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In recent times high-profile Wall Street investment banks have brought slick financial reasoning to the base art of loan-sharking. The most vulnerable Americans have been targeted for loans they can ill afford. Those with poor credit histories can be charged at double or treble the interest of a customer in good standing with the rating agencies. By the end of last year housing loans to six million unrated customers ‘sub-prime’ mortgages totalled $600 billion.
Three or four years ago Citigroup, Bear Stearns, Goldman Sachs, Lehman Brothers and HSBC acquired ‘sub-prime’ lenders (‘loan sharks’) which they historically regarded with disdain. Citigroup acquired Associates First Capital, and HSBC bought Household Finance, blazing a trail others were to follow. Finance houses have long teamed up with retailers to shower so-called gold and platinum cards on all and sundry with the hope of ratchetin up consumer debt – rising from 110 per cent of personal disposable income in 2002 to 130 per cent in 2006 – and subsequently charging an annual 18 or 20 per cent on money for which the banks are paying four or five per cent. Such hot rates of return gave the banks a taste for seamy lending. They discovered how to limit their own exposure, while raking in the charges, by re-packaging the debts as CDOs (Collateralised Debt Obligations) in which they capture the risk premium while sloughing off the risk.
With direct access to sub-prime mortgages, the banks and hedge funds bundle together and divide up the debt into ten tranches, each of which represents a claim over the underlying securities but with the lowest trench representing the first tenth to default, the next tranche the second poorest-paying tranche and so on up to the top tenth. Borrowers who can only negotiate a sub-prime mortgage have either poor collateral or poor income prospects, or both, and that is why they must pay over the odds. Of course the bottom tranche of the CDO euphemistically designated the ‘equity’ is very vulnerable but can still be sold cheaply to someone as a bargain. The purchaser will also be assured by those assembling the CDO that they can hedge the possibility of defaults in the ‘equity tranche’ by taking out insurance against it. The bank will for an extra fee also arrange this insurance, making the entire ‘credit derivative’ product very complex and difficult to value.
The top tranches, and even many of the medium tranches, will be more secure yet will pay a good return. The chief executive of a mortgage broker explains: ‘Sub-prime mortgages are the ideal sector for the investment banks, as their wider margins provide a strong protected cash-flow and the risk history has been favourable. If the investment bank packages the securities bonds for sale, including the deeply subordinated risk tranches, it can, in effect, lock in a guaranteed return with little or no capital exposureGenerally investment banks do not like lending money but they are good at measuring risk, parcelling this up and optimising its value.’ For such reasons Morgan Stanley purchased Advantage Home Loans, Merrill Lynch bought Mortgages PLC and Lehman Brothers acquired Southern Pacific Mortgages and Preferred Mortgages.
The investment banks are playing a rapidly-moving game of ‘pass the parcel’. Ideally the loans are bought one day, packaged over-night in India, and then sold on to institutional investors the next day. In recent months ‘sub-prime’ defaults have jumped. A Lehman Brothers analyst warns that some $225 billion worth of sub-prime loans will be in default by the end of 2007 but others say the figure will be nearer $300 billion. The ‘equity tranch’ is now dubbed ‘toxic waste’ by the insiders and analysts are waiting to see which bodies float to the surface. In early March the New York Stock Exchange suspended New Century Financial, a company which had taken on insurance obligations for submerged tranches of mortgage debt for most of the big banks.
The vulnerable in today’s America certainly include the aged and unemployed who risk their one possession by re-mortgaging their home to an investment bank. But many of the middle class find themselves vulnerable too. In recent years they have lost health care and pension benefits and have been tempted by easy credit into purchases they discover they can ill-afford. The Wall Street Journal reports:
Last week, HCBCs chief executive officer, Michael Geoghegan, sought to dispel the notion that the bank had lowered its lending requirements. The typical customer of HSBC Finance Corp., which oversees the bank’s U.S. consumer finance business, has an average household income of $83,000, is 41 years old, has two children and a home worth $190,000. Mr Geoghegan told investors: “This is Main Street America”, he said’.
Helped by their role in packaging and selling such ‘credit derivatives’ as mortage-backed CDOs the banks achieved remarkably good profits right through the post-bubble trough and well into the subsequent recovery. However indebted consumers were not so good for non-financial corporations in the post-bubble era since demand was dampened – by 2003 18 per cent of the disposable income of US consumers was required to service debt and only a housing price boom and re-mortgaging maintained consumer purchasing power. Neither the Fed nor the SEC were keen to crack down on the mortgage bonanza because it helped to maintain consumer demand and market buoyancy. The default crunch will not only cause great unhappiness to the victims who stand to lose their homes – it hurts the housing market and increases the chances of a downturn.
ROBIN BLACKBURN is the author of Age Shock: How Finance Is Failing Us (2007), a comprehensive account of risk and social insecurity in the age of financialization. See also Blackburn’s, ‘Financialization and the Fourth Dimension’, New Left Review, May-June 2006. He can be reached at firstname.lastname@example.org