What is Subprime Lending?

Subprime lending was developed in the late 1990s in the United States and became popular in the past five years.  Subprime lending simply means lending to people who have questionable capability to repay the loan. Banks, generally, lend to prime clients or those who have a good credit rating.  A good credit rating is earned by showing the capacity to pay back loans, no history of late or non-payments, acceptable property for mortgage etc. Those who do not pass the bank checklist are below prime or “Subprime”.

In any transaction, the higher the risk, the higher the rate. Subprime loans carry very high risks for the lender and thus, have very high interest rates.

The Subprime market was an opportunity for financial institutions to generate more profit by developing securities (tradable investment instruments) related to subprime loans. With aggressive global investment banking, these investment instruments with high returns reached financial markets all over the world and were snapped up all kinds of funds. As demand increased, the U.S. financial institutions granted more and more Subprime loans.

Over the past 10 years, the world saw massive inflow of capital to the USA.  Savings from Asia and Europe were seeking investment venues to fund their social overhead and sustain positive economic growth. Only the USA had the capacity to absorb these funds. Housing-related investment instruments, subprime lending included, offered a unique opportunity to the entire world.

Meanwhile, the culture of credit spending was pushing the American public to consume more.  With credit cards, liberal consumption and now liberal housing loans, America increased its importation thus sending its Dollars to China, Europe and Asia. Awash with US Dollars, these countries were snapping up US Treasury Bills and Bonds and mortgage notes. It was and continues to be a vicious cycle.

On the other hand, the USA housing sector, was going wild.  Lenders having cheap funds from the world gave out loans right and left mostly based on perceived increasing value of houses.  Mortgage brokers wanting to earn more commissions pushed borrowers to cash in on their “home equities” or to borrow more using their now higher valued homes as collateral.  With additional loans, they could fund everything from consumer goods such as toys, plasma TVs (from China and Asia), cars, vacations, second and even third homes.  Freddie Mac and Fannie Mae, two Government Supported Enterprises (GSEs) accelerated its massive purchases of mortgage papers from US domestic lenders and issuances of credit guarantees to US as well as global investors.

Investment Bankers and Insurers became more creative to fuel more credit.

More money was made available as investment bankers and insurers became even more creative issuing asset-backed securities and forms of complicated debt instruments. They are not restricted by strict capital requirements as commercial and savings banks. They bundled individual mortgage notes valued based on the increasing housing prices and sold them off to domestic and foreign investors as high yielding instruments.  These are the securities referred to as Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs) and other similar structured products.  

No real attention was given to the fact that a good number of these mortgages were loans given to borrowers with no real capacity to pay.  The commission-driven mortgage brokers aggressively sought out borrowers and arranged housing loans with banks.  Banks were eager to lend since they could sell these same mortgages to Freddie Mac and Fannie Mae very quickly.  There was just too much money available and too much money to be made in giving out housing loans.

These CDOs and CLOs became even more saleable when Wall Street players included something like an insurance policy in the package (Credit Default Swap or CDS). With the insurance guarantee, rating agencies (like Standard and Pours, and others) gave AAA ratings to these structured products.  Thus, even top banks like UBS, and Citicorp invested substantial amounts. Eventually, Citicorp and UBS covered their huge losses of $62Billion and UBS $42Billion with new capital right away.  Latest information from the IMF is that Subprime losses of banks have reached over $500Billion.

More and more investment instruments based on the value of other assets or financial instruments called Derivatives, took over the financial markets providing instant margins to traders, brokers, investment bankers and insurers.  These Wall Street operations were producing sustained profits out of buy and sell transactions of CDOs and the growing liabilities were not reflected in formal records (kept off-books).  All eyes were on the margins and profits as if there were no real risks and as if the increasing price of housing which was the fundamental basis for the asset value would never stop.  The fact is, it did.

In summary…

1. What funded Subprime? Too much capital from foreign investors looking for yields higher than what their own countries could offer.
    
2. Where did these funds come from?  In the case of China and Asia, their exports to the U.S. mostly made up of consumer goods.  In the case of the Middle East, oil proceeds from global energy imports.
    
3. How did Subprime get to grow to such high levels?  a) Wall street’s creativity in developing securities without adequate regulation; b) the failure of the established rating agencies to properly assess the true credit risks and c) the unmitigated insurance cover (CDS) on payment defaults sold over-the-counter.   Neither the Insurance nor Securities Regulators regulated them. 

