Subprime Mortgages: The Road To Ruin

As discussed in the previous post, Richard S. Fuld, Jr controlled Lehman Bros, instilling his own ambitions upon those working for him. Institutional Investor Magazine reported that at a company party on 7^th February 2005, Fuld showed his true colours in an address to his managing directors. Lehman shares debuted on the stock market in 1994 at a price of $8.00 (adjusted value) each. The end of day figure 11 years on was $92.70. The interim time period saw unprecedented growth. A conscious decision was made to pursue an aggressive market strategy some time in 2006 into a more capital intense banking model. All energies were focused on becoming the biggest player in Wall Street. To do so, the aim was in reaching a share price of $150 by 2007, but as he remarked:

“We have a problem. The problem is that now I can see 150. We’re getting close, and we need to raise the bar. So I want you all to think about how we get to 200.”

In a way this strategy was no different to any other investment bank. Lehman’s own model was not wholly unique, it was just a variation of how their competitors were generally organised. During the early-to-mid-2000s period, the mortgage market became a key element of Wall Street banking. Bankers found themselves dealing with securitised mortgages, summarised succinctly by the video at the bottom of the post. Lehman also got involved in this. It was viewed as a safer bet and profitable investment because of the strict approval process that was required for buyers to complete before they were allowed loans. This process required personal information about the buyer, including employment details and their income levels. A deposit of at least 25% the value of the house was also a prerequisite in some cases. These measures were needed to ensure that only a minority of mortgages were defaulted on. In any case that a default did occur, the recently purchased house would be used as leverage and would become property of the bank. This would help maintain the overall assets on their balance sheet, although their own cash reserves would become more illiquid. Thanks to the housing market this was proving to be successful. However, greed took over and the luck that the investors were experiencing desserted them.

A study conducted by Luigi Zingales (2008) highlighted that in the build-up to the subprime mortgage crisis, interest rates in the USA were set at a relatively low rate, and this had continued for a very long time. In turn, this lead to rising house prices for 9 consecutive years until 2006. The relative values of living over a 100 year period are indicated in Figure 1, taken from Robert Shiller (2005). This is interesting on the whole but our attention is drawn to the most recent era. Whilst interest rates and the cost of building remained fairly constant, the USA’s population grew steadily and house prices grew at an exponential pace.

It was also found that the loan delinquency rate dropped over the same time frame, which is the amount of loads that were defaulted on in comparison to the total amount of loans that were approved. Within the general population, confidence in the banking system was high and many more prosperous years were expected, as expressed in a survey by Case & Shiller (2005).

This proved to be a very profitable branch of their operations and investment banks saw an opportunity to make more money. The majority of those who qualified for a mortgage had already been approved and purchased their property. These earned large returns in interest due the sheer number of policies agreed. As a result, the mortgage brokers became more eager to lend because all of the risk involved was transferred to the purchasing bank. However, as the pool of possible customers dried up, so did the available profits. Therefore, they began to be more creative with the deals they offered to attract a larger portion of the public. A book by Schwartz (2009) claims this is when the lower quality adjustable-rate and subprime mortgages began to infect the market and pushed the boundaries of safe banking to the limits. This was a direct result of market regulations being relaxed.

Subprime mortgages are of particular significance. This is an alternative for borrowers with a lower credit rating. Effectively, these are riskier because the recipients of these loans are judged to be more likely to default on repayments. To reflect the higher level of risk involved, subprime mortgages are undertaken with a higher interest rate.

The idea of deflecting risk associated with mortgages was known as securitization. This was the practice of collating several mortgages together in a pool to be sold all together. Largely, there was very little monitoring of these deals, therefore, many types of mortgage were often grouped together whether they good or bad, prime, subprime or otherwise. There was further over-confidence with securitizations when the investment banks that agreed to buy them failed to perform their own quality checks. These blatantly obvious oversights meant that, more often than not, investment banks were in the possession of worthless and extremely risky securities, which were of considerably less value than they were credited as having.

Yuliya Demyanyk (2009) explains that the growth of the housing market was unsustainable and the quality of the mortgage loans had decreased year on year for nearly a decade. The risks that this brought were hidden by the excessive values given to properties at the time. This spelled trouble for banks when the level of defaults reached an all-time high and, consequently, the housing market bubble crashed in mid-2008. Now, investment banks, including Lehman, found themselves holding illiquid cash in the form of devalued housing. This deprives banks of the regular stream of money brought in by these investments, bringing on cash flow issues with their own loans to pay back and dividends to be issued to shareholders.

The examiner’s report into the Lehman Brothers Bankruptcy, conducted by Anton R. Valukas (2010), indicated that the management at the top of the firm were slow to recognize the crisis that lay ahead. The situation was grossly underestimated by Fuld and other executives, who didn’t think that it could infect other sectors within the market and it was too far gone by the time they finally took action. As they were aware that buyers would not be forthcoming, the decision was taken to “double down” with the mortgages the firm held. Akin to the blackjack strategy of the same name, it is a calculated gamble to hold on to mortgages already purchased in the hope that market conditions will improve again and will prove profitable. In a sense, Lehman was trying to weather the storm.

Essentially, the housing bubble bursting compounded the losses that Lehman had been accruing over last reported quarters. Their venture into housing assets had been funded by taking on loans with the interest offered by the held mortgages high enough to still turn a significant profit.

The video above, created by CrisisOfCredit.com, is a simplified version of events, which I think helps to explain how the subprime mortgage crisis came about and brought on the collapse of financial institutions including Lehman.