| Unless you have been living in a remote cave for the | | | | computer models began to realise that the returns as |
| past year or took a trip into space and have just | | | | they stood (the investment bank receiving its |
| touched down again, you will no doubt have heard | | | | £100m per year in interest from all the mortgage |
| of, and felt the effects of, the U.S subprime | | | | loans) required for everyone to pay their mortgage |
| mortgage crisis. It has rippled through the global | | | | and for no one to default or pre-pay. |
| economy destroying the financial health of | | | | “Hold on, they said, I don’t think it’s |
| institutions, businesses and individuals that stand in its | | | | realistic to claim that everyone will pay their |
| path. But what really happened? What really caused | | | | mortgage and if they default we won’t be able |
| the sub-prime mortgage crisis? | | | | to sell the house at its market value necessarily and |
| Well I went on a mission to find out... | | | | so we must account for this in our returns”. For |
| I spent time in numerous jargon laden trenches and | | | | example, say 20% of people default and the |
| only just managed to bend my head around a series | | | | investment bank can only recover half the value of |
| of esoteric concepts. | | | | the house. That means that in effect 10% of all the |
| Firstly there was the U.S housing price conundrum - | | | | loans are worthless, so instead of a 10% return, |
| why were house prices so high? | | | | investors would get a 9% return. |
| Then we needed to understand what Mortgage | | | | So in response to this the investment banks began |
| Backed Securities were and what they had to do | | | | to sell different types of shares to investors. Some |
| with anything | | | | shares cost a bit more, and came with higher risk and |
| And finally what were Collateralized Debt Obligations | | | | higher returns. Some shares cost less, and came with |
| By understanding the facts, dismantling the jargon | | | | lower risk and lower returns. |
| and simplifying the concepts I managed to piece | | | | How did they do this? |
| together an explanation of what really happened and | | | | This is where Collateralized Debt Obligations come in |
| began to understand the subprime mortgage crisis a | | | | to play |
| little better. | | | | Let’s go back to our investment bank’s |
| The U.S housing price conundrum | | | | special purpose vehicle. Instead of dividing up the |
| U.S house prices normally rise; at least according to | | | | share capital equally the investment bank separated |
| the Case-Schiller Housing Index they have been doing | | | | its 1m shares into 3 classes called Equity, Mezzanine |
| so at a steady pace for most of the 20th century. | | | | and Senior. These worked as follows. If you owned |
| However around 2000 they started to rise rapidly. | | | | Senior shares you paid less but got less return on |
| And from 2000 to 2006 they rose by a whopping | | | | your investment but at significantly reduced risk, in |
| 80%. | | | | fact you got paid first out of the money coming in |
| The conventional factors that economists would use | | | | from the mortgages. Then if you owned Mezzanine |
| to explain this phenomenon are an increase in the | | | | shares you paid a little more for your shares than |
| demand drivers, the two most obvious being an | | | | Senior and got a little higher return but you were |
| increase in the population and an increase in salaries. | | | | only paid from what remained from the pool of |
| However although the U.S population did increase in | | | | mortgage money after Senior shareholders were |
| that period by approximately 1.5% salaries actually | | | | paid. And finally, if you owned Equity shares, the |
| decreased by 3%. Therefore the net effect of the | | | | most expensive shares, you got much higher returns |
| demand drivers went down by 1.5%. | | | | that the senior and Mezzanine shareholders but you |
| So another conventional economic explanation is the | | | | were paid last from whatever was left in the pool of |
| supply drivers: housing must have dried up right. But is | | | | mortgage money after Senior and Mezzanine |
| this true? | | | | shareholders were paid. |
| Well in 2000 there were around 115m housing units in | | | | These types of shares are collectively known as |
| the U.S with 1.8 million new units being built each year. | | | | Collateralized Debt Obligations. |
| So during the same period from 2000 to 2006 the | | | | So how did all of the above contribute to the |
| number of housing units actually grew by about 6%. | | | | Sup-prime Mortgage Crisis? |
| What is going on? Demand was down, supply was up | | | | Well it goes like this: |
| and yet prices did not drop, in fact they sky | | | | Because you have lots of people making money |
| rocketed. | | | | from the new types of shares (Collateralized Debt |
| Something else must have been driving up the house | | | | Obligations.) the investment community are hungry |
| prices, but what? | | | | for more, so the banks need to sell more mortgages |
| Well between 1980 and 2000, if you wanted to buy | | | | and they can do so now to more people than ever |
| a house you would go to your bank manager and | | | | before because they have reduced their lending |
| they would ask you to put 25% down (meaning if | | | | criteria in part because they are not responsible for |