The US Credit Crisis in Perspective

Here are a few statistics cited from the presentation of Mr. Helmut Schnabel, Chairman of the International Association of Financial Executives Institutes (IAFEI) in its summit last September 5, 2008.

1. Total Subprime mortgage loans in U.S. in 2007 was $1.2 Trillion.
2. Total private mortgage loans in U.S. today is about $12 Trillion
3. Total non-mortgage debt of private households (i.e. credit card, auto loans and other consumer credits) is $2.5 Trillion
4. Total U.S. private household debt is thus $14.5 Trillion
5. Net worth of private households in U.S. in 2007 (i.e. their total assets less their total debt) amounts to $58 Trillion.
6. Private household assets to their total debt ratio is a healthy 5:1
7. Actual losses of banks and intermediaries from Subprime loans are in the magnitude of $512 Billion.  This represents approximately 3.5% of private debt and less than 1% of private household net worth.
8. In the last two weeks, new capital of almost $400 Billion was raised to offset the above losses of the affected financial institutions.

These numbers indicate that it is more fear and panic that is causing the present credit and thus llquidity crisis to further drive financial markets down. More than anything, it is clear that the U.S. consumer and the economy remain viable and nowhere near being in the brink of collapse. 

What is the impact of this US credit crisis on our economy

The Philippines is a very small financial market.  Our total market capitalization is just about US$133 Billion or US$.13 Trillion.  On the other hand, according to IAFEI, “the market capitalization of the worldwide equity and bond markets, plus the worldwide assets of banks, at the end of 2007, amounted to a total volume of over 200 Trillion US $. (Source: IMF, German Central Bank).  This puts the value of the Philippine financial markets at a miniscule percentage of .065 compared to that of the world.

From the very beginning, our markets were not really of much attraction to the global financial players.  One could say that we simply are too small to spend too much time on.  There is another reason why we could not have been a venue for these derivative investments.  We do not have financial market infrastructure that would have allowed the kind of loose and free-wheeling over-the-counter trading that caused a lot of unregulated instruments and transactions to take place.  In a sense, our “backwardness” kept us out of risk.

But given the extent that our economy is closely related to that of the U.S., significant repercussions could be anticipated in the coming periods.  For one, remittances from the U.S., which accounts for a substantial(over 33%) portion of total inward remittances, could temporarily decline.  For another, our merchandise exports to the U.S. would more likely also substantially decline. The purchasing power of the American consumers has been severely reduced by this credit crisis. It may take a while to turn that around.

But not all are negative.  Outsourcing business from America has a good chance of even increasing, as American business must even now focus more on increasing its competitiveness.  And, for reasons still to be studied and understood, oil prices appear to decline as the crisis continues.  This can only help us as we face the oncoming (though hopefully) temporary slow down in our economy.

We also have a few aces in our sleeves.  Government is accelerating agriculture and infrastructure spending.  OFW mobilization continues to be on the rise in more and newer markets for a broader range of skills. Hopefully, these and more innovative developmental spending will not only offset the expected reduction in economic activities from the U.S. but also provide more domestic employment opportunities for our available work force. 

The bottom line really is, it’s up to us. We have the power to turn this global crisis to an opportunity for growing our economy our own way.

(O)rganize (F)inances before (W)orking Abroad

It has been my advocacy over the past five years to concentrate on teaching financial literacy to income-earning Filipinos.  Fortunately or unfortunately, a great majority of Filipinos earning substantial regular income are the Overseas Filipino Workers or OFWs.  I am quite blessed to be able to get to know them and their problems related to financial literacy up close.  It gives me a real sense of accomplishment to be able to assist them in understanding the need to save and to grow their savings so that they may be financially independent when they come back for good in our country.

In the first place, the reasons why they go abroad is a combination of the following and not necessarily in order:

1. Lack of appropriate jobs for them locally.  Sometimes, they have job opportunities in the Philippines but they know that they have technical capabilities that will give them better paying jobs abroad.  The sense of accomplishment is also a very important part of life.  When they lose that feeling, it can be very depressing and the nagging thought that they could have done better in life will haunt them till they grow old.
    
