Pete’s blog

I’ve been thinking a lot lately about the economic problems that America and other place have been experiencing – the infamous ‘sub-prime’ debacle. I have a lot to say, so I’m going to split this into two parts, first: what is sub-prime and what actually happened? The second part will be about the responses and reactions to the crisis and promises to be a goody – yes I will be calling Alan Greenspan an idiot who doesn’t even know basic economics

So what is ‘sub-prime’ exactly? Well prime debt is debt to customers who have a good credit record and who have a very good chance of being able to pay back the debt in full. Therefore ‘sub-prime’ debt is debt that is below prime, ie. first time home owners, people with bad or non-existent credit histories, etc. ‘Sub-prime’ is debt that has a greater risk of the customer not being able to pay back the debt and default. Prime debt=low risk; sub-prime debt=high risk. Now banks and investment companies nowadays have large risk management committees and departments that analyse and assess risk and decide how much risk to take as a bank. Sub-prime debt traditionally has been considered too risky, the obtainable profits didn’t justify the risk. But then some clever person came up with a brilliant idea. If you have $1 million of sub-prime debt, you know that on average 5% of that debt will be bad and will default. What if you cut that 5% off and made a new financial instrument out of the 95% good debt? This would now be ‘prime’ debt, since you have an almost 100% likelihood that the debt will be paid in full. What an excellent idea! All it needs is a funky sounding name – Collateralised Debt Obligation! (CDO)

So banks lend money to sub-prime customers at 7% interest. They cut off the 5% bad part and sell the remaining 95% to another bank or investment firm at 5% interest. The sub-prime customer is happy – he just got a loan that in the past he had no chance of getting. The investment firm is happy, they are getting 5% interest on ‘low’ risk debt where they would normally only get 4% on prime debt. The bank is happy, the 2% difference in interest they are receiving and interest they are paying more than covers the expense of the 5% debt that will go bad. But there is also an added bonus for the bank – they no longer have a 95% of their debt on their balance sheet! They’ve sold the debt to another company and have gotten cash for it. Hmmm, what to do with this extra bit of cash? I know let’s lend it to more sub-prime customers and sell that debt too. Anyone seeing a problem here? This is where it all starts going wrong. In a lot of the articles about the Federal Reserve bail out of banks they frequently talk about ‘moral hazard’, but every ignores the initial ‘moral hazard’ that created the problem.

What is ‘moral hazard’? The term is normally applied to the insurance industry. The ‘moral hazard’ of insurance is that by promising to pay someone if his car is stolen means that the person will probably be less careful about making sure his car isn’t stolen. The insured person no longer carries any risk, because he knows he will be paid out, so his takes greater risks than he normally would. This is why insurance companies have things like no-claim bonuses and excesses. A excess returns a portion of the costs/risks to the insured, so he will be more careful in order to avoid the excess. A no-claim bonus comes from the opposite direction by incentivising customers to take fewer risks and avoid claiming.

So how does this apply to the sub-prime banks? Well the banks have sold 95% of the debt and they therefore no longer carry the risks and costs. Since they don’t carry the risk, they are prepared to take greater risks. Plus greed and bandwagoning come into play and everyone piles into the sub-prime market. Debt is given to riskier and riskier sub-prime customers.

See the problem emerging? Is it just 5% of the debt that will be bad now or is it going to be 10%? Suddenly the ‘low’ risk 95% sub-prime debt that is being sold is actually as risky as the original sub-prime debt would have been - 5% of the 95% is probably going to go bad. Add rising interest rates, falling house prices, rising oil prices, etc., all of which are putting strain on the borrowers, and you have a big problem on your hands. A whole heap of banks and investment companies are sitting with what they thought was low risk debt, but is actually high risk debt. They start incurring heavy losses where they weren’t expected and the true value of their investments is in doubt. Everyone panics, no one wants to lend any one any money and people are worried that banks and investment companies might suddenly go under. The credit market starts contracting, banks start trying to recall loans, even previously low risk prime debt is viewed with suspicion. And the whole grand edifice starts crumbling and everyone tries desperately to prop it up… Which brings me to the topic of next week

In the meantime, here’s a little bit of extra reading if you’re interested.

Slate Article: Rich Men Behaving Badly

America was conned - who will pay?

We will never have a perfect model of risk
We should reject this extremism of Greenspan’s