Justice Bao Gong: Subprime: What your banker did NOT tell you

Much have happened in the recent weeks in the financial circles. The origin of the financial turmoil is from the American housing market, where a recipe of cheap money then and the American Dream of house ownership coupled with bankers and mortgage brokers too keen to achieve their sales targets resulted in today’s financial mess. How then, does this result in the failure of 2 of US largest investment banks and the downgrade of the last 2 to commercial banks? How did Bear Stearns and Lehman Brothers go bankrupt? How did AIG, the largest insurer in America go illiquid?

Around midyear 2003, US Fed Fund Rate was a paltry 1% (Source: http://www.wsjprimerate.us/fedfundsrate/federal_funds_rate_history.htm), creating cheap money and liquidity. Previously, it was the bond insurers and experienced traditional investors who maintained a standard of risk management by placing a premium on the loans based on the seller’s credit worthiness or track record. But due to the growing competition and appetite of these mortgage brokers, more and more brokers are creating ’synthetic ABS’ or CDOs, collateralised debt obligations. The tight spreads on triple B ABS squeezed the traditional bond insurers out of the market, leaving the subprime securitisation market to the CDO sector.

The problem here is that when brokers package these CDOs, they do not assume the inherent risks involved in the underlying ABS- It is the investors that bear the credit risk. Renowned credit rating agencies rate these CDOs based on the underwriters, ie the mortgage broker or the banks, and they generally obtain very good credit ratings, and they may not rate the underlying asset which are the slices of subprime securities which are difficult to assess due to the intricate layers of packaging.

So, now comes the important part: What your bankers DID NOT tell you:

When investors, especially retirees who invested their life savings, 401k, etc into such structured products, ie minibonds, etc, they are usually not told the whole story. In fact, the name of the product is already misleading. When laypeople hear the word ‘minibonds’ they were given the impression they are buying a double A rating bond linked to the huge investment bank or corporation. What the salesperson may not tell you is that this CDO product is also linked to hundreds of ABS. aka, sub prime securities which are not rated and any credit events occurring on these securities could result in loss of capital.

The salesperson cannot entirely be blamed too. He is also working for a living, and he has revenue targets set by his bank and he will be fired if he does not meet his targets. If the salesperson tells the whole truth to the customer, he will lose the sale and face the possibility of being fired.

Banks make their sales staff sign on declaration forms that on one hand, require their bankers to explain ALL the risks related to the products to their customers, and yet on the other hand, will fire them if they do not achieve their sales targets. This is a fantastic way of protecting the bank themselves while relegating the blame to the sales person if anything goes wrong. There was an article written by a kind certified public accountant to Monetory Authority of Singapore (MAS) but according to the article, not much has been addressed- I have attached the letter for your reference (source: Today Newspaper)

Why do I know so much about banking products? Because I was a former banker, and I have been through it all, and it is time to share with the masses all that is happening behind the scenes, and share with the man on the street things that your bankers do not tell you.

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Your humble servant.

(Source: Today Newspaper)