So now that we understand what sub prime loans are and how they are packaged up into pools and resold, we can now look at how the sub prime crisis happened. By late 2004 the US economy was growing fast enough that the federal reserve decided to start raising interest rates, which it has continued to do until fed funds rate stood at 5.25% in January of 2007 (up from 1%). Several things happened as a result of this.

1. It became much more expensive to borrow money so less people could afford to buy a house and those that could, could not afford as large a mortgage as they could when rates where at 1%.

2. As there were not as many buyers, the real estate market began to cool and house prices which had been increasing rapidly in the years leading up to this began falling moderately.

3. If you remember correctly from our first article many of the sub prime borrowers took out adjustable rate mortgages where payments rose if interest rates rose and low initially fixed rate mortgages that quickly converted to adjustable rate mortgages. Their plan was to refinance these loans using the expected increase in value of their house to help them qualify for a better loan. As the housing market stalled however and their houses were no longer increasing in value, they could not refinance and therefore were stuck having to pay a much larger mortgage payment as the harsher terms of the loans they agreed to kicked in. This caused many of these borrowers to not be able to make their house payment and therefore their house was foreclosed on.

So the issue now is that there are billions of dollars in losses relating to rising defaults mostly related to sub prime borrowers.

From the financial institution side of the equation, the problem would be bad if everyone knew where all these loans were, which financial institutions and investors were going to lose money as a result of this, and how much money they could potentially lose.

If you remember from our second lesson however, these loans were for the most part no longer with the financial institutions that made the loans but had been sold off and traded among different financial institutions from around the world. As the subprime portion of these mortgage pools were defaulting at a much faster rate than expected, the institutions that held them stood to lose a lot of money as a result.

This has caused what is known as a liquidity crisis where no one trusts anyone else enough to lend them money at reasonable rates, even the largest banks in the world. This is a real problem for these banks, who basically are the financial system, because they rely on large short term loans from one another to cover their short term expenses.

Because these institutions are normally considered very credit worthy, and because these loans are short term, they normally come with a very low interest rate. As no one knows who has been left holding the bag with the subprime debt, the interest rates that are charged on these loans have gone through the roof.

This is why you read about the different central banks around the world having to step in and add liquidity to the market by basically injecting billions of dollars into the financial system to try and keep things from locking up.

If you also remember in our second lesson we learned about these huge pools of pools which are known as Structured Investment Vehicles. If you remember from that lesson these entities rely on this short term borrowing to buy the longer term debt and have to periodically roll the loans they are issuing over. The problem now is that they can no longer borrow short term to cover their obligations and are therefore in danger of having to sell off huge chunks of these mortgage backed securities to avoid running into financial difficulty. This is why you read about banks like Northern Rock having to be bailed out by the Bank of England and Citigroup having to raise billions of dollars from the Abu Dhabi Investment Authority.

As there are so many problems with the mortgage market right now however the market for many types of these pools has dried up as no one wants to buy them. This means that if these institutions are forced to sell they are going to have to do so at very low values in relation to how much the pools they own are probably still worth even with the problems. What this has caused is a situation where everyone that can is holding on hoping that the market will return to normal so they can exit their positions at a reasonable price.

Lastly and perhaps most importantly because the market for many of these pools has dried up, it is very difficult to tell how much they are worth. This has brought a lot of suspicion to even those who have come clean about how much subprime exposure they have, and how much the losses are they plan to take as a result, because there is really no way to know for sure if they have valued that loss correctly until the market returns to normal.

Currently there is still a lot of uncertainty as to when this will end and how bad it is going to end up being for the economy. All I can say here is that time is the key factor. If the banks and other financial institutions that are holding this bad debt come to a consensus on how much of it they are going to have to write down and how they are going to value the losses quickly, then things will be a bit painful in the short term but better over the long term. If there is no consensus on where and how much the losses are after the first quarter of next year, then we are probably in for lots of trouble and markets will head lower as a result.

Thanks! These lessons really helped me understand the problems faced in the US, which I needed for an essay on the Northern Rock case! You rock!

Glad you liked them. If you have any questions that I can help with on Northern Rock feel free to post them here and I will do my best to answer them for you as I am sure others would be interested as well.

