Economists predict that the Philippine economy will be hit hard by next year as exports continue to decline and the budget deficit widens. They say that even OFW remittances will decline as more companies are cutting jobs worldwide.
To gain a perspective of what is happening with the world economy, let us take a look at the root of the problem that is rooted in the US financial crisis. For this purpose I am posting my article published in Sunstar Pampanga on October 7 and 9, entitled: Understanding the US Financial Crisis:
We must have heard by now the ongoing financial crisis in the United States with the unfolding drama of once thought to be financially impregnable, multimillion-dollar companies collapsing, such as investment giant Lehman Brothers, Bear Stearns, government sponsored entities Fannie Mae and Freddie Mac, world’s biggest insurer AIG, Washington Mutual and recently, Wachovia.
To address this growing crisis, U.S. President George W. Bush has just signed a modified bailout plan to the whopping tune of $700 billion which his administration hopes will resuscitate the dying financial market and prevent the U.S. economy from spiraling down.
Reading and listening to the news reports about this crisis could prove very dizzying, what with the complex concepts and jargons of the world of finance that played significant roles in this problem. Terms such as mortgage backed securities, collateralized debt obligations, asset backed securities, credit default swaps, etc., could prove very daunting for the unitiated like me to understand.
To understand the undelying issues is to understand the news. This is an attempt to explain the uderlying causes of the U.S. financial crisis – after an excruciating research and study of the financial gobbledygook – which threatens not only the economy of the continental U.S. but of the world as well, given the magnitude of the investments in U.S. dollars of huge and several non-U.S. companies including sovereign investors.
The problem started with the housing bubble in the US where thousands of new homes have been built over a span of a few years and many have acquired housing loans to buy new homes. Lower interest rates and the availability of cheap money have driven the mad rush to build more and more houses which resulted in the supply overwhelming demand.
In a typical housing loan a lender will provide the money that the homebuyer will use to purchase a house. To protect the lender against failure by the homebuyer in paying the loan a contract of mortgage will be created whereby the house will be foreclosed (sold to the highest bidder and the proceeds to go to the lender) in the event the homebuyer is unable to pay the loan.
Lenders have considerably relaxed lending requirements for housing loans and many extended credit even to those with spotty credit history or those with poor record of paying or questionable ability to pay their loans. These loans came to be known as subprime or junk mortgages because of the increased risk creditors face with these type of borrowers – that of not being able to pay their loans or mortgages. MBS have much to do with this practice by lenders. More on this later.
An innovation of lending practice in the US is the adjustable rate mortgage or ARM. Under this scheme the interest rate is not fixed over the life of the loan and adjusts, either higher or lower, depending on the prevailing interest rate, unlike in a fixed mortgage loan where the interest rate is locked-in for the duration of the loan.
Many homebuyers with poor ability to pay have been enticed by lenders to take the ARM type of loans with so-called teaser rates where the introductory interest rate is low, thus resulting in lower monthly payments of their loans. Either these homebuyers did not appreciate the risk of interest rates increasing (which will increase their monthly loan payments) or were banking on the continuing rise of housing values that will enable them to refinance (getting a new loan on the house) to cover them against rate increases.
With rising home values homeowners could get loans against their houses over and above their purchase values. For example, if a homebuyer purchases a house worth $200,000 and gets a loan for this amount to finance the purchase, after a year or two the house might be worth $250,000 for which the homebuyer/homewoner could obtain another loan (refinance) over the same house for such an amount, thereby giving the homebuyer $50,000 in the pocket. This increase in value is what is called an equity.
In essence the ARM type of loan is a gamble on the part of the homebuyer, because he or she is gambling on the possibility of a stabilizing or decreasing interest rate in the future that will maintain or decrease the monthly loan payments, as well as on the increasing value of houses.
What these types of homebuyers did not anticipate, however, is that because the supply of new homes grew to a frenzy pace versus the demand for them home values also declined rapidly. From their peak in 2006 housing values have significantly dropped by 20%.
When interest rates increased known as a reset the monthly payments of ARM homebuyers ballooned. For most American households which are on fixed paychecks such sudden increase in monthly payments could hardly be afforded. What is sad is that these distressed homebuyers could not get their houses refinanced, which is their last hope to get them through the crunch because of the drop in home values. Thus, begins the bubble burst in the housing market.
