Subprime Mortgages Alert: Deutsche Bank in Trouble. Is RBS Next?
Americans say that history goes full circle. The financial crisis of 2008 is unfortunately coming back to haunt us. On 15 September 2016, the Deutsche Bank was fined for mortgage-backed securities relating back to the financial crisis. Funnily enough, it was also on 15 September 2008 that the Lehman Brothers investment bank declared bankruptcy—largely due to Lehman’s links to the subprime mortgage crisis—a major event that contributed to the 2008 global financial crisis.
A small diversion: Did you know that the word mortgage comes from the French mort (death) and gage (pledge): It is a death pledge; a promise to pay the loan until you die. It is a debt for life.
What is a subprime mortgage?: It is a housing loan given to a borrower with a poor credit history. Because of this risk, interest rates are higher which makes it difficult for borrowers to pay off their loans. This, sometimes, results in foreclosures: the lender forces the sale of the property in order to get the money loaned to the borrower.
Subprime mortgage crisis: In the mid-2000s, the big number of subprime mortgages granted, due to low interest rates, caused house prices to rise. When borrowers were unable to pay their loans because of their poor credit, this increased the difficulty of selling their homes and, finally, subprime mortgage lenders filed for bankruptcy. The housing crisis of 2007-9 hurt the American economy deeply. Many investment firms bought these high-risk subprime mortgages and sold them as mortgage-backed securities to investors. The problem is that they made these risky mortgages appear attractive by packaging them with other loans as being high-quality credit. This was very dangerous and eventually damaged the economy.
8 years later: On Thursday, (15 September 2016), the Wall Street Journal reported that the Deutsche Bank had to pay a $14bn settlement to the US Department of Justice (DoJ) for a probe into mortgage securities originating from the financial crisis. On Friday morning, shares in the bank fell 8%. The bank has said that it won’t pay such a large amount of money and that $2b and $3b are a more reasonable amount to end the DoJ’s probe.
Deutsche Bank has a series of lawsuits against it filed by individuals, companies and regulators involving the manipulation of foreign exchange rates, selling bad subprime loans, as well as price-fixing the Libor. The London Interbank Offered Rate (Libor) is the average of interest rates that banks charge when they lend each other and it is these interest rates that financial institutions, mortgage lenders and credit card companies use to set their own rates.
Deutsche Bank has challenged such an excessive settlement. However, this probe opens up Pandora’s box and it will be very bad news for other European banks which might also be facing penalties for selling and packaging residential mortgage-backed securities before the financial crisis.
Many big US banks already paid billions of dollars in settlements for misleading investors about mortgage-securities. They were accused of selling poorly-underwritten home loans as safer securities and creating a bubble of highly-priced homes worsening the following collapse.
Mortgage-backed securities: What are they and why are they toxic loans?
Old Model: Mortgage loan
If I went to get a $1m loan for a house in the past, this would be a mortgage backed or secured by my house. This means I am borrowing $1m from a bank, and if I can’t pay back the loan then the bank gets my house. The traditional way to get $1m loan is to go and talk to the bank which would give you the loan. In exchange, you would have to pay something like a 10% interest. Usually, in a traditional mortgage, you would have to pay some part interest and some part principal—which is when you are paying down the loan. Let’s say, if this was an interest-only loan for ten years, you would have to pay the interest for every year and in the end pay back the $1million loan.
New Model: Mortgage-Backed Security (MBS)
Now, imagine you need $1m and you go to the bank, and you pay them a 10% interest for the loan. While in the old model the bank would keep the payments, and get more deposits so it can keep giving out loans, in the new model the bank decides to sell these loans to a third party.
If many of us are borrowing millions from the bank and pay 10% a year, then the bank wants to get more money. It takes all these loans worth a billion and sells them to the investment bank which, in return, gives it a billion. Now, we, the borrowers, owe the money to the investment bank. Because the investment bank doesn’t keep loans, it creates a corporation, and transfers all the rights on those payments to this new company. The bank will take these shares and sell them to the public. It will IPO it.
IPO: An Initial Public Offering is a public offering where the shares of a company are sold to investors, and then to the general public, transforming a private company into a public one.
Once the corporation sells the shares it will get a $1.1b, let’s say. So the investment bank has paid the $1b for the rights to the mortgage payments and is now getting $1.1b from the investors; and it only had to put up this corporation. These shares are mortgage-backed securities. A mortgage-backed security is not only a promise to get money, but also gives the corporation the rights to the property itself. Because the money is backed by peoples’ mortgages, the corporation—in the case one of the borrowers is unable to pay their mortgage—has the power to auction off the borrower’s property and have money flowing back in to it.
This is crueller because in the past, as a borrower, you had some kind of relationship with your bank. Now, the corporation is a faceless body that does not know you or has any obligation towards you. They can sell your home for whatever price they like. Also, something like this will be devastating; knowing that your loan was sold from your bank to an investment bank, and each one of them made money off your debt.
Toxic assets: Mortgage-backed securities were called toxic assets during the financial crisis of 2008-9. Since people could not pay their mortgages, their houses were put on sale. With the inability to sell the houses or the debt, investment banks had massive losses. The unfortunate thing is that it was okay when banks were gambling with debt. Because in the end, the taxpayers’ money was used to bail them out.
Who’s next now?
The European banks which are under investigation are the following: Barclays PLC, Credit Suisse Group AG, UBS Group AG and Royal Bank of Scotland Group PLC. Some of these, in order to prepare for the mortgage investigations, have kept back money. But they are already facing problems with capital, cutting jobs and reorganising themselves.
Neil Wilson, market analyst at ETX Capital, is warning that the Royal Bank of Scotland could be fined up to $13bn by the US authorities: “Even a third of this figure would deliver a crippling blow to the lender, making its return to profitability even further off. It would also derail plans to return the bank to private ownership any time soon. After its latest loss, RBS has notched up £50bn in losses since the financial crisis – more than the £45bn stumped up by taxpayers to save the bank.” RBS will be settling a deal with US authorities some time in 2017.