A really simple explanation of the sub-prime mortgage crisis
A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain." ~ Robert Frost 1874 –1963
I originally posted this article on August 31. But it has suddenly become very topical so here it is again. My prediction that we are in for a bumpy ride was right – hold tight everybody.
The Northern Rock crisis demonstrates how vulnerable financial markets are to the interdependence of the institutions. It would appear that NR was not directly affected by the sub-prime crisis; they had not invested in any of the dodgy derivatives that are causing such problems (And which are described below).
However NR decided to expand their mortgage book (I understand by +50% in the first eight months of this year), a risky strategy in a housing market which had already seen such an enormous rise in prices. And NR did this by borrowing from banks which have been caught up in the sub-prime crisis.
These banks are suddenly finding big holes in their assets and can lend no more – and they too can be accused of acting recklessly. They may argue that they have abided by the rules but this is not an excuse. They have made dodgy investments using our money. Only constant vigilance by fund managers when they buy securities will prevent them falling into traps set by the greedy. They must look at what lies beneath.
The world's banking system is threatened by meltdown. It is unlikely that governments will allow this to happen, but the crisis will see the collapse of a few financial institutions and many people will be hurt. And this will happen even if a safety net is put in place. So we should try to 
understand what has gone wrong. It happened like this.
Risk of default
Banks lend money to people to buy homes, cars and so on, as well as to businesses to help them operate. These loans are secured by the borrower's income flow, which should be high enough to pay the interest and, eventually, to repay the capital as well. The lending bank assesses the risk that the borrower will default and, on the basis of that judgement, it may charge a higher rate of interest or require additional collateral security. The banks charge fees, in addition to interest, to make this assessment.
Asset Backed Securities
From the early 1990s, banks in the US decided to sell on the risks they 
had taken to other institutions, packaging them into asset-backed securities (ABSs). In this way, the originating banks get back the money they have lent. They can therefore make more loans, while their original risk is passed on to others.
The institutions – ordinary banks and building societies around the world – that buy ABSs can choose how much risk to accept because of the way they are packaged. ABSs are divided into tranches.
Buyers of the top tranche (the lowest risk) are entitled to the first part of the capital to be repaid. For example, if they are entitled to 60% of the capital, their investment is safe unless 80% of borrowers default and only half the money is recovered through repossessions (50% of 80% is 40%). In this example, since 60% of the money is safe (the money to which they are entitled), these investors lose nothing and all losses are borne by investors who bought the lower tranches. The risk of an 80% default is so small that credit rating agencies feel justified in giving these securities their highest AAA rating and major institutions feel confident in buying them.
The second tranche of securities might be entitled to the next 10% of repayments. For these investors to lose money, 60% of the loans would have to default and lose half their value (50% of 60% is 30%). So 70% of the money remains, 60% for the first tranche holders and 10% for the second tranche. Again, the risk of a 70% default is unlikely and could warrant an AA rating for the second tranche.
Wipe out capital
When you get to the bottom tranche, investors might only be entitled to the last 4% or so of the money. So just 8% of the loans losing 50% of their value would be enough to wipe out all the capital belonging to this group. These securities get a low rating (perhaps a maximum of BBB) because of their high risk. Only specialist institutions such as hedge funds who are accustomed to managing high risk would invest at this level. They are attracted by the much higher interest rates offered by bottom-tranche ABSs to make them worth owning.
Collateralised Debt Obligations
Investment bankers don't earn huge salaries for nothing. They had another trick up their sleeve to make even more money. They took the lowest tranches of ABSs and packaged them into Collateralised Debt Obligations (CDOs). The tranching process was repeated with these securities and – somehow – the credit rating agencies were persuaded to give the top tranche an AAA rating (perhaps because these securities were entitled to the first 75% of repayments). But the flaw should have been obvious: the underlying assets only had a rating of BBB or lower. The advantage to the sellers was obvious – they could get away with offering a low rate of interest on high risk securities because of their low risk rating.
So fund managers at major banks, who should have known better, were drawn into buying over-rated assets. They were following their rules by buying AAA-rated assets, but they were walking on very thin ice. With the structure of CDOs, if the underlying assets (the whole portfolio of original mortgages) lose more than 5% of their value, losses start to affect all AAA-rated CDOs, many of which have been bought by the major international banks. Already dangerous – but there is worse to come.
Improper checks
US banks have been altering the methods they use to check the riskiness of borrowers. They have also changed the way they structure their loans. Here are a couple of things they did:
- Interest charged at adjustable rates became common. The worst were exploding adjustable rates. Clients were offered very low teaser rates which, once the introductory period was over, could be raised significantly, resulting in repayments increasing by 25% or more. This is now the main reason for home owners falling behind in their mortgage payments.
- In order to speed up the process of lending money, loans were offered without the borrower having to provide documentary evidence of income. Research has shown that 60% of borrowers overstated their income by more than 50% on their application forms.
The effects of these changes are:
- Poorly substantiated loans in the US are estimated to account for 47% of loans made in the past year, compared with 2% in the year 2000.
- Average homeowner equity in the US has fallen from 22% in the year 2000 to 13.5% in 2006.
Sub-prime crisis is only just beginning
The sub-prime crisis is only just beginning as the large number of people who overstretched themselves by inflating their incomes when applying for loans face the prospect of a sharp rise in repayments as their introductory rates expire in the next couple of years. Estimates suggest that 20% or more of the sub-prime mortgages made in 2006 will default. Since there is already a glut of properties on the market, there is a risk that recovery of capital will be affected by lower prices.
The top tranche of CDOs have a higher credit rating (AAA) than the lowest tranches of ABSs (say BBB). But compare the following figures and the problem becomes crystal clear. Buyers of the lower tranches of ABSs face a real risk. Studies suggest that 20-30% of all loans (the assets which underlie their securities) will default and lose 30% of their value, a cumulative loss of 8-10% of the total value of the loan book. Enough to put the capital of lower level ABSs at risk. But buyers of the top tranche of CDOs are facing an even bigger risk. Their capital is threatened by a cumulative loss of just 5%. And these investors are high street banks and the like who have been attracted by the AAA ratings.
Dodgy investments
So the die is cast. Those CDOs are out there. Not only in investment houses like hedge funds, which are set up to deal with high risk, but in high street banks, building societies, savings and loans. These institutions have discovered that big holes are appearing in their balance sheets and, one way or another, they will need to be plugged. This means that your "safe" cash deposits – and mine – have been used by our friendly banks and building societies to buy these dodgy investments. We are in for a bumpy ride.
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