Now one might be asking, how is this housing problem related to the financial crisis? The answer lies in the structured finance instruments developed by finance-savvy investors.
To address this growing crisis, U.S. President George W. Bush has just signed a modified bailout plan to the whopping tune of $700 billion which his administration hopes will resuscitate the dying financial market and prevent the U.S. economy from spiraling down.
Reading and listening to the news reports about this crisis could prove very dizzying, what with the complex concepts and jargons of the world of finance that played significant roles in this problem. Terms such as mortgage backed securities, collateralized debt obligations, asset backed securities, credit default swaps, etc., could prove very daunting for the unitiated like me to understand.
To understand the undelying issues is to understand the news. This is an attempt to explain the uderlying causes of the U.S. financial crisis – after an excruciating research and study of the financial gobbledygook – which threatens not only the economy of the continental U.S. but of the world as well, given the magnitude of the investments in U.S. dollars of huge and several non-U.S. companies including sovereign investors.
The problem started with the housing bubble in the US where thousands of new homes have been built over a span of a few years and many have acquired housing loans to buy new homes. Lower interest rates and the availability of cheap money have driven the mad rush to build more and more houses which resulted in the supply overwhelming demand.
In a typical housing loan a lender will provide the money that the homebuyer will use to purchase a house. To protect the lender against failure by the homebuyer in paying the loan a contract of mortgage will be created whereby the house will be foreclosed (sold to the highest bidder and the proceeds to go to the lender) in the event the homebuyer is unable to pay the loan.
Lenders have considerably relaxed lending requirements for housing loans and many extended credit even to those with spotty credit history or those with poor record of paying or questionable ability to pay their loans. These loans came to be known as subprime or junk mortgages because of the increased risk creditors face with these type of borrowers – that of not being able to pay their loans or mortgages. MBS have much to do with this practice by lenders. More on this later.
An innovation of lending practice in the US is the adjustable rate mortgage or ARM. Under this scheme the interest rate is not fixed over the life of the loan and adjusts, either higher or lower, depending on the prevailing interest rate, unlike in a fixed mortgage loan where the interest rate is locked-in for the duration of the loan.
Many homebuyers with poor ability to pay have been enticed by lenders to take the ARM type of loans with so-called teaser rates where the introductory interest rate is low, thus resulting in lower monthly payments of their loans. Either these homebuyers did not appreciate the risk of interest rates increasing (which will increase their monthly loan payments) or were banking on the continuing rise of housing values that will enable them to refinance (getting a new loan on the house) to cover them against rate increases.
With rising home values homeowners could get loans against their houses over and above their purchase values. For example, if a homebuyer purchases a house worth $200,000 and gets a loan for this amount to finance the purchase, after a year or two the house might be worth $250,000 for which the homebuyer/homewoner could obtain another loan (refinance) over the same house for such an amount, thereby giving the homebuyer $50,000 in the pocket. This increase in value is what is called an equity.
In essence the ARM type of loan is a gamble on the part of the homebuyer, because he or she is gambling on the possibility of a stabilizing or decreasing interest rate in the future that will maintain or decrease the monthly loan payments, as well as on the increasing value of houses.
What these types of homebuyers did not anticipate, however, is that because the supply of new homes grew to a frenzy pace versus the demand for them home values also declined rapidly. From their peak in 2006 housing values have significantly dropped by 20%.
When interest rates increased known as a reset the monthly payments of ARM homebuyers ballooned. For most American households which are on fixed paychecks such sudden increase in monthly payments could hardly be afforded. What is sad is that these distressed homebuyers could not get their houses refinanced, which is their last hope to get them through the crunch because of the drop in home values. Thus, begins the bubble burst in the housing market.
Now one might be asking, how is this housing problem related to the financial crisis? The answer lies in the structured finance instruments developed by finance-savvy investors.
Let us backtrack on the mortgages originated by lending companies to homebuyers. In the past lending companies retain the risk of non-payment when they extend loans to borrowers. But with the emergence of certain finance instruments, which we will tackle shortly, lenders have learned how to distribute the risk while at the same time generating more money to lend to borrowers.
A lending institution that generated several mortgaged loans could now sell these loans (or the right to receive payments on them) to an investment company. The proceeds from the sale of these loans will then be used by the lending institution in extending more loans to borrowers, such as prospective homebuyers. At the same time the risk of default from the loans it previously originated is passed on to the investors of these loans.
