The inside story of the sub-prime crisis

By February 26, 2016Featured, Finance, Insights, Property
sub-prime-crisis

The film The Big Short , starring Christian Bale and Brad Pitt, tells the story of the hedge fund managers who predicted the sub-prime crisis. In fact the risks in the mortgage market were recognised in the US well before the housing crash.

For example, in this Wall Street Journal article in 2004, the boss of America’s biggest mortgage lender Countrywide was forced to defend its practices. So why was the situation allowed to continue for four more years until it triggered the financial crisis?

Research by three academics – Professor Anne Wyatt, Professor Peter Wells and Dr Willoe Freeman – into Countrywide’s accounts has helped to document what went wrong. Countrywide gave out a staggering £2.2 trillion in loans between 2000 and 2006 and had a 17 per cent share of the market, but as house prices began to collapse, its share price crashed. It was acquired by Bank of America in a $4.1 billion ‘fire sale’ in January 2008.

Here are some of the key problems the academics discovered:

  1. At one time companies giving out mortgages raised the money by taking deposits from savers which naturally limited their lending. Loans also had to be insured against the risk of borrowers defaulting and insurers imposed strict lending criteria. However from the 1980s, the government relaxed the rules to encourage home ownership. Companies could bundle mortgages together and sell them on as high-yielding securities to investors, providing them with immediate income. Therefore mortgage debts which would normally be classed as liabilities on their balance sheet were treated as ‘sales’.
  2. Because the income now came at the start of the mortgage rather than spread over the full term, it allowed Countrywide to grow more rapidly, but meant future revenues were more volatile – however this fact was not spotted until too late.
  3. Because Countrywide felt it could pass on the risk of mortgage default to investors, there was little incentive for it to maintain credit standards and the proportion of subprime loans it gave out increased significantly. Rising house prices masked the problems initially, as even where customers defaulted, their properties could usually be sold at a profit.
  4. The bundled investments lacked transparency and investors were not fully aware of the risks so they continued pouring in money, which led to a dramatic expansion of mortgage lending.
  5. The company’s colourful co-founder Angelo Mozilo held the dual roles of CEO and chairman. He earned more than his five top executives put together and no doubt had a strong influence on the board. As management rewards were linked to the share price, it also encouraged short-term gains and excessive risk taking. Mozilo, the son of a Bronx butcher, was charged with insider trading and fraud and later agreed a $67.5m settlement.

The academics say: “It’s time for a ‘back to fundamentals’ approach in banking and finance where credit quality is sacrosanct, and success in getting the loans back in, and not loan volume, drives executive compensation. Transactions such as securitization that are primarily designed to fund expanded operations should also be accurately classified as financing transactions and accounted for as such on the balance sheet.”

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