Subprime mortgage tremors: an international issue.

Foreign investment in MBSs helped to fuel the subprime mortgage crisis by providing ever expanding sources of mortgage funds. The surge of overseas capital pouring in the U.S. economy has also helped to keep interest rates low. Researchers estimated that extensive foreign investments have lowered U.S. mortgage rates by at least 50 basis points and maybe even one full percentage point (Bardhan and Jaffee 2007).

Asian investments in the U.S. mortgage market have been focused primarily on federally regulated agency mortgage-backed securities, such as those issued by the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Association (Freddie Mac). However, as the demand for U.S. mortgage securities increased, foreign investors moved into investing in unregulated mortgage securities, particularly mortgages offered through unregulated mortgage brokers.

While China is still eager to invest its U.S. $1.33 trillion foreign exchange trade reserves, it now considers U.S. mortgage-backed securities too risky. According to the HUD website (HUD News Release 2007), as of June 2006, China held approximately $108 billion in MBSs, up substantially from $3 billion in 2003 and $100 million in 2002. In May of 2007 the Chinese central bank abruptly halted purchases of U.S. MBSs, but did not move to liquidate existing holdings.

International Consequences

Securitization and Leveraged Buyouts

The subprime mortgage crisis has affected hedge funds and banks worldwide. The process of transforming mortgages, credit-card receivables, etc. into marketable securities is called securitization. This relatively new process was considered highly attractive as it allowed banks to issue riskier loans without corresponding increases in risk for themselves, that is, until the recent mortgage crisis, which has revealed its faults. One of the most glaring faults has been complexity of the products being sold. Popular collateralized debt obligations (CDOs) are being used to "transform existing debt instruments that are accurately priced into new ones that are overvalued" (The Economist. September 22, 2007b). How is this done? CDOs combine top-rated investments with low-rated investments so that is it almost impossible to determine the real value of the debt instrument.

Another fault of securitization has been the gaming of regulations. Ratings agencies appear to have been too liberal in their AAA ratings of structured products, and particularly CDOs (The Economist, September 22, 2007b). First their rating models have been called into question by not identifying correlations between different markets. They also suffer from conflicts of interest since the appraiser is paid by the seller, not the buyer as in most situations. By keeping ratings of CDOs high, it has been easy for banks to continue securitizing and repackaging debt with the highest ratings and the lowest regulatory cost. Investors believed that the ratings were a guarantee of the quality of investments, but later found that low-rated securities had been combined with investment-grade paper, which brought the real value of the investment below their investment restrictions.

Leveraged buyouts also have become popular in recent years, as they provide high yields and also slice cash flow into tranches with varying exposure to credit risk (Leverage buyouts 2007). In the United States, various assets included in the leverage buyouts were bonds originated from securitization of subprime mortgage loans. Many banks located worldwide heavily invested in these risky projects since profits were thin due to overall low interest rates (The Economist--Securitization, Sept. 22, 2007b).

Another issue involves the distance between the mortgagee and the loan holder. In prior years, most banks held loans to maturity and had incentives and instruments to receive appropriate payments; now neither the originator nor the loan holder have such incentives as they bear no risk, since they hold the loan as a small part of a complex portfolio (The Economist--Securitization, Sept. 22, 2007b). All of these conditions make these securities attractive in that there are fewer funds to retain in reserve, which in turn would lead to higher profits.

European Banks and Conduits: Lack of Transparency

One of the important tasks of mortgage securitization was to spread the risks among many entities worldwide, which was easily accomplished due to the global economy. The subprime mortgage crisis in the US immediately affected the European market, which in turn had repercussions for the U.S. market.

In August of 2007, events within the U.S. subprime mortgage market triggered an increase in financial market volatility and reassessment of market risk. Demand for asset-backed securities decreased dramatically, as investors tried to shift their funds into low risk assets, such as governmental bonds, which caused the stock market to lose stability. At the same time, some major European banks revealed their direct and indirect exposures to the U.S. sub prime mortgages, which triggered rumors about the stability of those banks (The Financial Market Turmoil 2007).

