Why there is a subprime loan crisis.

Last week a friend raised the questions on the subject of subprime loan problems in the US. He asked me why the problems were so serious and said crisis of such size to the financial markets had not been seen for many years. Also, he was amazed why the big names like CitiBank and many other, though reluctant, have to go overseas to seek for capital injection. Also, Bear Stearns bailout by JP Morgan Chase had surprised many.

Though related, I try to avoid discussing on the advanced credit risks models such as JP Morgan Creditmetrics model, Credit Sussie's CreditRisk+ model or Merton's KMV model. It is because they are too complicated and too quantitative for most of my readers to understand. Also, this topic and their extension to the regulatory capital and economic capital of a bank are so wide that a blog is too short for it.

Instead, my blog this time will focus on the qualitative side of the credit risk management. There are five main causes that I think of which account for 85% of the crisis.

The first one is superstitious. There was no real downturn of real estate market since the Second World War. It is because of this long perception, most people believe that the direction of the real estate market is only up and no down that made the bankers were very relaxing in their mortgage lending.

The next is the culture. The shareholders and Institutional Investors of the Banks have a high demand for short term performances. These gradually changed the landscape of lending cultures of the banks by emphasising on short term return and tolerating higher risks on the long end of the balance sheets.

Thirdly is the incentive packages to the bankers. The bonus is normally tied to the performances, while higher returns are commensurate with higher risks. So, to aim for bigger bonuses, the bankers are encouraged to go for higher risks business at the expenses of the shareholders.

Fourthly, most banks are relying on the external rating agencies to assist them in rating the Mortgage Back Securities (MBS) and Collateralized Debt Obligation (CDO)in their investment portfolios. So, if there is a lending problem, it is not just a one to one single problem but it is a problem for all the banks at the same time.

Lastly, the credit derivative markets such as credit default swaps and credit spread options etc have been expanding so fast that the contagion is easily get out of hand. The domino effect could spread quickly from one bank to another which could easily collapse a financial system. That was why the Federal Reserve had to take quick actions to stem the spreading by involving into the deal of Lehman Brothers, yet risking the allegation of encouraging moral hazard among the banks.

Though the subprime problems are still overhanging the financial markets, I think we have seen the worst already. It is a painful experience to learn from it but it does help the bankers to minimize committing the same mistakes again.