Important Notes on Financial Tsunami (2008-) 金融海嘯筆記

November 2010

1. Mid-Term Election (中期選舉) of the United States, 2010

- It took place on Nov 2, 2010.

- It elected members of the Senates(參議院) and House of Representatives(眾議院).

- It is called “Mid-Tern” because it takes places at about the middle of a presidential term (總統任期) (Obama was elected in November 2008, making November 2010 the middle of his presidential term).

2. Why is an election in United States important to us?

- All bills (法案) must pass through the Senate and House of Representatives.

- The result of 2010 mid-term election is that Republicans dominate the House of Representatives while Democrats still have majority (though weakened) in the Senate.

- With Republicans controlling the House of Representatives, Obama’s policies (especially economic policies) will have a hard time in the House of Representatives.

3. Still, why is it important to us in Hong Kong?

- Hong Kong, being an international financial center, will be impacted by whatever happening in United States.

- More importantly, Hong Kong Dollar is pegged (掛鉤) with US Dollar.

- What went wrong (or right) in United States will affect us, especially when we in the midst of the financial tsunami.

4. What caused the Financial Tsunami (金融海嘯)?

- The closing of the Lehman Brothers (雷曼兄弟)? No, it is just a consequence.

- What caused the financial tsunami is the burst of the subprime mortgage (次按) market (you can infer transitively to the greed of human kind).

5. What is a mortgage (抵押貸款) anyway?

- A mortgage is a loan that you borrow from a bank to buy a home (a flat, an apartment, a house, etc.), whereas the home itself is leveraged to secure the loan.

- It means that you pay the bank every month (principal plus interest). While you own your home operationally (i.e., you can live in it) but the bank owns your home financially. That is, the bank cannot open your door and use your toilet without your permission, until you cannot pay back the loan (default the loan).

6. Mortgage has been around for a long time; it never caused any problem, right?

- If loans are lent to borrowers who have the ability to pay, of course, there is no problem.

- That is, if the bank screened the borrowers carefully, there is no problem; the bank can absorb a small number of bad loans but not a lot.

7. Then, what is subprime mortgage?

- A subprime mortgage is a mortgage lent to borrowers who don’t have the ability to pay for it (i.e., the income is too little for the loan).

- When the economy is good, house prices go up indefinitely. Everybody can pay for the mortgage because the loan can be “paid” for by the rise of the house price alone, but what if the economy goes down?

8. If subprime mortgage is not good, why does it exist?

- It dates back to 1998 when Bill Clinton (克林頓) was still the President of the United States.

- Since 1933, there is a law called the Glass-Steagall (GS) Act (格拉斯-斯蒂格爾法) that separates commercial banks (商業銀行) and the investment banks (投資銀行) (ibanks, as we know them). That is, a bank is either a commercial bank or an investment bank; a commercial bank cannot own an investment bank, and vice versa.

- Note that GS Act, or the non-existence of it, by itself has nothing to do with subprime mortgage, but in politics, everything can be related, and traded.

9. The Glass-Steagall Act sounds good. Why is it a problem?

- In 1998, The Citibank (花旗銀行), which was a commercial bank, wanted to merge with Travelers, which was primarily an insurance company but it owned investment banking businesses (notably through the acquisition of Solomon Brothers in 1998). This was a no-no, and the merger was prevented by the Glass-Steagall Act.

- With lots of lobbying, the abolishment of the G-S Act was approved by the House of Representatives and Senate, reaching the desk of President Clinton for approval.

- Bill Clinton threatened to disapprove (veto) it unless the banking industry agreed to do something in return, and that was to strengthen the Community Reinvestment Act (CRA) (加強社區再投資法案).

10. What is CRA?

- In the past, banks, for good reasons, will only lend to trust-worthy customers. Poor people cannot get the loans they need for, say, sending their kids to colleges, fixing their houses, or starting small businesses that could improve their lives. This is unfair, isn’t it?

- The Act, in non-technical terms, says that banks cannot discriminate low-income people when mortgage loans approvals are considered.