One of the most vivid examples of the subprime crisis international ramifications occurred in one of many German banks that experienced trouble with subprime investments. This bank, IKB, specialized in financing mid-sized companies but made some risky investments in United States asset backed securities and consequently suffered losses. However, the facts are not clear; for example, how did a bank with only 1.4 billion Euros in equity invest 12.7 billion in special securities without even showing it on the bank's ledgers? Two special audits conducted by the Auditing Association of German Banks did not find anything unusual (Hornig et al. 2007). It was later found that the whole portfolio was held offshore and off-balance sheet by a conduit named Rhineland Funding, which was paying IKB "advisory fees" of 50 million Euro a year (The Economist--Asset Backed Securities, Aug. 9, 2007a). Another bank, the German Sachsen LB, owned by the state of Saxony, ran into serious liquidity trouble after it was revealed that its Irish affiliate (which was not shown on Sachsen balance sheet) was heavily investing in the U.S. subprime mortgage market (Der Spiegel--German Banks, Aug. 20, 2007). In this case, the chain of fraudulent and negligent behavior had a direct impact on regular people in Saxony, as the state bank was financed partially through the taxpayers themselves.

In the previous European bank examples, all risky operations were conducted through conduits not shown on banks' financial statements. Furthermore, the banks mainly borrowed money through short-term debt (asset backed commercial paper). Now that these instruments are no longer effective, Moody's representatives say that many have found funding "either impossible or achievable only at exorbitant levels" and as a result S14 billion worth of bonds were downgraded (The Economist--Asset Backed Securities, Aug. 9, 2007a).

Actions Taken to Overcome the Crisis

Banks became suspicious of each others' credibility, which in turn affected money market and inter-bank loans that provide banks with liquidity for day-to-day operations. In the end, short-term interest rates rose significantly, and the market's liquidity severely diminished. The European Central Bank (ECB) had to use significant funds to overcome the liquidity crisis. The ECB first provided liquidity through reverse repurchased agreements, which are agreements to purchase securities with the promise to sell them at a specific, higher-than-original price at a specific future date. These provide funds to the original seller and are analogous to a loan. With the help of these operations, the money market received more liquidity than it would require under regular circumstances (The Financial Market Turmoil 2007). The ECB worked closely with many other banks worldwide, all of which took steps to overcome the crisis. Just recently The United States Federal Reserve took an active part in the regulation of the subprime crisis. It provided funds by lending directly to the banks at its discount window, cutting traditional excess charges in half (The Economist--Smash the Glass, Oct. 18, 2007c).

On November 1st, 2007, the Federal Reserve announced its decision to lower its target for the federal funds rate by 25 basis points to 4.5% and stated that "strains in financial markets have eased somewhat in balance" and that "the upside risks to inflation roughly balance the downside risks to growth" (Press Release Oct. 31, 2007a). However, this statement is debatable; some analysts indicate that the dollar will remain under pressure due to the rumors that some large financial institutions have not revealed their true exposure to the losses caused by subprime mortgages. As a result of this fear, and after the rate cuts by the Federal Reserve, the U.S. dollar continued to fall (Garnham 2007). The growth of the market in prior years and in the first quarter of 2007 was a shock absorber for the European market; even though many financial institutions were adversely affected by this crisis, the market as a whole should experience a fast recovery from the disturbances (The Financial Market Turmoil 2007).

Some analysts indicated that a number of world economies were exposed to the crisis to an even greater extent than the United States (Capell 2007).

By April 20, 2008, the Federal Reserve had lowered the federal funds rate to 2.0%. This was the seventh rate cut since September, 2007, when the federal funds rate was cut from 5.25% to 4.75% (Federal funds 2008). The drastic interest rate cuts have helped slow mortgage default and foreclosure rates, but have severely weakened the value of the dollar and contributed to the gasoline crisis in the U.S. since the price of oil is pegged to the U.S. dollar.

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