Below find my discussion with Michael. Would like to share with people interested in this topic.
*All the material is quotated from Michael Hsueh's blog post.
Michael, 08/11/07
Impact of mortgage crisis spreads all over the world. Recently, Bear Sterns’ two hedge fund investing mostly in subprime mortgage related securities failed to allow investors to withdraw the money and announced their net values were probably less than half of their initial investment amount. Besides, a long Island based mortgage lender called American Home Mortgage filed for Chapter 11 and laid off more than 7000 employees, in the meantime, several peers facing the same difficulties. It seems that fallout from the credit crisis intensified in these few days, after three hedge funds under BNP Paribus, the largest financial group in France, froze the withdrawal request from investors and a lender investing subprime mortgage backed securities seeking for bailout in Germany. The central banks in U.S., Japan, and E.U. all pumped fund into banking system to stabilize the tightening short term capital supply and to pushed the short term interest rate back to fund rate level.
Why and how did it happen? I think expanding monetary policy around the world after last economic downturn, institutional investors and individual investors with lots of money in hand, and the heavily use of securitization products might explain some of the reasons.
First of all, the low interest rate environment caused borrower to take more and more leverage and investment, no matter in credit card, mortgage loan, leveraged buyout and capital expenditure. Right after the downturn in 2001 and 2002, the banks around suffered from a series of defaults and from the fragile equity market. The IPO and M&A business shrank, the brokerage volume dropped, and the capital needs dried up. As a result, the central banks began to cut interest rates in order to boost up the economics and avoided the possibility to deflation which happened in Japan in 1990s. Aspired by the monetary policy and the capital supply, the home buyer, consumers, and companies started to leverage their credit and boost up the growth of housing market, consumer spending, and M&A activities, which in turn vitalized the asset prices, business earning, and the comeback of private equity and the boom of hedge fund; however, it also brought the speculation and the bubble on the commodity market, the housing market, and the overbidding of targets around the world.
Secondly, as the interest rate level hit the record low around the world in 2004, the global economics seemed not so robust and the equity market didn’t rebound much from the turmoil of 2001; therefore, the infrastructure fund, mortgage-backed securities, CDO, these fixed income products attracted investors much. Imagine that, after the tumbling stock market in the recent past, the investors long for a safer investment vehicle that could protect the principals and earn a decent yield compared to the low-interest deposit or treasury bonds. For example, Macquarie, the largest investment bank in Australia, specializes in securitization and infrastructure investment. It caught the opportunity of the investor preference and the low funding cost to acquire many infrastructures around the world, such as the cable TV in Taiwan, the stock exchanges, the harbor. It even wants to buy airport and toll road in Taiwan. It got lots of money from fix-income investor and abundant financing power from commercial bank or bond market to acquire these targets on e after the other, and then it packaged these targets into a pool to certain infrastructure fund. As a result, the bank could expand its business in a very short period through its business model.
Third, the accelerator or the culprit of the fallout may be securitization. Theoretically, these securitized, fixed income products could certainly deliver their interests to investor based on the cash flow of the underlying, which could be an infrastructure, such as toll road, harbor, airport, commercial real estate, and residential real estate, or could be debt or receivables, such as loans, bonds, subprime mortgage, or account receivable, etc. But it depends on the stability of the cash flow generated and the price of the underlying assets. In my opinion, because these kinds of products really have their merits and can really make bunch of money, the investment banks are willing to advice their clients to securitize their assets. On the other hand, for the commercial bank, they can earn the spread between the net interest income they earned and the interest expense they paid to those investors under the conditions that the credit risks had been taken by the investors through securitization. Securitization changed the mindset and the way commercial banks, insurer, and homebuilders doing business. For example, once banks thought the only way to lower credit risk is to wait until the borrower repay or to sell down to others in secondary market, but now they can hedge or transfer the credit risk by means of CDO or CDS. Therefore, all these stakeholders fell in love with these products and thought the party could last forever, since the investors have lots of appetite, the borrowers have lots of needs, the price of the collateral have lots of potential to appreciate, and the economics seemed well.
The subprime mortgage crisis happened because investor appetite for MBS shrank in view to the default rate of subprime mortgage done in 2005 and 2006 growing sharply. Hence, the mortgage lenders got strapped in lots of fragile mortgage loan but without any buyers willing to buy its loan or securitized one. At the same time, the home buyers with worse credit record can’t get credit approval to buy the house and the housing market investors also got burned in the downturn of housing price and have to sell them to repay the mortgage. In the end, the impact will broaden to constructors, the retailer, and the banks with large exposure in mortgage loan. What’s more, the crisis in subprime mortgage will probably spread to other fields such as leveraged buyout segment and hedge fund segment. The crisis has awaked the lenders and investors the credit sense with the evidence of the spike credit spread over treasury yield and the difficulties to get financing in some ongoing M&A deals initiated by private equity funds. Once, the economics turns upside down and the stability of cash flow turns sour in previously acquired targets, the possibility of recap or IPO becomes remote, and the banks started to tighten credit facilities, private equity funds will suffer severely and leveraged-buyout turmoil will emerge.
