The GFC Story: A House of Cards July 17, 2009

I had the privilege of sitting in on a presentation with Jason Ju today an Investment Manager here at MLC.  Jason very succintly explained to us the sub-prime mortgage bubble and how it lead to the collapse of the financial markets and the drying up of the money markets throughout the global financial industry.

I thought I’d do a bit of a public service and also crytallise my own thoughts on the issue by putting up a short post attempting to describe the problem as I understand it.

The whole entire, big hairy ugly thing can be traced back to the US Mortgage Market and as I understand it two very big mortgage lenders Fannie Mae & sister co. Freddy Mac who came up with the idea of the Mortgage Trust.

Lending practices were very loose in the US and you could just about get a loan from anywhere, not only that, if you didn’t feel like making those nasty repayments anymore you could hand the keys in to the bank to remove yourself from obligation.

At the time money floated freely through the system and this caused dramatic inflation in the price of US property. At the same time Investment Trusts were set up by big mortgage companies like Fannie Mae & Freddie Mac and investors flocked towards these products promising a steady return from the cash flows coming in the form of repayments made on the pool of mortgages attached to these Mortgage Trusts.

Investment managers hedged equity portfolios (i.e. shares) against these apparently “safe as houses” Mortgage Trusts, other Managed Funds invested into these, Hedged Equity Products and pretty much every major financial institution around the globe had some exposure to these US Mortgage Trusts and to similar financial schemes setup around the world.

The House of Cards was formed, waiting for the fall.

In September 2008 the critical mass of housing supply was reached and the value of houses in the US plummeted people started handing their house keys in to their loan offices, as the perceived value of their property was no longer considered worth making the repayments.

The once highly regarded Mortgage Trusts coupled to these mortgages could no longer make the required returns. People started redeeming their unit holdings in these trusts in mass creating a shortfall in cash to fund the redemptions being made in all funds that were invested in these trusts.  The Hedged Equity Funds dropped as they used these mortgage trusts as the hedge for their equity portfolios.

Large financial institutions started to fail Lehman Brothers, Bank of America, Fannie Mae & Freddie Mac all suffered dramatically as did many other traditional & investment banks. Equity markets crashed as these large Fortune 500 companies started to declare bankruptcy, these shockwaves were felt around the globe as all international markets coupled to Wall St felt the pinch. Unemployment rates soared creating stagnation in the world economy.

And so is the story of woe, the Global Financial Crisis as we know it today…