Big Time Debt Crisis

The financial crisis that swept across America in 2007, and has now worsened in January 2008, seems very confusing. How could these subprime mortgage loans result in such a complete rout of the global stock markets and now also a looming American recession?

I have a special perspective on this financial situation, since my career included 25 years in banking. This emerging crisis began long ago and is the culmination of decades of bad choices by the financial community, particularly in America. The obsessive desire for short term gains to justify inordinate bonuses for CEO’s (and their supporting management) has finally brought us to a Day of Reckoning.

My post-graduate degree was from the “School of Hard Knocks” – on Wall Street in New York. I remember clearly my arrival to this new world. I had just graduated from Harvard University, where there were student demonstrations against the Vietnam War, idealistic concerns about poverty in America, and growing worries about the morality of the American government. Arriving at Wall Street in 1970, my angle of observation abruptly changed.

A crusty old banker gave us new management recruits a hypothetical challenge: we needed to bring in some new loans to increase the revenues at our bank in order to justify our salary. We needed to choose between lending to an unsuccessful businessman of good character, or else lending to a successful businessman who was totally unscrupulous.

It didn’t take long for our banking class to discern the “right answer”. Obviously, we could not get repayment on our loan by lending to an unsuccessful businessman, so damn the moral scruples and make the loan to the immoral client. (In my later banking career, I found out that both choices were equally bad.)

This vignette illustrates how little morality has ever counted on Wall Street. The only commandment they seemed to follow was Thou shalt not get caught! Virtually everyone worked exclusively for advantage to themselves, at the expense of everyone else. If there was a profit to made, that was sufficient justification for almost any conduct.

Despite this moral blind spot, Wall Street was an outstanding place to learn all about finance. People came from every continent to participate in this exciting marketplace. The New York technical expertise was unrivaled. In those days, it was truly the world’s financial Mecca.

However, there was one cloud in this brilliant sky in the 1970’s. It came from making large loans to poor nations (seemingly at a good profit.) I asked my bosses the innocent question of how these poor borrowing countries would ever be able to repay such giant loans. The executives retorted: “these loans will be refinanced, since a sovereign state can not possibly declare bankruptcy”. As it later turned out, my naive skepticism was prescient. When these loans eventually came due, there was indeed no refinancing available. This was the start of the Third World Debt Crisis, which lasted for decades, but which was small compared to the current financial problems.

In such a short space, I must oversimplify the current subprime situation to its central points. The engineers of these subprime loans correctly observed that mortgage loans have been remarkably solid historically in both good times and bad. Furthermore, the houses used as collateral have steadily risen in value, decade after decade. So why not offer these loans to a larger population including those without any credit history, since they would pay a premium rate to offset slightly higher anticipated loan losses?

What was left out of the equation was that the advent of vast sums of new mortgage credit would drive housing prices up sharply, until the housing bubble finally burst. That is what has now transpired. Many borrowers in America find they have mortgages which are bigger than the reduced value of their houses. Many of these people were already financially stretched when they applied for the subprime mortgages. So now the borrowers either walk away from their debt, or else their bankers call the mortgage loans, because the loans have gone into default.

There were other elements to this subprime situation, such as artificially low initial mortgage payments, which then rose sharply after a few years. But the central point is that these loans violated all reasonable credit standards. With the collapse of the housing market, the collateral is now inadequate as well.

Beyond subprime mortgages, creative financial engineering has created many other shaky financial debt structures, which are also collapsing like dominoes now. In aggregate, these additional classes of debt are bigger than the subprime loans. The largest financial institutions in America, and elsewhere, are facing the most severe crisis in confidence since the 1930’s. They are trying to raise new equity from foreign investors to stave off disaster. Who knows where this will all end.

(For those who read my blogs regularly, you may remember that I have been suggesting that a major correction is imminent in a number of my blogs last year, particularly the one entitled “A Hard Rain is A-Gonna Fall” on March 8, 2007)

But this is just half of the story of the Debt Crisis. The American Government had a major role in creating the conditions which brought this crisis about, so they deserve equal blame. I will explain that macro situation in a subsequent blog.