2. Want the experience and adventure abroad.  There are some OFWs who are not really there for the sense of accomplishment but for the thrill of being alone abroad and living a different life.  Granted that this might not be a great number of people but it is true especially for those who are young and single. Hopefully, they can combine their work and pleasure.
    
3. Want for better pay.  I can’t say much more about this.  Everybody wants better pay whether in the country or outside.  Sometimes though, they need to carefully analyze their net pay.  I know of some who thought they were getting higher pay in another country but cost of living and other expenses related to moving away actually gave them a net pay lower than what they would be receiving in the Philippines.

Based on my and CFE Team’s personal experience in dealing with OFWs, it seems that at most, only 10-20% would know how to manage and grow their money.  This same ratio probably applies as well to those who stay and work in the Philippines. Personal money management, or applied wealth management is not really taught in schools.  It’s only now that we are seeing our advocacy in promoting financial literacy (personal finance) being brought to schools. A group, led by a prominent College in Parañaque and one of the largest (if not the largest) Investment Bank, has put together a Capital Markets Institute of the Philippines (CMIP) to precisely educate teachers who teach finance and economics in investments and personal finance. CFE is fortunate to be actively involved with this group.  One of the key and immediate objectives is to reverse the prevailing counter-productive mindset among the earning classes, i.e., the mindset of the “here and now”- the seeming drive  to live their chosen lifestyle immediately at any expense up to and including borrowing beyond their means.

Pre-Departure Fundamentals

Before they even leave the country, first and foremost, they should have a personal financial goal.  They should know exactly:

1. How much they are worth.  They need to make their Personal Statement of Assets and Liabilities and Personal Income & Expense Statements.
    
2. They should agree with their family left behind what their budget should be and be ready to send only that and no more.  Their family should not be tempted to thinking that they can now spend as much as they want just because their OFW is earning in foreign currency.
    
3. Remember that in making that family budget, they should follow the formula INCOME-SAVINGS= EXPENSES.  It is important that they not only keep some money for their personal expenses abroad but also the savings for themselves.
    
4. They should try their best to follow the 80-20 rule.  They should save 20% of income for their future capital.  If they can’t save 20% they can start even with 1% but they have to get that winning experience.
    
5. Need to learn what options they have for saving both here and abroad. They should not just send everything to their family and relatives.  In fact, it is better that they make arrangements for direct placements of their investments with financial institutions before they leave.  In their working country, on the other hand, they should try to find out the safe methods of keeping their savings.  If they feel confident about investing there over the long term with a reputable financial institution, they could do that.

The whole end goal of most OFWs is to come home “for good” with enough saved so that they can sustain a fairly comfortable financial life with their family.

These goals have to be quantified over specific time periods.  They need to monitor their progress and thus should regularly update their personal financial plan. 

Many times, OFWs become so homesick and start believing that they have enough saved and that they can easily find a job or business when they come home.  They start believing that what they have saved will tide them over until they find the job or business.  Unfortunately, many times this is not a realistic assumption. 

If they still need a job, they should be relatively sure they have that job before coming home for good. For those who dream of getting into business, they should prepare for the business that they intend to get into.  They should prepare themselves together with their family in identifying what business they will get into, thoroughly study the identified business and have a complete plan in how to set it up and start operations.  Ideally, the business should already be running even before they give up their job abroad. They can start to prepare for this by working on their plans each time they come back for their vacation.  

One of the better ways to do this is to look into franchise businesses that fit their goal.  In some cases, Franchisors can provide active management of the business in the start-up year.  This way, the OFW or his family member can be taught how to run the business on-the-job. There is no better way to prepare and train than going through this kind of hands-on training.

Typical Back-For-Good Situations

When they are finally home in the Philippines, some OFWs say they cannot adjust to the new life.  Most of the time, it is because they realize that  what they have saved is not enough.  This is so because it usually is taking them longer to find a job or to think or put up a new business.  In this case, their only choice really, is to cut down on their expenses drastically until they are able to settle down.   

Those who have lived in the Philippines all their lives know that setting up businesses can lead to a lot of frustration especially since the choice of business should be dependent on the passion of the person, interest, size of market and sufficient funding.  To all the OFWs out there, always remember the saying that “The grass is always greener on the other side.”  Examine your options well whatever side you are in now before making important decisions to uproot yourselves and move overseas.