Subprime crisis

This story is originally written in Russian and can be found on this site «Субпрайм кризис» (dimus.me). The present translation is made by ChatGPT with a few corrections.

Capital eschews no profit, or very small profit, just as Nature was formerly said to abhor a vacuum. With adequate profit, capital is very bold. A certain 10 per cent. will ensure its employment anywhere; 20 per cent. certain will produce eagerness; 50 per cent., positive audacity; 100 per cent. will make it ready to trample on all human laws; 300 per cent., and there is not a crime at which it will scruple, nor a risk it will not run, even to the chance of its owner being hanged. If turbulence and strife will bring a profit, it will freely encourage both. Smuggling and the slave-trade have amply proved all that is here stated.

Thomas Joseph Dunning

Many of my friends, acquaintances, and even strangers have expressed their opinions on the causes of the banking crisis in the United States in 2008, the so-called subprime mortgage crisis, when the U.S. financial system, and therefore the entire world, was at risk of collapse. Each person who was affected or interested in this event saw and evaluated what happened differently. Due to a lack of information, much remained unclear and illogical, but the majority consider this crisis to be something random, a force majeure like an earthquake or a locust invasion. As an eyewitness and someone who suffered financially, I also occasionally pondered, compared facts, argued with someone, and ultimately decided to present my own concept or reconstruction of events "on paper." Being not a financier, banker, or broker, I do not claim to approach this scientifically; I am simply contemplating how such a thing could have happened. My assistants in this endeavor are common sense and the direct question: Cui bono? If you don't like it, don't read it; if you disagree, offer your own version and remember the First Amendment rights. In the worst case, if there are refuting facts, classify this essay as fiction or "hot air" as one of my relatives used to say.

But let's get to the point. First, about the concepts, starting with the mortgage definition - a loan secured by real estate, also known as a mortgage loan. A certain John Wilson wants to buy a house, but he doesn't have enough money. He can borrow from relatives on his word of honor, or he can go to a bank and use this same property as collateral: the bank provides money, and your word of honor remains with you, but as long as the loan - the mortgage - is not paid off, the house belongs to the bank. If you stop making payments, you will be evicted, and the bank will sell the house to recover its money.

Here is an illustrative scenario that calls for a basic grasp of arithmetic principles. Typically, a bank does not provide the entire amount but only 80% and the remaining 20% must be paid by the buyer upfront. If a house is valued at 500,000, the buyer would write a check for 100,000 (called a down payment), and the bank would provide a loan of 400,000. This is done to split the risk between the buyer and the bank, meaning the buyer must demonstrate his seriousness of intention. Additionally, the bank carefully checks many things: a) credit history, b) criminal background, c) current employment and work history, d) income level, e) existing debts, f) recent deposits into your account and their sources, g) tax payments for the past 2 years, and more, which you may not even be aware of. The purpose behind all of this is to prevent the granting of a loan to an individual who may potentially face difficulties in repaying it. A widely used banking criterion, your loan payments should not exceed one-third of your total income minus other debts. Payments on a 400,000 loan over 20 years at 5% interest would amount to approximately 30,000 per year, which means a minimum annual salary of 90,000. And if you don't have that, the bank employee would politely suggest looking for a cheaper house.

At long last, all the necessary checks have been successfully cleared, the mortgage loan obtained, the house purchased, and the grass planted, hallelujah! Two years go by, and suddenly, bems-s-s! You lose your job, savings run out, payments are overdue, and the bank sells "your" house. If the house price hasn't dropped below 340,000, the bank doesn't lose anything, but the buyer is at a loss: He already has paid 100,000 as a down payment plus 60,000 in loan payments over 2 years of homeownership. But the good thing is that you can start all over again. It would be unwise to examine a scenario in which the house price upon default exceeds 400,000. In such a case, the buyer sells the house independently, repays the bank debt, and retains the remaining amount as profit. It's all straightforward, and such lending practices have been in use from ancient Sumerians to the beginning of the 3rd millennium BC.

