One of the questions that I get a lot from friends and colleague’s is this: "If the Global Financial Crisis happened predominantly in the USA, how did all these sub prime loans spread across the entire Finance industry - not just the banks?"
The easiest way to explain this is with Banana’s.
Head to your nearest super market or grocery store and approach the fresh food section.You will often see a bunch of Bananas that has been bundled up for you with a discounted price tag. Upon a closer inspection you notice that there are some good looking Banana’s in the package; correct colour, good size etc.. You also notice that there are some small, greenish ones and a couple of Banana’s with bruising that aren't quite ideal. You make a quick decision that the 'good' Banana’s are better than the 'bad' ones overall, and you purchase the pre packaged Banana’s at a discounted price.
The grocery store feels like it has achieved a good deal by getting rid of sub prime stock, whilst the consumer feels as though they have picked up Banana’s for a bargain. Mutually beneficial transaction - everybody wins.
The SAME thing happened with ‘good’ and ‘bad’ Loans, they were called Collateralised Debt Obligations. Essentially, banks observed early that sub prime loans were going to default. To get rid of the liability from their Balance Sheets - they bundled it together with a high quality AA rated loan from a Blue Chip company and sold the pre packaged loan to a Hedge Fund, Insurance Company, Retirement Fund and Governments with a high yielding interest rate to entice the investor into purchasing.
Similar to the consumer looking for Banana’s - the Investor assumes that the 'good' loans outweigh the 'bad' loans and they will be able to return a higher yield than the risk they are taking on.
It turned out that the 'bad' loans were so incredibly bad that they outweighed the 'good' loans significantly. All of a sudden, defaulting Sub Prime Mortgages are appearing on Balance Sheets right across the USA, Europe and Asia Pacific in Banks, Insurance Companies, Retirement Funds and Hedge Funds. Which led to astronomical losses across the industry, crippling the credit system leading to the ‘credit crunch’.
The scariest part however is this: I can walk into my nearest grocery store tomorrow and see 'good' Bananas bundled with 'bad' Bananas for a discount. And I just wonder if Banks are doing the same thing with their 'bad' loans.
Be very aware when purchasing supposed Tier 1 or 2 Debt at a heavy discount from Financial Institutions - or if your Financial Advisor suggests this as a new and exciting investment opportunity. There is probably a very good reason as to why it is selling at such a discount in the first place.
Be very aware of the hype – and look at the numbers.