- This is to prevent banks from making discriminative decisions, known as redlining; figuratively, it is like using a red pen to outline poor neighborhoods on a map and any loan applications coming out of these neighborhoods are automatically disqualified.

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11. CRA also sounds good? Why is it a problem?

- The law forces banks to lend to home buyers across the board, to borrowers who cannot prove that they can repay the loans.

- The banking industry accepted it for the huge benefits of deregulating the banks.

12. What is the result of the trade between freedom and community commitment?

- The merger of Citibank and Travellers has created the CitiCorp (花旗集團).

- And subprime mortgages were born.

13. What is the role of securitization (證券化) in the creation of the financial tsunami?

- Securitization is a truly innovative financial vehicle, though it has become very common now.

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In essence, everything can be sold, including your mortgage loan.

- First, you made out a mortgage of one million dollars and promise to pay it back in 10 years; suppose in the end you have to pay 2 million dollars (principal plus interest).

- Banks these days are not patient enough to wait for 10 years to make this humble 1 million dollars (interest) from you.

- In a few months, your mortgage will be sold to a financial institution, which, say, pays the bank 1.25 million dollars and you will send your loan payments to that financial institution.

- In this way, the bank makes 0.25 million in a short period of time.

- This is great, except one thing …

14. Does the bank have motivations to screen the borrowers?

- The bank has all the incentives to lend out money because the more it lends the more money it makes.

- And the bank has very little risk to bear, since if you cannot pay the mortgage it is the problem of the future owner of your mortgage.

- Now, you should recall two big names, Fannie Mae (房利美) and Freddie Mae (房地美), which are the largest mortgage companies in United States.

- They expand the mortgage market by securitizing mortgages in the form of Mortgage-Backed Securities (MBS, 按揭證券). In other words, your 1-million-dollar loan is not sold as one single unit to one single buyer but is chopped up in thousands of pieces (securities), mixed and matched with other mortgages and even other types of loans to create securities with different levels of risk, and sold to thousands of investors.

15. It is only the mortgage companies, right? Why was AIG (美國國際集團) involved?

- Well, mortgage companies know how to protect themselves: they buy insurance for their investment. That is, if you cannot pay your mortgage, the insurance company will pay to the mortgage company.

16. Too Big to Fail (大到不能倒)

- At the time Lehman Brothers fell, AIG had issued 2.7 trillion USD of “insurance policies” on various investments, among which about 1 trillion USD came from 12 major financial institutions. Talk about it professionally, these “insurance policies” are called CDS (Credit Default Swap, 信用違約掉期).

- If AIG falls, these financial institutions fall too because they cannot recover their losses from AIG and they certainly cannot pay for the loss themselves, so it will affect your parents’ retirement plans too.

- AIG was considered “Too Big to Fail”. As a result, the US Government has to save AIG.

- After AIG was stabilized, the other financial institutions were stabilized too. This looks like the end of the financial tsunami (in fact, some people believe the tsunami was over and we are just dealing with its after effects). The US government has become a major share holder of AIG, Freddie Mae, Fannie Mae, plus many other large financial institutions.

There are many books written about the financial tsunami. Find out more about Quantification Easing (QE, 量化寬鬆貨幣政策) as in QE1 and QE2 and other terms such as CDO.

Commercial banks vs. investment banks

- Commercial banks make profit by taking your deposits and lending them to businesses (individuals or whoever), making profit from the difference between lending and deposit interests. Commercial banks deal with your money and my money, so they better be safe. Commercial banks are heavily regulated by the government.

- Investment banks are middlemen between institutional investors (retirement funds, etc.) and investment opportunities (there are other businesses but that would be too much to cover). Investment banks engaged in high-risk (and high-return) investments and are lightly regulated.

- When economy is strong, commercial banks make much less money than investment banks.

- The result: every commercial bank wants to be an investment bank too, and the pressure builds up …

AIG

- A lot of us in Hong Kong know AIG, because it owns the famous AIA.

- Your parents’ life insurances and retirement investments may be vested with AIA.

- AIG was just listed in Hong Kong Stock Exchange in October 2010, raising about 15 billion US Dollars and making it the largest stock issuer this year in Hong Kong so far.