Best Regards,
David

Hi David,
Thanks for your lessons that's just what I needed to make anything from what's going on.
Looking forward to more economics lessons from you.
Stay well
Beatrice

Hi Beatrice,

Thanks a lot for the comment. I am glad the videos helped out and there are more to come soon.

Best Regards,
Dave

Hi Dave,

Thank you very much for your video. There is one part I'd like to seek your elaboration. That is the last bit: "...This has brought a lot of suspicion to even those who have come clean about how much subprime exposure they have, and how much the losses are they plan to take as a result, because there is really no way to know for sure if they have valued that loss correctly until the market returns to normal".

I thought when the firm bought the security, the had the price of the security and also the expected cash flows they will receive. So why you say that there is no way they can value how big the loss they have made and how much their exposure was?

Thank you very much for answering my question and for your sharing!

Regards,
Celine

Hi Celine,

Thanks for the question and for contributing the the community.

There are two things which determine the value of these and any other security:

1. As you have stated what the expected cash flows are for that security. In this instance how much money is going to come in from the mortgage payments on the mortgages which make up the securities.

Although the mortgage backed securities are structured in a way which the cash flows are more stable since they invest in a lot of mortgages and diversify exposure there is no way to know for sure what those cash flows are going to be. The reason being in this case because they are determined by how many people pay their mortgage payment, how many people pay off their mortgages ahead of time, and how many people default.

The problem here is that the defaults have risen higher than was expected and there is a lot of uncertainty about how much higher they will go. This creates a situation where it is difficult to estimate what the cash flows from the security will be which is the first problem.

2. While you estimate the value of these and any other security by analyzing its cashflows what ultimately determines the value of a security is what someone else will pay for it. Now in a rational market this is based on what the cash flows of that security are expected to be.

So the first problem here is that there is a lot of uncertainty as to what those cash flows will be creating uncertainty about the value that the firms which own these securities will be.

The second problem is almost everyone is scared to buy any of these mortgage backed securities or is like Citigroup and Merril who have had so much trouble that that don't really have the money too even if they wanted to.

What this has created is a situation where the market for these things has dried up. So with no way to see what other securities of a similar type are selling for in the market there is no way to no for sure what the value of any of these things actually is because there is no way to know what someone will pay for it.

Hope that makes sense. If there are any other questions or comments on this please feel free to leave them below.

Best Regards,
Dave

Hi David! How have accounting standards and rules contributed to this crisis? Aren't accountants/auditors responsible in making brokerage firms come clean on the real value of level 3 asstes and make the institutions declare it on their financial statement. Seems like another Enron/Accounting scandal coming up with ficticious asset and revenue values. Whats the role in accounting /accountants in this crisis you believe?

Hi Jeevmania,

Thanks for joining and participating in the community.

Accounting is not really my area of expertise so I would be happy to have others input on this if I am off base but from what I know I don't think that accounting standards or accountants played a major role in this crisis especially when compared to Enron.

Enron was a case of outright accounting fraud and accountants pretty much being in on that and helping the firm to create the vehicle's which facilitated the fraud.

Before August of last year when things started to come unraveled there was an orderly market for most of these securities which allowed firms to value them based on their actual market value. As they were being valued on what other people were paying for similar instruments there wasn't really any playing with the numbers that could be done. Now that the market has disappeared for many of these instruments and firms have to value on a mark to model basis there is the potential for problems to arise from an accounting standpoint, but this is a consequence of the problem and not a cause as I see it.

The real problems here at least so far seem to be in the loan origination practices or in other words how firms that were making loans to home buyers went about this with things like no document loans and making loans to people who they knew could not afford them, the ratings agencies lack of understanding of what the actual risk of these instruments was, and then too much appetite for risk from the financial institutions involved in collateralizing and then purchasing those securities.

As I say however accounting was not one of my better subjects so if there are other opinions on this I welcome them.

Best Regards,
Dave

Hi David,

I just saw your 3 part series and liked it a lot. I think it's an excellent overview for those who are uninitiated on this subject. Although I thought I knew the concepts, the videos still helped make things very clear.

I was just wondering about more specifics of securitization in particular ABS,MBS and CDO - do you have any recommendations on any good sources for this material.

I really appreciate your efforts. Thanks so much!

I look forward to more postings from you.