Now let's discuss a bombshell novelty: the subprime mortgage. The conditions are like the previous example, but John doesn't have 100,000 for a down payment. Impatient readers may argue, "Just take it easy, dude, continue living as you did while renting, and save up for a house." However, what if the individual genuinely desires to own a home?

In the beauty salon, John's wife, named Mary, of course, tells her friend about the situation, and her friend advises her to seek help from Tracy. Tracy, as it happens, works as a mortgage broker, specializing in connecting prospective homebuyers seeking loans with banks. In this role, she acts as an intermediary, akin to a soul catcher, facilitating the process between the buyer and the financial institution. The bank is reluctant to spend time and effort searching for clients, so it pays Tracy from 2% to 5% of the transaction amount, that is, the mortgage; it is a very profitable business, and Tracy's interest in John and Mary is genuine. There's also another reason why it's better to act through an intermediary, which I won't explain, but I'll give you a hint: you can sue a bank, but you won't get much from Tracy.

Being invited for tea at the Wilsons, Tracy educates the couple: you don't need any down payment. In Bank A, we'll take 400,000 at 5% interest for 20 years, and that will be the primary or prime mortgage. In Bank B, we'll take an additional 100,000 for 15 years at 6% interest and use it as a down payment in Bank A. Bank B will also lend you this 100,000, secured by the house. However, in case of a buyer default, Bank B will be second in line for the money after Bank A, which is the essence of a subprime mortgage. As Tracy says, the risk is minimal: house prices are rising and will always rise (false), and if anything happens, you can sell the house at a profit and settle with both banks. Besides, Bank B has knowledgeable people (true), and they wouldn't risk their money if they weren't confident that prices would rise (false).

Mary is thrilled, but John still has doubts: what if Bank B doesn't offer a subprime mortgage? What if Bank A doesn't approve the source of the down payment? "Ah, John, you're smart," says Tracy. "I envy you, Mary. Your husband asks such good, valid questions! I'll go and check everything straight away. If it's a no, it's a no, but you guys are lucky. I have connections in the bank, I know everyone, especially the loan department director in B and the manager in A. I like you guys, otherwise, I wouldn't have bothered trying. Mary, these pastries are to die for!”

The next morning, Tracy calls John: it seems that the director of Bank B, Mike, agrees, but the subprime will be for 5 years, not 15, and the interest rate will be 10%, not 6%. But they need to decide quickly because rules or rates may change. John tries to calculate the principal and interest amounts but gets confused and calls Mary to explain the situation. Mary is a decisive woman, and the couple is now in Mike Limonchik's office. He quickly lets them know that the opportunity is unique, and no bank other than B would have agreed to such terms for them. However, the bank's genuine mission is to help its clients, and if Sophie from Bank A approves the plan from her side, Stephen won't stand in the way.

For those curious, Tracy's income from the deal consists of two parts. Firstly, the Wilsons pay her a modest 1.5-2% of the transaction amount for brokerage services aka origination fee. Secondly, she receives a yield spread premium, which is half of the difference between the bank's interest rate (guess 4%) and the interest rate on the loan she signed her clients up for (guess 10%). Half of 10% minus 4% equals 3%, which needs to be multiplied by the loan amount to calculate the broker's share. It's obvious that the interest rates for subprime and prime mortgages are different, but the approach is clear. For those who studied German in school, the term "yield spread premium" can be translated as "Ertragsaufschlagsprämie" (literally "profit margin premium"). I think "division of spoils" would sound more literary, but someone working in this field probably could provide a better definition.

What drives Mike? 100,000 under these conditions will bring the bank a profit of 25,000 in 5 years, which is not bad even considering the 5,000 that will go to Tracy as a commission according to the agreement. However, there is a significant risk for the bank to lose money if John and Mary stop paying before 3 years and housing prices decline even slightly - after all, it's a subprime mortgage. A Russian-speaking reader might think something negative, for example, that sweet Tracy is giving a kickback (meaning sharing) to Limonchik, but that's not the case. This is not Russia, and besides, it's irrelevant. The answer is right here, just hold on for a moment longer. And to pique your interest, I'll tell you that Mike didn't even bother to seek approval for the deal from Sophie - no need!