When applied to mortgaged loans on houses these sold loans are called mortgage backed securities or MBS. The investment company that purchased these loans packages them for sale in the form of bonds (debt securities) to prospective investors. Unlike traditional bonds, however, the income from the MBS flows to the investors which come from the mortgage payments of homeowners.
The ability of lending companies to transfer the credit risk to others through the instrumentality of MBS made it palatable for them to extend high risk loans to people with poor credit history, for after all they could easily dispose of these loans to willing investors.
Since holders of MBS rely on payments being made by homeowners to generate profit, the failure or inability of many such homeowners to pay the mortgages on their homes leading to foreclosures – which became a nation-wide phenomenon in the U.S. – brought financial ruin to companies that invested heavily on MBSs.
According to former Federal Reserve Chairman Alan Greenspan, the creation of MBS based on subprime mortgages or high risk mortgages is the leading source of the current U.S. financial crisis. Aside from MBS, however, there are still other species of structured finance that are being blamed for the crisis, such as the more complicated collateralized debt obligations (CDO) and credit default swaps (CDS).
The simplest definition of CDO that I came across the web is that it is an investment that is backed by debt. To better understand CDOs the mechanics of how they work must be understood. Typically an investment company raises money from several investors and issues corresponding bonds (securities) to represent the investors’ interests. The money generated are invested in the purchase of loans, bonds or other assets with collateral, hence the term collateralized. These mixture of debts is called a portfolio.
The payments that the investment company receives from the portfolio is the source of income that is distributed to investors. A lot of CDOs have invested in MBS or securities in which the underlying assets are real estate mortgages.
A credit default swap (CDS), on the other hand, is an insurance against failure by a company in the payment of its obligations. For example, if you buy P100,000 worth of bonds from a company you can purchase a CDS that will pay you P100,000 – after payment of an upfront fee and premiums at set intervals for the duration of the agreement, usually five years – in the event the company that issued the bond fails to pay its obligation in what is called an event of default.
What differs a CDS from a real insurance is that one does not need to have an economic stake in the thing insured against (insurable interest) – such as that which a homeowner has over his house in insuring it against fire or other losses. Anybody can insure another’s investment in a company or in other words speculate on that company’s gain or loss. Furthermore, CDSs are unregulated.
The problem with these CDSs is that so many companies invested and speculated on them (there are an estimated $60 trillion – yes in trillion! – worth of unregualted CDSs lying around), and what exacerbated the problem is that these CDSs covered CDOs and MBSs that are based on subprime mortgages. Now if you do the math here you will see that since housing foreclosures have become so widespread the stream of income that is supposed to flow to the holders of these complicated, three-lettered investments (CDS, CDO and MBS) has been severely stemmed.
American International Group (AIG), which is the world’s biggest insurance company, had invested heavily on these CDSs. It sold more than $400 billion worth of CDS which led to its calamitous fate.
These gigantic setbacks suffered by huge financial institutions led to a freeze in the credit markets. Lending companies, including banks, are now holding tight to their money and adamant to lend them – even to each other.
To use a now famous cliché, this seizing of the financial market has trickled down from Wall Street to Main Street (to the common Americans). With banks and other financial institutions not lending money, companies are unable to resupply their inventories that will enable them to produce or sell more with the net result of more people losing their jobs (already, the Department of Labor has reported about 159,000 Americans losing their jobs); investments are being stalled as the lack of capital holds investors from venturing or expanding their businesses; people cannot obtain loans to purchase cars, homes, get equity on their homes, and are holding tight on their cash by reining in on spending resulting in a slowdown of the economy.
Indeed, the scenario for every American has become bleak. Although some experts express reservation on the effectiveness of simply pumping money back into the US economy in reviving its financial market, hopefully the newly-signed bailout plan of the Bush Administration will stem the tide of collapse of the U.S. economy.
As already mentioned the stakes here involve not only the US economy but of the world as well. Just recently in the news, European Union member-countries are working hard to come up with a consensus on how to protect their economies. The U.S. financial or credit crisis has already affected huge banks and financial institutions in Iceland, Germany, and the U.K. Let us hope and pray that a viable solution will soon be found.
