Securitization

This article tries to explain what is securitization. Lets consider what a bank does? A bank gives loans to its borrowers. If it is a small bank we call it as a sub originator and this small bank transfers these loan to a bigger bank which is called as originator. Now, this originator can sell off this loans to a trust and get money. And this trust sells of these loans in form of bonds to various bond holders

Now this trust collects money from the bondholders and gives it to Originator. And now this originator can lend of this money to more borrowers. Selling off the loans to a trust is known as Securitization.

Sub-prime crisis - Origin and Impact

The origins of this crisis can be traced from late 1990s, when the dotcom bubble started. After the crash of the dotcom bubble in 2000s most of the countries including US were facing economic recession. Interest rates were low during these periods and lending standards were not good. This led to the rise of another bubble in 2001 in the form of real estate. The prices of the real estate property sky rocketed during this period. There was a rat-race for buying houses and people were taking loans as it was very cheaply and easily available. Lending agencies used innovative products to attract customers. During 2004 through 2006, concepts like ‘teaser rates’ became popular in mortgages. These teaser rates (initial low interest rate) applied through varied time period, ranging from few months to couple of years depending on the mortgage creditworthiness. The thing which the borrowers forgot was that at the end of this freedom period the rates can rise rapidly, raising the minimum instalment to be paid out of their capacity. During this period lenders were so confident that they qualified borrowers only by their ability to pay the teaser rates.

One may trace the sub-prime crisis to the securitization – conversion of home mortgages into bonds. The man behind securitization was an Investment Banker of 'Salomon Brothers' - Lewis S. Ranieri. In 1980s Salomon launched Mortgage-Based Securities (MBS) – bonds with bundles of mortgages, bought from bank lenders, as collateral. For this, Salomon used a special purpose vehicle known as Collateralized Mortgage Obligation (CMO). Monthly instalment was used to pay the interest on these bonds. We will discuss about securitization separately.

Securitization had some negative implications on the mortgage standards. Since anyone can originate a loan and sell it to the Investments Banks, which package them and sell them as MBS, it lead to originators writing risky loans as they need not worry about the payback of loan. This problem was dealt by slicing MBS into tranches on the basis of the risk profile. These tranches which may have different maturity period were given ratings by credit rating agencies like S&P and Fitch. The most risky tranches were difficult to sell except for the hedge funds and some pension funds. These hedge funds were so eager to buy these securities that they didn’t care about the huge impending risk associated with these tranches and continued to invest in them.

With the collapse of the housing bubble in mid 2005 real property price declined so much that many owners holding became negative equity, mortgage debt became higher than the value of the property. During the housing bubble, many property owners used their property as collateral to raise money for consumer spending. With the crash of housing markets these lenders faced huge defaulter problem and were unable to recover their losses.

Aggravating the issue was the rising interest rates, coupled with the maturity of the freedom period of teaser rates, which increased the monthly payments. Many house owners felt incapable of meeting their financial liabilities and went bankrupt. Amongst the institutional players affected were the sub-prime lenders, banks, housing developers, and investors like hedge funds and pension funds. The impact was not limited only to US, as UK’s leading subprime lender Northern Rock sought bankruptcy protection.

Sub-prime crisis - An Introduction

What is Sub-prime crisis?

In our earlier discussion on sub-prime mortgage, we acknowledged that both creditors and debtors carry high risk in such kind of lending. Sub-prime crisis is the result of those risks.

Sub-prime crisis is associated with the increase in foreclosures of the sub-prime mortgage borrowers. It was significant enough in the year 2006 to create headlines. In year 2007 the total value of the sub-prime mortgages was more than two trillion dollars, which makes about 15 % of the total mortgages. Due to the sub-prime mortgage market meltdown the houses of millions of Americans are under the risk of foreclosure. Over six hundred thousand of such foreclosures were initiated during the first half of 2007.

What is sub-prime mortgage?

To understand sub-prime crisis we have to first know sub-prime mortgage.

‘Mortgage’ according to the American Heritage Dictionary is

“A temporary, conditional pledge of property to a creditor as security for performance of an obligation or repayment of a debt.”

Sub-prime lending/mortgage is characterized by the following:

1. Loans to borrowers with poor credit history, poor credit rating
2. Risky to both borrowers and lenders
1. Borrowers can get their security/collateral foreclosed
2. Lenders can lose the money they have lent
3. The higher risk is counter balanced by higher interest rate
4. ‘subprime’ is the credit status of borrower and not the interest rate

Generally the sub-prime lenders offer some incentives since they are charging higher interest rate. Some of the schemes in market are:

Interest Only Loans – Paying only interest during the initial years,
Adjustable Rate Mortgage (ARM) – Mortgage in which interest rate is periodically changed depending on an index.
Hybrid ARM – Rate is fixed for a period of time and floating.
Option ARM – Borrower has option of choosing either a minimum payment or an interest only payment.
Teaser Rate – Getting loan at an initial fixed interest rate for couple of year and then converting it into variable rate.
NINJA Loan – Mortgage given to a person with No Income, No Job, and No Assets.
Liar Loan – Mortgage provided without requiring documentation from borrower.
Balloon Payment Loan – Mortgage which has a large balance due at maturity.

In the next article we will discuss about the sub-prime crisis. :)