How to Explain the Sub Prime Crisis In Simple Terms Part 2
83So now that we understand things from the borrowers side of the equation lets look at things from the lender side.
One of the reasons why this is such a big problem is because so many different types of financial firms and investors have exposure to these subprime loans. To understand how we must understand something which is known as securitization. Securitization in simple terms means taking a bunch of assets, pooling them together, and offering them out as collateral for third party investment. Securitization happens with many different types of assets but for the purposes of this article we will focus on how they apply to mortgages.
Up until relatively recently when you went to get a loan for a house from a bank, they would lend you the money and then hold your loan, earning money from the fees they charge you to give you the loan and the interest that you pay the bank on that loan. As the money the bank was lending out was the money that people were depositing in the bank, the bank was limited on how many loans it could do by how much money it had on deposit. As the bank was holding all of the loans on its books so to speak it also held all the risk for those loans.
As a way of diversifying risk and allowing the banks to make more loans (thus earn more fees) investment bankers came up with a process for securitizing mortgages so they could be sold off to other financial institutions and investors in a secondary market. So very basically instead of holding all the loans they make to homebuyers on their books, lending institutions will now pool a bunch of these loans together and sell them in the secondary market to another financial institution or investor.
The pools that the loans are put into are referred to as Mortgage Backed Securities (MBS for short), Collateralized Debt Obligations (CDO for short) or Asset Backed Securities (ABS for short). For the purposes of this article you do not need to understand all the details of each as they are very similar in the fact that they all act as a way of taking individual loans and bundling them up so they can be sold in the secondary market. This frees up capital for the bank and reduces their risk, so they can make more loans and earn more fees. What you do need to understand however is the following:
1. A large portion of the financial institutions that are potential purchasers of these mortgage pools will not buy or are restricted from buying sub prime debt because it is considered too risky.
2. To get around this what investment bankers did was take a pool which contained subprime mortgages and divided it up into different levels (also referred to as traunches). Each level was then defined by who would take the first losses if and when any of the subprime borrowers in the pool stopped making their mortgage payments. The lower levels were the first take these losses and the higher levels were the last.
3. Next they got the companies who assign credit ratings to different types of debt instruments which are referred to as ratings agencies to come in and assign different credit ratings to each level. The higher levels which were the last to take losses if and when mortgages defaulted were given high credit ratings and the lower levels that were the first to take losses were given the sub prime ratings.
4. What this allowed investment bankers to do was to sell off a large portion of the sub prime loans as debt instruments with above prime credit ratings thus expanding the number of potential buyers of that debt.
The types of firms that invested in these instruments varied widely from other banks, to hedge funds, to pension funds, to insurance companies not only here in the United States but all over the world.
The last thing that it is important to understand in this lesson is that many of the financial institutions which held large amounts of these instruments held them in what is known as a Conduits, Special Investment Vehicle (SIV) for short, or Special Purpose Vehicles (all basically the same thing). These are semi separate off balance sheet entities which allow banks and other financial institutions more flexibility from an accounting and regulatory standpoint in their operation. Again here the details are not important but what is important to understand is that:
1. These entities hold large amounts of mortgage "pools" as one large "pool of pools". So instead of holding say $50 Million in mortgages they will hold a bunch of those smaller pools as one pool of $1 Billion or more.
2. They finance or fund their operations by issuing short term debt to buy this longer term debt essentially having to pay a lower interest rate on the short term debt that they issue to raise money than they earn on the mortgages that they are investing in.
3. Because these loans are short term they have to be "rolled over" or redone fairly frequently to continue the financing of the Special Investment Vehicle.
For the first few years as interest rates stayed low, the economy continued to expand, and real estate prices continued to rise, everything went smoothly and pretty much everyone was doing well. As we will learn in our next lesson however this all started to change when these trends started to slow.
So that wraps up our second lesson in this three part series on the subprime crisis. You should now have a good understanding of both the borrower and lender sides of the equation so we can now take a look at where it all went wrong in the third and final lesson of this series.
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Hi Thomas,
Thank you for the feedback and for the question. As you probably know all else being equal the shorter the time frame that one borrows money for the lower the interest rate that is going to have to be paid by the borrower and therefore the lower the interest rate that is recieved by the lender. Similarly, all else being equal the more creditworthy the person or institution is that is borrowing the money the lower the interest rate they are going to have to pay.