| you wanted to buy a house worth £100,000 you | | | | collecting the mortgages, the investment bank is, and |
| gave the bank £25,000 and got a mortgage on the | | | | some investor somewhere is willing to buy from the |
| remaining £75,000), verify that you had a secure | | | | investment bank a higher value of share for a higher |
| job and demonstrate a good credit score, say a 700 | | | | return. This is perceived by the investment bank to |
| points. | | | | offset the risk associated with the bank’s lending |
| In 2001 this changed to you needing to only put | | | | to higher risk individuals, the NINAs. |
| about 10% down, verify that you had a job and | | | | But they all got their numbers wrong and instead of |
| demonstrate an OK credit score, around 500 points. | | | | something like 10% defaulting on their mortgages, |
| By 2003 this had changed to you needing to put no | | | | which historically may have been true and was no |
| money down, simply claim that you had a job and | | | | doubt incorporated into their computer models, some |
| demonstrate no credit score what so ever. These | | | | 40% defaulted. |
| people were known as NINAs : No Income, No | | | | Why did so many people default? |
| Assets. It is the mortgages given to this class of | | | | When the housing market is booming and property |
| borrowers that the real estate industry refers to as | | | | prices are on the rise even those that default on |
| subprime mortgages. | | | | paying their mortgages can sell up and even make a |
| So the bank’s lending criteria got more and more | | | | profit. This way the banks get their money back and |
| relaxed with time, which in turn meant that the | | | | no one is really hurt. But when the housing market |
| number of people now able to bid on a home was | | | | slows down those that can’t pay their mortgage |
| significantly larger than before. And it is this that | | | | have no option to default and the bank has to |
| pushed up demand and caused the enormous rise in | | | | foreclose on the property meaning they lose money |
| housing prices over the last few years. | | | | and so do the investment banks and their investors. |
| But why did the banks relax their lending criteria to | | | | And this is what happened, the housing market |
| such an extent? To understand this we need to | | | | slowed down and house prices began to fall, due to |
| move into Mortgage Backed Securities. | | | | demand tailing off, a surplus of housing stock and |
| So what are Mortgage Backed Securities? | | | | interest rate rises. |
| Well, these sound rather obscure but in fact they are | | | | So lots of people, mostly the NINAs whose incomes |
| not so difficult to understand. Here we go. | | | | were wholly insufficient to cover the mortgage |
| We start with borrowers; people like you and me | | | | payments they took on, could no longer afford to |
| who need to buy a house with a mortgage. We go | | | | pay their mortgage and without any equity left in the |
| to the bank and we ask for say £1m to buy a | | | | home were forced by the banks to foreclose. This |
| house. The bank agrees and charges us 10% interest | | | | meant that the investors in the Mortgage Backed |
| on the mortgage. Say they do this with 1000 | | | | Securities and Collateralized Debt Obligations had a |
| customers; they would have £1bn in mortgage | | | | significantly reduced return due to the huge number |
| loans and receive £100m per year in interest. | | | | of people no longer paying their mortgages. These |
| Then comes along an investment bank who says to | | | | investors included investment banks, hedge funds, |
| the bank, “hey we want to buy your mortgages | | | | private investors, institutions such as Insurance |
| from you and package them up so that we can sell | | | | companies and pension funds and...You guessed it, |
| them to investors”. Now this sounds rather | | | | banks! |
| strange but it’s very simple. Basically what | | | | A consequence of the creation of Collateralized Debt |
| happens is the investment bank buys the rights to | | | | Obligations was that investors, not banks, would |
| the loans and the cashflows (basically the interest | | | | assume the risk for the relaxing of the bank’s |
| payments as well as any principle that is paid by the | | | | lending criteria so as to be able to offer more |
| borrowers) and incorporates a new company (a | | | | mortgages to more people including high risk |
| Special Purpose Vehicle) and divides the share capital | | | | borrowers. But in the end the banks got greedy too |
| into say 1m shares, now each share is worth £1,100 | | | | and it’s these toxic assets that many banks are |
| (which is the £1bn in loans plus the £100m interest | | | | holding on their balance sheets that are expected to |
| they expect to receive divided into 1m shares). The | | | | cost the U.S taxpayer about $8.5 trillion ($3,291 USD |
| investment bank can now sell these shares to | | | | per person) via the U.S. government’s |
| investors on the market and it is these shares that | | | | commitment to funding a host of economic stimulus |
| are known as Mortgage Backed securities. | | | | programs. |
| So what does this have to do with the subprime | | | | I hope you have enjoyed this article and that I have |
| mortgage crisis? Well it turns out that the investors | | | | helped make understanding the subprime mortgage |
| and investment banks with their sophisticated | | | | crisis easier for you. |