DavidWaring

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.

anantjain

Hi David,

I have a doubt on how these financial companies finance MBS. This is how you have put it in the article:

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.

Can you explain the part where the MBS of SPV are being financed by the short term debt?

Thank You,
Anant Jain

David Waring

Hi Anant,

Thanks for the comment. I am not sure how to explain it differently than I have above why don't you let me know what you doubt is and then perhaps I can address that.

Thanks
Dave

anantjain

I am naive to financial markets, so pardom my ignorance. I think the way you can explain this to me is how mony flows. Somebody who is buying MBS where does he get money from,

for example is it like borrowing money at a lower interest rate from the fed (money inflow) and buying MBS where the interest returns are higher (money outflow)?

David Waring

Hi Anantjain,

No worries that is what we are all here for is to learn.

Normally the shorter the duration is that one borrows money for the lower the interest rate they are going to have to pay on that money.

So for instance, if you are a business owner and have a need for cash to cover some unexpected expense that you are going to pay back in 1 week, then the bank is under normal circumstances going to give you an interest rate on that loan that is less than if you take out a loan for 10 years.

Secondly, the larger and more financially stable an institution is the lower the interest rate they will have to pay to borrow money all else being equal.

So, as is explained in the video series, these CDO's are made up of a bunch of 30 year mortgages which are taken out by individuals. Since the loans are long term and taken out by individuals (some or all of whom do not have very solid financials) the interest rate that those individuals are going to pay on those mortgages (and therefore the interest rate that the SPV holder of the mortgages is going to receive) is going to be relatively high.

The SPV that holds the CDO on the other hand is normally very credit worthy and therefore can normally borrow money over the short and long term for less than an individual can.

What they would do is basically take their good credit rating and obtain short term loans to buy these CDO's which hold long term debt. Because the financial institutions are able to obtain a lower interest rate (due to their solid financial s plus the fact that they are borrowing money on the short term) than they are receiving on the long term debt that they are buying, they are going to make money.

For instance if they borrow money at 3% from other financial institutions (probably not the Fed) for 1 year and then use that money to buy a CDO which pays say for example 7% then they pocket the 4% difference in interest rates.

The key here however is that they need to be able to refinance and obtain a new loan at the end of the year (this is called rolling it over) so they can continue the process. This is the key because once cracks started to show in the subprime market, the SPV's which held these CDO's started to have trouble obtaining new financing and were thus put into a position where they were going to be forced to sell off some or all of their CDO holdings at fire sale prices. This is why you heard about banks like HSBC and CITI Group bringing those off balance sheet SPV's onto their balance sheets so they could use the balance sheet of the parent company to obtain financing and avoid having to sell off those assets for much less than they are actually worth.

Hope that helps. If there are any other questions or comments on this please feel free to post them below.

Best Regards,
Dave

anantjain

Thanks David, this sums it up very well.
In this entire discussion the one thing that I am concerned with is the role of rating agencies, no doubt large companies like Citi with strong fundamentals deserves good rating but I think the quality of loans that they have should have been one of the major factors in deciding the credit rating when they were raising money. This simple fact which I think was ignored by Credit rating agencies could have prevented the Sub Prime crisis as this would have checked the money pumping into MBS. I have seen a similar kind of scenario here in India where the rating agencies have started rating IPOs (Initial Public Offerings) and have gone horribly wrong. The IPO ratings were done considering the present market technicals and competely ignoring the company fundamentals and when the markets crashed these were the stocks which suffered most.

David Waring

Hi Anantjain,

Yes I agree and there is a lot of talk about similar things here with the ratings agencies in the US. A big part of the issue seems to come down to the fact that these ratings agencies are paid by the firms whose debt they are rating to rate that debt so there is a potential conflict of interest there. There also did not seem to be a good understanding of exactly how these instruments were put together by the ratings agencies which has magnified the problem.

Best Regards,

Dave

sakthikumar

DAVID,
simply supperb .

David Waring

Hi Sakthikumar,

Thanks for the comment I am glad you liked it.

Best Regards,
Dave

Unregistered

Wow, I just happened on this site because I needed a quick explanation of the subprime mortgage problem. I am about to write an article about how it has affected animals. Thanks so much for making this understandable for non-economists like me.