After reviewing the
subprime crisis explained lesson 1 you should now understand things from the borrower's side of the equation. So now lets look at things from the lender's side.
One of the reasons why this is such a big problem is because so many different types of financial firms and investors have exposure to these subprime loans. To understand how we must understand something which is known as securitization. Securitization in simple terms means taking a bunch of assets, pooling them together, and offering them out as collateral for third party investment. Securitization happens with many different types of assets but for the purposes of this article we will focus on how they apply to mortgages.
Up until relatively recently when you went to get a loan for a house from a bank, they would lend you the money and then hold your loan, earning money from the fees they charge you to give you the loan and the interest that you pay the bank on that loan. As the money the bank was lending out was the money that people were depositing in the bank, the bank was limited on how many loans it could do by how much money it had on deposit. As the bank was holding all of the loans on its books so to speak it also held all the risk for those loans.
As a way of diversifying risk and allowing the banks to make more loans (thus earn more fees) investment bankers came up with a process for securitizing mortgages so they could be sold off to other financial institutions and investors in a secondary market. So very basically instead of holding all the loans they make to home buyers on their books, lending institutions will now pool a bunch of these loans together and sell them in the secondary market to another financial institution or investor.
The pools that the loans are put into are referred to as Mortgage Backed Securities (MBS for short), Collateralized Debt Obligations (CDO for short) or Asset Backed Securities (ABS for short). For the purposes of this article you do not need to understand all the details of each as they are very similar in the fact that they all act as a way of taking individual loans and bundling them up so they can be sold in the secondary market. This frees up capital for the bank and reduces their risk, so they can make more loans and earn more fees. What you do need to understand however is the following:
1. A large portion of the financial institutions that are potential purchasers of these mortgage pools will not buy or are restricted from buying sub prime debt because it is considered too risky.
2. To get around this what investment bankers did was take a pool which contained subprime mortgages and divided it up into different levels (also referred to as traunches). Each level was then defined by who would take the first losses if and when any of the subprime borrowers in the pool stopped making their mortgage payments. The lower levels were the first take these losses and the higher levels were the last.
3. Next they got the companies who assign credit ratings to different types of debt instruments which are referred to as ratings agencies to come in and assign different credit ratings to each level. The higher levels which were the last to take losses if and when mortgages defaulted were given high credit ratings and the lower levels that were the first to take losses were given the sub prime ratings.
4. What this allowed investment bankers to do was to sell off a large portion of the sub prime loans as debt instruments with above prime credit ratings thus expanding the number of potential buyers of that debt.
The types of firms that invested in these instruments varied widely from other banks, to hedge funds, to pension funds, to insurance companies not only here in the United States but all over the world.
The last thing that it is important to understand in this lesson is that many of the financial institutions which held large amounts of these instruments held them in what is known as a Conduits, Special Investment Vehicle (SIV) for short, or Special Purpose Vehicles (all basically the same thing). These are semi separate off balance sheet entities which allow banks and other financial institutions more flexibility from an accounting and regulatory standpoint in their operation. Again here the details are not important but what is important to understand is that:
1. These entities hold large amounts of mortgage “pools” as one large “pool of pools”. So instead of holding say $50 Million in mortgages they will hold a bunch of those smaller pools as one pool of $1 Billion or more.
2. They finance or fund their operations by issuing short term debt to buy this longer term debt essentially having to pay a lower interest rate on the short term debt that they issue to raise money than they earn on the mortgages that they are investing in.
3. Because these loans are short term they have to be “rolled over” or redone fairly frequently to continue the financing of the Special Investment Vehicle.
For the first few years as interest rates stayed low, the economy continued to expand, and real estate prices continued to rise, everything went smoothly and pretty much everyone was doing well. As we will learn in our next lesson however this all started to change when these trends started to slow.
So that wraps up our second lesson in this three part series on the subprime crisis. You should now have a good understanding of both the borrower and lender sides of the equation so we can now take a look at where it all went wrong in the third and final lesson of this series, the
subprime financial crisis explained Part 3.
As always if you have any questions or comments please feel free to post them in the comments section below, and have a great day!
InformedTrades has been providing coverage and explanations/commentary on the economic crisis in the United States. Click here to view our crisis coverage.