Subprime made simple

Private Eye explains.
The success of subprime loans depended on the way they were packaged and sold. Investors were offered financial derivatives such as "collateral debt obligations" - clever products offering higher than market interest rates secured on property. What could be better than that? Especially to banks, hedge funds and institutional inventors looking to boost income. By 2006, the CDO market  was worth $500 billion a year.

But like the wartime tin of sardines that was for buying and selling but never opening, these complex structured financial derivatives were never seen for what they really were - until it was too late - by those who were paid for their investment expertise and bought them.

One of the reasons is that they were "black boxes" which many of those buying did not understand. Financial derivatives have reached a such degree of complexity that only the architects probably understand how they work. Everyone else just looks at the return - which is why banks in the US, Australia, France and Germany have suddenly discovered massive problems the directors did not know they had.

While the complexity of derivatives and the ignorance of those who invest in them is new, the main driver of the subprime market is old; greed. In all the handwringing of recent weeks, little or nothing has been said about what really explains the subprime scandal - which although so far a US problem, will soon be felt here.

Subprime mortgages have their origins here as well as in the US among predatory lenders bottom-fishing for borrowers who cannot really afford to borrow and/or should not be loaned more but have homes as security. This is a highly profitable business for all involved.

Borrowers are enticed by brokers who are on big commissions to make loans. So they are happy to connive with the borrower, who is desperate for the loan and will say  anything about their income to get it. For the lenders, too, there are fat fees and juicy interest charges. So they have no reason to turn away anyone who is still breathing - if they own their own home. Many of those working for the lenders are on commission-related pay.

The lenders look to unload the risk, either to bigger banks by selling on the loans, or both look to Wall Street and City investment banks to package this toxic time-bomb into a format that will make it look anything but high risk, and attractive to investors round the world seeking better than average income. Just imagine the fees and bonuses to be made on selling the $50bn to $500bn-a-year of these CDO packages, every year from 2000 to 2005. And then, finally look at the management fees changed by the managers who brought this good thing to their fund holders.

At no time was there any incentive for anyone from the poor homeowner with bad credit to the hedge-fund manager with the Lamborghini life style to say - "but what if the borrowers can't pay?" Because if they had the whole edifice would have collapsed - as it did when rising US interest rates tipped thousands of subprime borrowers into foreclosure. But, by then, brokers, lenders, bankers and managers had all made a fortune.

The inbuilt problem with this business model was there for regulators in the US and Britain to see. But as in the US, the Fundamentally Supine Authority did nothing until it was too late. The full cost of this global wilful blindness is likely to be felt well into next year in bank and fund failures, higher mortgage rates and more repossessions. But by then, the same clever people who brought the world collateral debt obligations will have come up with a new winner, and the lemmings will be there again with their bank accounts full of OPM - Other People's Money.