A lending institution that generated several mortgaged loans could now sell these loans (or the right to receive payments on them) to an investment company. The proceeds from the sale of these loans will then be used by the lending institution in extending more loans to borrowers, such as prospective homebuyers. At the same time the risk of default from the loans it previously originated is passed on to the investors of these loans.
When applied to mortgaged loans on houses these sold loans are called mortgage backed securities or MBS. The investment company that purchased these loans packages them for sale in the form of bonds (debt securities) to prospective investors. Unlike traditional bonds, however, the income from the MBS flows to the investors which come from the mortgage payments of homeowners.
The ability of lending companies to transfer the credit risk to others through the instrumentality of MBS made it palatable for them to extend high risk loans to people with poor credit history, for after all they could easily dispose of these loans to willing investors.
Since holders of MBS rely on payments being made by homeowners to generate profit, the failure or inability of many such homeowners to pay the mortgages on their homes leading to foreclosures – which became a nation-wide phenomenon in the U.S. – brought financial ruin to companies that invested heavily on MBSs.
According to former Federal Reserve Chairman Alan Greenspan, the creation of MBS based on subprime mortgages or high risk mortgages is the leading source of the current U.S. financial crisis. Aside from MBS, however, there are still other species of structured finance that are being blamed for the crisis, such as the more complicated collateralized debt obligations (CDO) and credit default swaps (CDS).
The simplest definition of CDO that I came across the web is that it is an investment that is backed by debt. To better understand CDOs the mechanics of how they work must be understood. Typically an investment company raises money from several investors and issues corresponding bonds (securities) to represent the investors’ interests. The money generated are invested in the purchase of loans, bonds or other assets with collateral, hence the term collateralized. These mixture of debts is called a portfolio.
The payments that the investment company receives from the portfolio is the source of income that is distributed to investors. A lot of CDOs have invested in MBS or securities in which the underlying assets are real estate mortgages.
A credit default swap (CDS), on the other hand, is an insurance against failure by a company in the payment of its obligations. For example, if you buy P100,000 worth of bonds from a company you can purchase a CDS that will pay you P100,000 – after payment of an upfront fee and premiums at set intervals for the duration of the agreement, usually five years – in the event the company that issued the bond fails to pay its obligation in what is called an event of default.
What differs a CDS from a real insurance is that one does not need to have an economic stake in the thing insured against (insurable interest) – such as that which a homeowner has over his house in insuring it against fire or other losses. Anybody can insure another’s investment in a company or in other words speculate on that company’s gain or loss. Furthermore, CDSs are unregulated.
The problem with these CDSs is that so many companies invested and speculated on them (there are an estimated $60 trillion – yes in trillion! – worth of unregualted CDSs lying around), and what exacerbated the problem is that these CDSs covered CDOs and MBSs that are based on subprime mortgages. Now if you do the math here you will see that since housing foreclosures have become so widespread the stream of income that is supposed to flow to the holders of these complicated, three-lettered investments (CDS, CDO and MBS) has been severely stemmed.
American International Group (AIG), which is the world’s biggest insurance company, had invested heavily on these CDSs. It sold more than $400 billion worth of CDS which led to its calamitous fate.
These gigantic setbacks suffered by huge financial institutions led to a freeze in the credit markets. Lending companies, including banks, are now holding tight to their money and adamant to lend them – even to each other.
To use a now famous cliché, this seizing of the financial market has trickled down from Wall Street to Main Street (to the common Americans). With banks and other financial institutions not lending money, companies are unable to resupply their inventories that will enable them to produce or sell more with the net result of more people losing their jobs (already, the Department of Labor has reported about 159,000 Americans losing their jobs); investments are being stalled as the lack of capital holds investors from venturing or expanding their businesses; people cannot obtain loans to purchase cars, homes, get equity on their homes, and are holding tight on their cash by reining in on spending resulting in a slowdown of the economy.
Indeed, the scenario for every American has become bleak. Although some experts express reservation on the effectiveness of simply pumping money back into the US economy in reviving its financial market, hopefully the newly-signed bailout plan of the Bush Administration will stem the tide of collapse of the U.S. economy.
As already mentioned the stakes here involve not only the US economy but of the world as well. Just recently in the news, European Union member-countries are working hard to come up with a consensus on how to protect their economies. The U.S. financial or credit crisis has already affected huge banks and financial institutions in Iceland, Germany, and the U.K. Let us hope and pray that a viable solution will soon be found.
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