Tuesday, October 02, 2012

JP Morgan & The Sack of Not Very Nice Stuff: Are the Chickens coming home to roost?

In 2008  the world trembled on the brink of an international financial meltdown. Stock markets sank; banking systems were almost frozen; house prices plummeted; and most people wondered what the hell was going on? Who was doing what to whom to cause this crisis?

We are about to find out.

The Greed Trigger:

The trigger of the disasters was greed in the American and European financial systems, coupled to people who did not do the jobs they were supposed to do.

The problem came about because of debt instruments called subprime mortgages, which were used to create some fancy financial instruments called derivatives. The concept was very simple; the execution was morally bankrupt in many cases.

If you were a bank, and one of your customers came to you to borrow money to buy a home, you used to check out their finances to see if they could pay off the loan. If they could, you gave them a mortgage and waited 20 or more years for them to repay it. If they did not pay, some of your shareholders’funds (equity) would be lost.

Cluck! Cluck! Oh, cluck ...

But the smart guys on Wall Street found an easier way for all the investment banks, accounting firms, legal firms, banks and a bunch of middlemen to make money. They came up with the idea that these mortgages on the homes of Americans could be packaged and sold to investors. An investment bank would create the structure; the banks would lend the money to their customers and take a mortgage on their customers’s homes; then the banks would sell the mortgages to the new vehicles. Those vehicles would then sell ownership
interests in the mortgages to pension funds, insurance companies, corporations and anyone else who had spare cash to invest in them. The investment banks would ask the rating agencies (S&P, Moody’s) to rate the paper sold to those investors.

What went wrong?

These new vehicles meant the banks did not have any meaningful stake in the mortgages they granted to their customers, because they could sell these mortgages to the new vehicles and simply take a quick fee.

So the banks and other groups decided to boost mortgage lending, including to people who were risky credits – hence the subprime mortgages.

And no-one seemed to notice this simple fact: If you collected a lot of mortgages and put them all in one basket, and if, say, one third of those mortgages were very risky because they were issued to ordinary people who really did not have much of a chance to pay the interest and principal, then the basket would be a risky one.

That’s what happened.

The Chickens come home:

It’s election year, and Surprise! Surprise! The Obama administration launched an investigation into the subprime market and a few weeks before the November 6 presidential election, a large sum of money is being claimed from a major investment bank:

The BBC's Robert Peston has seen confidential internal emails from America's biggest bank, JP Morgan Chase, which throw light on the culture of banking in the run up to the global financial crisis.

Peston told the Today programme: "What's new about this case is the detail of what went on at Bear Stearns.

"The case actually does cite emails from bankers at the time admitting that what they were trying to sell was 'a sack of...' well, not very nice stuff.

"It's the sheer scale of how bankers, in a frenzied way, ignored the appalling quality of what they were buying and flogged it to investors to generate maximum profits."

It is widely believed that this will not be the last case; President Obama’s task-force will reportedly use it as a blueprint for other cases.

JP Morgan defends itself:

Not surprisingly, the charge is being resisted:

JP Morgan said: "The NYAG civil action relates to Bear Stearns, which we acquired over the course of a weekend at the behest of the US government. This complaint is entirely about historic conduct by that entity."

How many bad assets went into the basket?

The amount of dud mortgages put into the basket and then on-sold to investors is pretty high in this case:

There are two jaw-dropping elements to the case brought Monday night against JP Morgan by the attorney general of the state of New York. First is the estimate that investors incurred $22.5bn of losses on $87bn of bonds made out of low-quality mortgages and sold to them in 2006 and 2007 alone.

Second is the disclosure of a manic and frenzied culture of procuring and packaging as many mortgages as humanly possible, to maintain the bonds spewing from the investment bank, to generate as much short-term profit as humanly possible.

All this is a bit like the fifth instalment in a series of horror films, with each succeeding production gorier than the preceding one.

Sooner or later, somebody is going to point a finger at the rating agencies and suggest that they, too, should be called upon to answer the simple question: Why did nobody tell investors that a bunch of questionable mortgages were put into the basket of mortgages that the investor was being asked to invest in?
Those chickens are going to come home in cases like these, and the fur is going to fly!

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