Subprime America Infects Asia And Europe Part 1

As the US real estate market collapses, questions about subprime mortgages and those unable to pay are in the news. These are not inconsequential questions. Over $1.5 trillion of subprime—don’t ask, don’t tell—mortgages were issued and are now beginning to default.

As the defaults mount, the consequences will spread to countries and institutions far beyond the shores of the US and the desks of the originating lenders—for the majority of America’s subprime loans are owned by investors, banks, insurance companies, and pension funds in Europe and in Asia.

Why Would Anybody Do Such A Thing?

It retrospect, it wasn’t a good idea, to wit, to loan $1.5 trillion without asking applicants how much money they had or how much money they made. It seems improbable that bankers (remember those thin-lipped disapproving loan officers) would loan money under those conditions. But they did and this is why:

One year after the collapse of the US stock market in 2000, the NASDAQ dropped 80% and the US government feared a deflationary depression—a no money no demand depression like the 1930s—could happen.

So in 2001 the US government took quick and decisive action—in retrospect stupid and short-sighted—and flooded the US with money to prevent a depression from developing; but, in the process they created a real estate bubble and, as the bubble deflates, those who can’t pay their bills, aren’t.

Banks aren’t in business to loan money to those who can’t repay them and they knew that customers who “took advantage” of subprime mortgages were at high risk of default. So the banks sold their subprime loans.

Now, who would buy a “subprime”, e.g. substandard, loan? Who would buy a subprime steak, a subprime car, a subprime house, a subprime dating service? This is where the genius of Wall Street came into play.

To sell these soon-to-explode debt bombs, Wall Street cleverly bundled them with higher rated AAA debt and gave them a new name, CDOs, collateralized debt obligations, and sold trillions of dollars of 30% subprime but AAA rated CDOs to unsuspecting buyers.

Even if you don’t know what a CDO is, CDO sounds a lot better than subprime or substandard. That was the genius of Wall Street. It was a way for Wall Street to sell shaky debt before the fenders fell off. And it worked, at least for Wall Street.

These debt bombs are now embedded far across the global financial landscape, the majority bought by European and Asian investors and institutions seeking downstream revenues; but instead of downstream revenues, they will be absorbing unexpected and significant losses.

Fully 50% of the 2006 earning of HSBC, The Hong Kong Shanghai Banking Corporation, the world’s third largest bank, were wiped out by the subprime losses of its US subsidiary. AXA, a French insurance company and CommerzBank, a German Financial Services company were also major buyers of Wall Street’s subprime AAA rated debt and will suffer the consequences for so doing.

But it was not only European and Asian banks, insurance companies, and hedge funds and pension funds that will suffer, wealthy Japanese investors may suffer the greatest losses of all. It is believed that the highest-yielding but riskiest tranches (risk level) of the subprime CDOs were bought by wealthy individual Japanese investors.

The head of structured finance research at Nomura Securities, Mark Adelson, said these investors did not fully understand the risk they were taking, depending instead upon the ratings given by credit agencies such as Moody’s or the advice of those managing the security.

"A partial understanding of it is often no better than no understanding," Adelson said. "The devil is in the details; if you understand it vaguely, you can get your lights punched out."