That’s whats behind the worldwide sub-prime crisis, millions of people missing payments, albeit on loans that may have been mis-advised or even extortionate but it doesn’t gloss over the fact that one guy in Ohio who decides he’s not going to pay his mortgage any more is not an isolated event when its correlated with all the other homes in the state who also decided to do the same. When you put all of these loans together (this is a simplified view just to make the point) then the Bank of ‘Wherever’ will suffer because of it.

Eventually the securitization process will start to feel the pressure, securitisation is where banks take all of their loans and then they put them into a ‘book’ of loans. So (I’m going to do this blog in layman-speak) basically all of the pages that are mortgages are put together into a folder, this is called a ‘mortgage book’ and then a thing called ‘gap maturity’ is worked out by risk analysts and this will tell you how much cash flow you can expect from the mortgage book over time, this is based on an assumed percentage that will fall into arrears/repossession, a certain amount that will pay off early or switch their loan to another lender, and other financial calculations based on market conditions.

You can sell a ‘book’ of loans based on the cash-flow of the underlying asset, so if you have 1,000 mortgages and each of them are being paid off then you can ‘securitise’ them, basically you sell that debt to another party to decrease your own risk. The easiest way to think about it is actually quite literal, imagine you have a house rented out, well, you could sell that house with the renter in place and somebody would give you a certain amount of money for the property and then a premium over an above that based on the lease (we’ll say in this example that you have a 20 year lease in place), that’s kind of the idea, banks would sell the loan and get a premium based on the fact that the debt is creating a cash-flow, and the debt is asset backed (the mortgage lender has the first lien or ‘right’ to the property).

What happens though when all of the folks who own the 1,000 houses that represent this ‘mortgage book’ decide they are not going to pay? That’s where the trouble begins.

Securitization turns non-liquid assets into liquid assets. If a bank sells its book to a pension fund (just for an example of who might buy a ‘loan book’) then the pension fund gives them the money they lent out plus a premium based on the ongoing cash-flow. You can securitise anything once it has an ongoing cash-flow, this happens with people who own large tranches of property that are rented out, it can happen with car fleets or any other asset that creates an ongoing income.

Normally there is a SPE or SPC (special purpose entity/company) which is set up to take on the ‘book of loans’ and this is done to reduce risk, the risk gets reduced because by having the ‘loan book’ sold by putting everything into a specifically formed company the ownership of which is totally outside of the Lenders hands it means that if something happens then this ‘new company’ will bite the bullet, not the lender. Basically the loans get transferred from the bank to the SPE/SPC and this takes the risk off of the banks balance sheet and places it with the owners of the SPC who are typically pension funds, hedge funds, or other investment entities.

This model seemed to work, so well in fact that like every successful element of the market, derivatives started to arrive, a derivative is something that is ultimately market based but not on the ‘actual’ market. For example, you can buy an ETF (exchange traded fund) which goes on the movement of the NASDAQ, in this case you are not actually buying the NASDAQ basket of shares, just part of a fund that is based on it, so if the market moves you are affected but you own not actual stock. That in a nutshell is how derivatives tend to work, they are based ‘on’ the market rather than ‘in’ the market.

The Derivative in the Mortgage game came as CDO (collateralized debt obligations), so investment banks that bought the ‘mortgage books’ from the smaller local ‘Banks of Wherever’ would gather up all of the ‘loan books’ and put them in a new Security, the CDO, and this would be sold to investors who would pay for the loans and pay a premium based on the cash-flow that was meant to come in over the years. The attraction was that worldwide property was in a bull market so the actual risk on the loans (even though it was known that some would go bad) was seen as not being too high because if it came to repossession

there would be plenty of equity in them. Equity is the difference between the value of a property and the mortgage held against it, normally this is a positive figure, you own a house worth €400,000 and the mortgage is €150,000 in that case you have ‘equity’ of €250,000. You can borrow against this equity which is what happens when people do ‘top up mortgages’.

CDO’s were typically sold in ‘tranches’ and they are graded accordingly, prime, Alt-A and the now infamous ‘Sub-Prime’ (sub-prime loans are loans given to people who have existing arrears or who cannot prove their income) remember, a CDO is a security that is based on all of these separate ‘mortgage books’, the buyer is not actually buying the ‘mortgages’ themselves they are simply replenishing the cash to the Investment bank who in turn make a profit on the sale and they use the freed up cash to buy more mortgage books and that’s how it went for a very long time.

There are also companies that offered insurance against defaults, in regular mortgages you hear about ‘bonding’ and what a MIG (mortgage indemnity guarantee) or more commonly an ‘Indemnity Bond’ does is give the bank some assurance for loans above a certain loan to value that if the loan goes into default that they can make an insurance claim against the Bonder. This also happened in CDO’s. One of the big topics recently was about Mono-line Insurers.

In future posts I will go further into the basics behind the sub-prime mess but for now (having just read back over what was written thus far) I’ll be happy knowing that you haven’t fallen asleep already!