US Subprime crisis claims big scalp

Warren Spector was one of the leading brokers involved in putting together the securitisation deals at the heart of the subprime lending crisis.

The subprime lending crisis has its roots in one simple lie: that people in financial difficulty can buy their way out of trouble. Alan Greenspan understood that, and before his retirement warned US banks that rubbish lending policies resulted in higher levels of default and that risked destabilisation of the markets.

His replacement has a different view and recently told a Congressional committee that if people have equity in their homes, it is not imprudent to borrow against that equity to support an income v expenditure shortfall. He had no sensible answer when a Senator asked him, point blank, how it can be that a fund which is entirely made up of sub-standard, high risk lending can be awarded a high credit rating e.g. AAA.

The answer lies, at least in part, in the halls of Wall Street. Just like the lies over valuation of tech companies based on so-called "revenues" (i.e. gross billings without regard for bad debt or other liabilities) Wall Street worked on the assumption that sub-prime mortgages were nothing more than pawnbroking exercises and that no matter what the land/house value would recover the debt.

Nice idea but flawed because it depends on two things:

first: there is a margin for error - called "equity" - that is that the amount borrowed will be less than the value of the mortgaged property. Unfortunately, loans of more than 100% of property value were being granted.

Secondly, it assumes that property prices will at best rise and at worst remain stable, so that as default interest and penalty bite into the equity, there will still be enough money to pay off the whole debt. But property prices have stopped rising in the parts of the USA where there is the most long-term debt, and salaries have not increased - indeed, due to inflation, in real terms, salaries for many Americans have decreased over the past five years. Worse, in some parts of the USA, prices are deflating, driven in part by a rise in the number of repossessions. That usually signals a rapid downward spiral in property prices.

So the fundamentals of the market in sub-prime based investments were simply wrong.

So was the way many of the schemes were operated. At its most ridiculous, some schemes raised capital from investors whose only understanding of the basis was the prospectus that said that the money would be going into property backed bonds providing a higher rate of return than is usual in the mortgage market. The higher rate of return came from charging those with financial difficulties or poor credit histories a higher rate of interest to compensate for the risk that their borrowing would go bad. No one seemed to notice that this was doomed to be a self-fulfilling prophesy.

Bear Sterns Asset Management cannot take the blame for this: but Spector is not a sacrificial lamb. Just last month, two investment schemes - Bear Sterns calls them hedge funds, closed down - between them they lost USD1.6 milliard of investors' money, says the Wall Street Journal. That led to Standard and Poor's downgrading the company's rating at the end of last week.

Spector was no junior rogue trader. He was president and co-chief operating officer, a member of the executive committee and a member of the board of Bear Stearns.

The ripple effects were being felt this morning on both the Hang Seng and the Simex markets with drops of around 5% by 1 pm. Nervous eyes were focussed on London and Frankfurt as shares in pre-trading were already heading south.

"When American Sneezes...." A pan Asian conference organised by BISfaculty will take place in Singapore on 24 / 25 September 2007. See BISfaculty.Com for details.