So basically what was happening is that the banks that were investing (and making until recently) large amounts of money into the subprime market were borrowing money by issuing short term debt which they had to pay a low interest rate on because it was short term and because they had a high credit rating and investing the money they borrowed in the mortgage pools which paid a much higher interest rate because they are longer term debt that carried a lower credit rating for the most part than the banks. So for instance they would borrow money short term and pay a 3% interest rate, invest the money they borrowed in the long term mortgage pool debt and earn say 7%, pocketing the 4% difference.
Hope that helps. Let me know if there are any other questions.
Best Regards,David
David:
Why are the CDO's now being held by many financial institutions considered worthless and being written off? Isn't there some inherent value to these? For example, Merrill Lynch is planning to write down almost 15B in CDO's. Can you explain why these have no value?
Thanks,
Gene
Hi Gene,
Thanks for the comment and thats a good question.
It is not that the CDO's that they hold are now completely worthless, its that they hold a lot of CDO's which have now declined drastically in value.
As an example with easy numbers say a firm is holding 10 CDO's worth a billion a piece. Then each CDO declines in value 40% because of all the problems in the mortgage market, then the total writoff the firm is going to take is $4 Billion.
Hope that helps. Let me know if there are any other questions.
ThanksDave
Thanks for this great article, I understand it pretty well despite being a real novice in finance. Thing is I don't understand why financial institutions would need to borrow money from the bank or mostly why banks would buy or lend money from financial institutions? What for? I know this may seem like a stupid question but I get stuck on this. Thanks Jimmy
Hi Jimmy,
Thanks for the comment I am glad you liked the article. Your question is a good one that I am sure a lot of people don't understand so I will do my best to explain here.
One of the ways that banks make money is by whats called leveraging their balance sheet. What this means in simple terms is that in addition to the money a bank has on deposit a bank also has the ability to go out into the market and borrow money based on their credit worthiness just as any other company does. As most banks have a high credit rating which allows them to borrow a lot of money at a comparitively low interest rate one of the ways in which they make money is by borrowing money and then lending the money they borrow out at a higher rate than what they are paying to borrow it.
Hope that helps. Let me know if you have any other questions.
There are certain things that need explanation from your article
FIs can buy only highly rated debt (read CDO). So they could not have lost money buying the riskier tranches because they could not have bought them in the first place. Only the hedge funds could have bought them and what should have happened is that these hedge funds should have gone under which would have strained only the investors in these hedge funds.
Another possible reason I can think of (loud thinking) for why firms like Merrill lost money was because they underwrote these loan pools and with no buyers available for these, they were forced to buy these. Even then this should not be a problem as long as the default rate is low and interest rate is high. Default rate rising from 6 to 9 cannot explain this. You still have 91 out of 100 people paying back higher interest rate (sometimes as high as 22% and the cost of funds for Merill being much lower than that)
So why did Merrill lose money.
Hi Drake,
Thank you for the comment.
I agree that many institutions are prohibited from buying the riskier traunches but this does not mean that they do not have exposure to sub prime. What happened is that the originators of the CDO took a bunch of MBS that contained only subprime debt and then divided them up into traunches all of which contained subprime debt. They then made some of the traunches high grade paper by assigning the order of which truanches took looses first, with the junk truanches taking the first losses and the high grade paper being the last to take losses.
So the problems here are:
1. The default rates are a lot higher than were expected when these CDO's were originated. While this effects the junk tranches first there is a domino effect moving up the chain to the higher grades of paper.
2. Because the default rates are higher than expected people now think that the ratings agencies who rated all these CDO's did not rate them correctly either because they did not understand them well enough or because they were lenient with their ratings in order to get business.
3. When you combine the above two things what you have is a situation where no one wants to touch any of this debt, even the high grade debt which was orginated in this manner, with a 10 foot pole.
While in a rationale market a debt instrument is valued by taking the present value of future cash flows when there is doubt in those cash flows and confusion reigns markets become irrational, no one wants to buy this stuff, and therefore its worth a lot less than what the future cash flows most likely warrent because no one will buy it.
