Monday, December 5, 2016

Here is the succinct but complete explanation of the subprime crisis. One, which apparently should not be told.

Just four factors explains it all, or at least 99.99%.

Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the more money for us. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces and immediate profit of $210.000 for those involved in the process.

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies.

Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker. 

Capital requirements for banks. Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.

Clearly the temptations became too much to resist for all involved.

The banks, like the Europeans, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies.

Of course it had to end bad... and it did!

Can you image what would have happened if the craze had gone on one year more?

I have explained all the above in many shapes or form, for much more than a decade. Unfortunately it is an explanation that is not allowed to move forward, because it would put some serious question marks about the sanity of some of the big bank regulators.

Might I need to go on a hunger strike to get some answers from the Basel Committee and the Financial Stability Board?