Hsiang-wei -08/12/07
Hey buddy,
Your "murmur" really reflects the problems about financial industry I think of all the time. I always ask myself does financial industry really improve the real productivity of our society. Or its most functions are just about manipulating numbers to host lots gambling games to satisfy the greedy humanity for mass consumers and itself. In my opinion, finance should be a tool to observe, control and re-allocate the monetary resources to make sure the input resulting in the most output, which is very important function in the management system to improve the productivity. But does the reality look like the way it should be? Or it is me who is too naive?
According to the law of mass conservation, the mass of the reactants must equal the mass of the products through the process in a closed system. In the case of US subprime mortgage, is the value of the prime market able to double or triple in the subprime market? Once the supportive momentum stops and the market crashes, it takes more than what it invested to settle down the chaos The most pathetic is that the game hosts are not the ones suffering most but those players, who gain the least but take the most risk, bear the down side effect. Of course, the financial tools enable the game hosts sell out the risk, transferring the risk to others.
I am thinking of applying IB sales summer internship besides my consultant application plan to diversify my job hunting risk. However, I don't really know whether financial industry improves people's life or it is just a game proving good monetary return only. I would like to know your opinions to this issue.
Hsiang-wei
Michael - 08/12/07
Hi Raymond,
It’s my pleasure to have your comment on my stuff and your precious idea. As for your argument on whether finance contributes to the overall economy, whether finance only results in manipulation of numbers and in the endless gambling and speculation, and whether the value of the prime market able to double or triple in the subprime market, I would share some of my thoughts.
First, let’s define what finance is and how it works in our life. Without finance, we can only do one dollar business if you have only one dollar, which means no leverage, no payment tenor, all cash and all by yourself. Then you will have limited clout to expand your business. Therefore, I argument for finance should play its role in corporate finance and daily business practice. Let’s go further to discuss trading and investment. Trading and investment are zero sum games, which is equal to your idea of the law of mass of conservation. The purpose of trading could be hedging or speculating. Somebody loses and somebody wins, but each one of them has his/her reason to do the transaction. For hedging, I think finance has its reason to exist in the world and it made the business owners concentrated on their core businesses. Besides, investment is also a way to finance the issuers of stock or debt in the primary market and a way to increase personal wealth and to reallocate wealth in the secondary market. As for the derivatives products or securitization tools, I believe they all have their merits to exist in similar reasons.
However, human is greedy, proud, and fearful in the process of investment or of any business practice. Providing subprime loan is not bad initially, but it has gone too far and stakeholders involved were too greedy and overconfident in the business model, which they thought is invulnerable and eternal. Then it turned into a speculation on the housing price and unlimited investors’ appetite for these CDO and MBS. Therefore, though I think finance and these advanced financial instruments are beneficial, I admit that human couldn’t resist greed and the weakness of personality.
Finally, I believe after the credit crisis in mortgage loan, investors will turn to select the credit worthy investments, such as treasury bills, AAA rating bond, and gold. The spread of junk bond grade will definitely widen, which you could observe from the credit default swap points of those companies with worse credit rating, in the meantime, however, you can see the yield dropped sharply for the treasury bonds, the sign that suggests not only Fed probably cut interest rate in near future but also investors seeks for safe harbor during the crisis. Therefore, I agree with you that prime market will perform wildly from subprime market under the condition that the subprime crisis won’t spread further to shake the global economy severely.
Note: thanks for your application for the law of conservation of mass, which I found its definition on wiki as follows:The law of conservation of mass/matter, also known as law of mass/matter conservation (or the Lomonosov-Lavoisier law), states that the mass of a closed system of substances will remain constant, regardless of the processes acting inside the system. An equivalent statement is that matter cannot be created nor destroyed, although it may change form. This implies that for any chemical process in a closed system, the mass of the reactants must equal the mass of the products. The law of mass/matter conservation may be considered as an approximate physical law that holds only in the classical sense before the advent of special relativity and quantum mechanics.This historical concept is widely used in many fields such as chemistry, mechanics, and fluid dynamics. However, mass is not conserved in nuclear reactions.
Best regards,
Michael
新鮮的現擠橙汁跟橙皮切絲讓整道菜有著很特殊的田園風味 
洋蔥大蒜磨菇三種新鮮素材的味道混合在一起真的滿妙的! 再加上中間清爽的花椰菜, 口感也很平衡. 
口感很像台灣的哈密瓜, 但是又更清甜一點!