Wilsons went to Bank A, serious people here indeed, they could have bought Bank B with pocket money, but our brave Tracy confidently enters through the service entrance and goes straight to Ms. Sophie Goldhander - senior director in the mortgage department and tells our story. "Let them come - we should attempt to assist," Sophie says after two minutes, and for the next half an hour, the ladies discuss Tracy's new silver bracelet.

The door is open, Tracy, like an emanation of Mother Teresa, calls John and asks him to gather the necessary documents - time doesn't linger. The spouses are in Goldhander's office, quite nervous, but they encourage each other with statements like "didn't really want it." Unlike John, Sophie graduated from Babson College with honors and she is very proficient in counting. The payment for the subprime will be 25,000 a year, which together with the payments on the principal loan amounts to 55,000 a year. John and Mary together make 105,000, and the "one-third rule" says that their payment capacity does not exceed 35,000 a year. Savings are 15,000, and that's it.

At some point, Sonia wants to send them home, but business is business, her Odessa genes remained undiluted over the course of four generations. She slowly flips through the papers: the credit rating is only 625, but for such a loan, it should be 700, Mary still has an outstanding student loan, and it's clear that they can't afford 55,000 a year... "Well," she says, "according to our bank's criteria, we can only offer you a loan at 6.5%." (It's only an additional 3,000 a year, dear reader). "But Tracy said it will be 5%?" Mary timidly begins. "Unfortunately, this is all I can do for you, my friends, decide”. As O’Henry wrote: “Bolivar cannot carry double." But the Wilsons have already decided: "Agreed," the couple say in unison. In a sudden change of heart, Sophie's demeanor softened, as if she momentarily experienced a sense of shame regarding the effortless triumph. "Great, sign here, here, and here, just the initials. Congratulations, for loan processing, the bank charges $1,342, which will be added to your first payment, goodbye."

In the corridor, Tracy is waiting for them, she became 20,000 richer, and all her thoughts are occupied with buying a new Mercedes. Well done, guys, I'll give you a ride to Mike's and back. And that's it, the deal is done: the lawyer will take care of the purchase, the former homeowner will receive $500,000 from Banks A and B minus a 6% commission from the real estate broker, and the Wilsons will have the keys to their fulfilled American dream. The old furniture, of course, will go to the Salvation Army or straight to the junkyard.

And what about our brave employees M. Limonchik and S. Goldhander, who put the interests of the client above their own? Did not they blatantly violate the bank's loan issuance rules? Are they trembling in anticipation of being fired? Cut the crap! They acted strictly according to the instructions of their superiors, and those, in turn, all the way up to the bank presidents, Mr. Benjamin Scream of Bank A and Mr. Subkolodny Jr. of Bank B. Only a very naive person would think that our directors would risk their salaries of 200-300 thousand out of pure altruism. Sophie has seen Mr. Scream angry on occasion. Alright, what's next then? After all, the Wilsons won't last even a year, right?

Exactly, the risks are too great, and banks need to "hedge" them, which means transferring them to others. That's the job of another department, led by a recent graduate of MIT, Mr. Sanobich. When there are a thousand people like the Wilsons who took mortgage loans, their credit obligations are bundled into a new financial instrument called Mortgage-Backed Securities (MBS). For these packages of obligations, the average yield, let's say 5.2% per year, is calculated, and they are sold wholesale or retail to interested buyers as high-yield securities. Banks immediately get their money back, which was issued as mortgage loans, and they can lend it again. It's a money cycle that happens up to 12 times a year, and the risks drift away to the happy owners of these MBS securities. Goodbye risks! I forgot to mention that although banks charge a meager 0.8% for selling these packages and selflessly delegate all the future yield to MBS owners, mortgage lending still brings them modest but steady profits. It's not like selling boiled egg soup. Multiply 0.8% by 12, and you get a 10% annual return, which Benja Scream and Subkolodny Jr. will distribute among the good employees as bonuses at the end of the year. That's why Tracy's services are so well-paid — you must keep the f-cking wheel of fortune spinning fast.

