appropriate. Going forwards, we have a clear understanding as to how portfolios may need to be adjusted so as to benefit fully from these developing conditions, whatever should happen.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/