LESSONS FROM THE FINANCIAL CRISIS FOR TODAY’S MANAGERS

[We often hear the word the economy is in bad shape and this happened because to a worldwide financial crisis whose origin lies in the USA and it has impacted India too. Ever since the financial crisis, the world economy is yet to fully recover. Indian economy is also affected due to world-wide slowdown. What is this financial crisis? How it has impacted the world economy as well as India’s? How it has impacted a common man, a housewife, and a college going student? What are the lessons for today’s aspiring managers?

The genesis of financial crisis of 2007-2009 lies in the housing loan market of the U.S.A. A housing/mortgage loan in the U.S.A during 1930s had extremely unusual structure biased towards the lenders – floating rate interest with 5 to 10 years maturity, payments typically covered only the interest, and the principal balance due at the maturity. The mortgage loan amount to property value, Loan-to-Value (LTV) ratio, was usually less than 50%. Due to difficulty in saving the principal amount in short maturity period, the borrowers very often use to renegotiate the loan. The lenders had the option to terminate the relationship at maturity and demand full repayment. Failing such repayment, the lender could seize and sell the property to recover its principal amount which was only half of the value of the property. After the Great Crash of the October 1929, many banks became bankrupt resulting in depositors losing their deposits, the value of household property fell to about 50%, and mortgage loan banks were unable or declined to refinance the loans at all, and the borrowers could not pay their interest amounts and/or principal loan. During 1931 to 1935, there were typically 250,000 foreclosures every year. This experience led the federal government to transform the mortgage finance market in the United States.

To stimulate mortgage lending & give good access to mortgages to potential home buyers, the U.S. federal government enacted National Housing Act of 1934 and 1938 which helped in creating a number of government sponsored entities (GSE) like Federal Housing Administration (FHA), the Federal National Mortgage Association (FNMA, Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac), and the Government National Mortgage Corporation (GNMA, Ginnie Mae).

The structure of the mortgage changed with the typical mortgage (called touchstone mortgage) has a 30-year life, fixed rate of interest, level payments, requires a down payment of about 20 percent, and self-amortizing (interest as well as principal loan are paid during the life of the loan in EMIs).

Savings and Loan Association (S&L) (also called Thrifts), are typically home loan lenders in the U.S. When an S&L grants a loan to the borrower, it would typically hold the loan for its life and service the loan itself by collecting payments on the loan, along with payments on taxes and insurance. This mortgage production method is known as Originate-to-Hold (OTH) model. In this OTH model, the S&L deposits tied up in funding a particular mortgage represented ‘dead money’ during the life of the loan and as such those deposits could not be used to expand home financing any further. In order to help the originators – S&Ls to free their tied-up capital, the (GSE – Fannie Mae and Freddie Mac buy the loans which were guaranteed by Ginnie Mae. However, these GSEs use to buy only so called conforming mortgages which should meet four essential requirements – monthly mortgage payment for principal and interest, property taxes, and property insurance should not exceed 28% of the borrower’s before tax income. The total payment on the mortgage along with other obligations such as credit card payment, auto loan payment, etc. should not exceed 36% of before-tax income; there should not be more than one late payment within the previous year & the borrower should have a specific level of credit score; the borrower should pay the closing costs and down payment along with cash in the bank to meet an additional two months of loan payment; and the loan size was also limited. Mortgages that do not meet these requirements are nonconforming mortgages. Mortgage loans fall into two categories: prime and non-prime. Prime loans are conforming loans. Nonprime mortgages are of three types- Alt-A, Subprime, and HEL or HELOC. The non-prime loans come under nonconforming loans.

Mortgages purchased by Fannie Mae and Freddie Mac were sold in the market through Securitization – a financial mechanism under which various contractual debts/loans like home loans, auto loans, credit card debt/loan obligations, etc. are pooled together into a single contractual debt by a securitizer and converted into financial securities like bonds carrying a rate of interest, a face value, duration etc., and sold in the market to various investors. This mechanism was developed to promote liquidity in the marketplace. Mortgage-backed Securities (MBS) was created out of a pool of only mortgage/home loans and sold to investors in the form of mortgage pass-through security or participation certificate. From 1970 until 1983, Fannie Mae and Freddie Mac issued only pass-through certificates guaranteed by Ginnie Mae. But this structure has limitations – Ginnie Mae guarantee was available to relatively few mortgages, like FHA (federal home agency, a US govt. agency like National Housing Board in India) and VA (a US govt. agency for veterans – ex-servicemen and their spouses, etc.), mortgages and the mortgage pool thus formed should be homogeneous – same principal amount, interest rate, maturity period, same credit quality, etc. Also, there was risk of prepayment – borrowers repaying the loan amount before maturity. This, prepayment risk was instrumental in developing more sophisticated types of MBS.

In June 1983, two investment bankers – Salomon Brothers and First Boston, helped Freddie Mac to introduce a new kind of sophisticated MBS – Collateralized Mortgage Obligation (CMO). CMO allowed the heterogeneous mortgages to be pooled together – different interest rates (adjustable or fixed), different maturities, different qualities (prime, sub-prime, Alt-A, etc.), etc. The cash flows from the pool – interest and principal –were sliced into various “tranches” based on the seniority, typically divided into three tranches: Senior, Mezzanine, Equity or Toxic. The payments – interest and principal are paid seniority-wise. Once the senior most tranche securities are paid-off, and then turn of next junior one will start, and so on. However, each ‘tranche’ security should be first rated by a credit rating agency like S&P. Senior tranches consist of securities with credit rating of AAA to A, Mezzanine with BBB to B, Equity with much lower rating or no ratings. Senior tranche being AAA to A are considered to be much safer as they signify low default risk, so this tranche carry less rate of interest compared to other tranches, while equity or toxic tranche have high default risks, so this toxic tranche securities carry a high rate of interest.

Since 1980s, after the growth of MBS and CDOs, the securitization of the mortgage market increased considerably. At most of mortgage companies, the mortgages were originated with the intention of selling them to Securitizers (Originate-to-Distribute (OTD) model). Majority of the securitization was done by the three GSEs. The contribution of GSEs to securitization of mortgages is astonishing: in early 1908s, agency MBS represented approximately 50 percent of the mortgage market, went up to 64 percent by 1992 and a 73 percent by 2002. However, after 2002, the mortgage as well as securitization market changes dramatically, with non-agency MBSs representing 15 percent in 2003, 23 percent in 2004, 31 percent in 2005, 32 percent in 2006, and overcoming agency MBSs – 56 percent in 2006. A large portion of this issuance consisted of subprime and Alt-A loans. Non-prime mortgages were only 14 percent of the total mortgages in 2001 and it jumped to 48 percent of the total in 2006. Many of these subprime loans were of adjustable rate loans, due to be reset in the period 2007-2009, which played a part in the advent of the financial crisis of our time.(To be continued in June 2019 edition)