So, let's take a moment to consider who these fortunate buyers of the new financial instrument, MBS, are. Have they thoroughly examined the contents of these high-yield securities, recognizing that within them there may exist a mix of "healthy" mortgages along with, let's say, the more problematic ones, such as the Wilsons', who will, unfortunately, be declaring bankruptcy within a maximum of two years? Some individuals failed to conduct the necessary due diligence, reminiscent of the buyers of Enron stocks (it will be said not before nightfall!), while others relied on certain Credit Rating Companies that shamelessly assessed the risk as AAA, deeming it the lowest possible, even less likely than the bankruptcy of the United States itself. The question arises: What risks lie within MBS? Even if some Wilsons and Dodsons cease to make payments, specialized agencies will step in to initiate foreclosure proceedings on their homes, ultimately selling them on the market and directing the proceeds to the owners of these securities. Listen to Mr. Sanobich and embrace the concept of buying, for everything will ultimately turn out fine!

Seemingly, everything was right and great, but how did this damn subprime crisis happen in 2008? No one expected it, neither the modest and hardworking managers of departments, funds, and MBS, nor Mr. Subkolodny Jr., who had worked in the financial system for 58 years, starting as a mailroom clerk, nor Misha Limonchik (cum laude), nor Sophie, who could mentally multiply six-digit numbers. And yet, it's very simple: there were many Wilsons, but not infinitely many, whereas Tracy's career and income level were infinitely attractive—everyone saw the new Mercedes. Initially, loans were given to people with a credit rating of 750, then 650, and eventually to everyone. At first, only those with steady jobs were eligible, then temporary jobs became OK, and eventually, they turned a blind eye when a potential borrower presented a fake paycheck, which they downloaded from the internet.

Gradually, banks also reached the minority populations, but things were different here: the government, driven by liberal-humanitarian ideas, guaranteed loans to them to purchase homes without any documents, or rather, the government guaranteed banks an unconditional return on such loans using taxpayer money. Who would refuse to grant such a loan? Special semi-government agencies, with amusing acronyms Fannie Mae and Freddie Mac (those interested can read about them on Wikipedia), engaged in this type of lending. The prefix "semi" means that the government has just a partial role in covering the losses of these organizations, while in the case of profits, there were entirely private owners and managers who appropriated those gains. The main humanitarian idea was that every person, regardless of income, had the right to the American dream, which meant owning a home, and the government was supposed to finance that dream. If this idea had to be lobbied through Congress, it would be only a minor effort, for those elderly congressmen who weren't convinced from birth.

Thus, economic interest ultimately triumphed: the low mortgage rates brought many aspiring homeowners to the market, the supply of houses for sale was limited, and prices began to rise, resulting in profits from purchases. Today, you bought it for 500, and within three months, the house is already worth 600 thousand. What difference does it make whether the Wilsons took prime or subprime? They already have 100 grands in their pocket—Tracy was right! Now is a perfect time to sell (flip), but prices keep rising! John couldn't resist and bought a motorboat on equity line credit for 20 thousand, so what? Wilson boys are happy to go deep sea fishing with daddy. According to some data, in the pre-crisis years, 20% of the entire housing stock in America was being resold each year, which means 30 million houses and apartments. Banks, in particular, enjoyed significant profits and, as we know, did not take any risk—everything was hedged. However, there was a shortage of funds for loans, so banks increasingly started lending not from their working capital but from the money of individual depositors. This was prohibited by law (Glass-Steagall Act 1932), but in 1999, under pressure from banks, President Clinton lifted this ba

But the chickens have come home to roost after all those years of steady growth... the moment came when there was no one left to take mortgages and pay them off. That's when the crisis occurred. Roughly speaking, the total debt on loans became approximately equal to the population's aggregate income, and the market capacity was exhausted. Certainly, no banker, except for the main character of the movie "The Big Short," and Bernie Madoff could have imagined such a turn of events. It was like a Black Swan suddenly appeared! And everything started rolling downhill: first, customers stopped taking packages of toxic assets (MBS garbage), and many banks ended up being owners of these mortgages. Then homebuyers began to declare bankruptcy en masse (in the millions), house prices rapidly fell, and the proceeds from foreclosure were less than the loan amount. It's evident that the holders of subprime mortgages suffered the most since they received nothing after the prime banks, as home prices fell by 30-40%.

Small commercial banks (those not dealing with individual depositors) began to go bankrupt, but that didn't bother much until their debt to larger banks, which risked depositors' money, became threatening. The smell of trouble emerged: the bankruptcy of a behemoth like Bank of America meant the loss of individual deposits for many millions of people and a potential uprising in an unpleasant form (I won't judge what kind). Someone might argue that individual deposits (up to $250,000) are insured by the government, and the organization FDIC manages the special insurance fund. But unfortunately, the resources of this organization amount to only 5% of the insured money—I heard it on the radio in an interview with the head of the FDIC. Imagine this: a relatively small bank goes bankrupt, and everything goes according to plan—FDIC returns the money to insured depositors. But if it's the Bank of America or Chase, then there won't be enough money. That's what "too big to fail" means. As soon as the public learns about this, everyone will rush to withdraw their deposits from every bank. And that's when the collapse of the US financial system, and indeed the whole world, occurs—a complete disaster.

Now it becomes clear why President Obama and his administration quickly injected around $700 billion into leading banks and some insurance companies in 2008-2009—it was crucial to avoid any doubts about the solvency of regular deposits. Everything else is secondary. It seems that Lehman Brothers were allowed to perish because they didn't deal with individual depositors, and their collapse wasn't as terrifying.

The repercussions of the bank executives' naivety unfolded in a manner that couldn't be ignored. Mr. Ben Scream gracefully retired, in accordance with his agreement with bank A, which bestowed upon him an annual sum of $1.5 million along with a substantial one-time bonus of $50 million. Stepping into his shoes was Miz Goldhander, who swiftly ascended three rungs on the corporate ladder. Meanwhile, the impact of fate proved too much for Mr. Subkolodny's modest bank B, which specialized in subprime loans, leading it to succumb to bankruptcy. Unwilling to accept any responsibility, Mr. Subkolodny Jr. insisted that the crisis was the outcome of external forces like the KGB and an extraordinary convergence of circumstances, unparalleled in the financial world since the advent of money. Although compelled to resign, the board of directors didn't fully align with his argumentation and saw fit to reduce his pension to a humbling $440,000 per year, while curtailing his bonus to $16 million.

In conclusion, who suffered? Mrs. Subkolodny, who cried when she learned how her husband was rewarded for 58 years of impeccable service? Investors of course! MBS (mortgage-backed securities) were mainly bought by mutual funds where the pension savings of working citizens, including the author's 401(k) plan and other programs, were held. They lost approximately 30% of their savings. These savings are not guaranteed or insured by anyone. And, of course, those who took out mortgages, bought houses and didn't manage to flip them. The Wilsons went bankrupt, sold their boat, and now rent an apartment in a residential complex. Sometimes they meet in the courtyard with Tracy, who invested all her money in new construction in Florida right before the crisis. But she still keeps her Mercedes, now old and slightly beaten up.

Dimus - 2016

English translation by ChatGPT 3.5 - 2023

[1] "The Black Swan: The Impact of the Highly Improbable" - a book by N. Taleb, 2007

[2] FDIC - Federal Deposit Insurance Corporation