What you are saying about Merrill is exactly what happened. The fees for underwriting these CDO's were very large and a huge profit center for the bank so when the market became saturated with them and demand dropped Merrill held many of the CDO's they originated hoping to sell them at a later date so they could continue to earn those juicy fees. Unfortunately for them they got left holding the bag.
If there is another angle on this that I am not seeing or if there are other things that are not clear please feel free to comment.
Best Regards,Dave
Hi Dave,
Thanks for the reply.
Elaborating further from the point where Merrill was forced to buy these CDOs. Even though they could not sell them as the market dried up, they were still receiving money from the mortgage payments which 91% of the borrowers were paying. (default rate was 9%). If the average rate of interest on these 91% was even 10% higher (100=91*1.1, they say it was 200 basis points more) then Merrill could not have made a loss.
What is the flaw in the above reasoning
Best Regards
Drake
Ok I think I understand where the confusion lies better now. A lot of this you may already know but I am just going to lay it all out here just to make sure we are on the same page about how these things are valued.To get the value of a debt instrument which pays expected cashflows over a fixed timeframe into the future you take those cashflows (in this case expected mortgage payments) and you discount them back to the present time using a set interest rate. The components which make up the interest rate that you use to discount those cashflows back to the present time are 1. inflation expectations 2. the default risk and 3. the real interest rate (the rate of interest that the market would charge to lend money if there were no default or inflation risk) So if for instance I am Merril and I am expecting to recieve $500 Million this year in cashflows for a particular CDO which is holding a bunch of 30 year mortages and the default rate rises and I receive $450 million instead, the loss to my firm is not $50 Million. The reason why is because since the default rate has changed this has changed the default risk component of the CDO which changes the interest rate that will be used to discount ALL of the cashflows back to present for the Entire life of the CDO.As a simpler example lets say a company buys a 10 year treasury bond that pays $10,000 at maturity. As an example lets say the market interestr rate for this bond at the time is 6%. To get the value they would have to pay today they would take the future value $10K and discount it back to the present using the market rate of 6% which would give the cost to them of that bond today of $5,583.94.
So lets say they bought this bond and then tommorow something crazy happens and people's inflation expectations go through the roor and rates for that same type of treasury go to 8%. Now the cost or value in the market of that same bond that they bought yesterday is $4,631.93 or almost $1000 lower.Now, as far as the company is concerned they still get their 10K at the end of the bond's life just as before. As far as the market is concerned however the value of that same asset is now $1000 less than it was yesterday and, as the company must carry this asset on their books at market value, they have taken a $1000 loss.So in short although the increase in the default rate seems small it has a huge effect on the discount rate used to value the CDO's and as they are long term instruments this has a substantial affect on their present value. As in the example above with the bond, Merril and these other firms must carry the asset on their books at market value regardless of wether they plan to sell them or not, thus the huge write downs.For more on bond valuation see: http://en.wikipedia.org/wiki/Bond_valuationLet me know if that does not answer your question. Best Regards,Dave
Hi Dave,
Thanks for the exellent and detailed reply.
I understand what u r saying.
The value of the CDO held has now to be discounted by a higher rate as it has become riskier and hence the loss.
But was not another option for Merrill to just hold these CDOs like the buyers of CDO do and enjoy the above average interest. The loss is only notional and will arise only if they sell the CDO pool today.
Taking your example of bond, the loss arises only if you sell the bond, otherwise all that is happening is you are earning a lesser rate of return on your money. 6% rather than 8%.
I am still not convinced
Hi Dave,
Does the reasoning about notional loss make any sense
Best Regards
Drake
Hi Drake,
Sorry for the delay in reply I am in the process of moving so things a little hectic right now. The short answer is that yes they can hold those positions and don't have to sell them but they have to hold them on their books at some value. The issue here is these assets which were once worth say 100 Million are now worth 70 Million for example using the above methodology and from an accounting standpoint that is a loss.
Once I have gotten settled in I will post a more detailed response as to why this is so.
Best Regards,Dave
Hi Drake,
Sorry for the long delay in reply here.
The longer answer, which I actually found an articl on so I don't have to write it out ;-) to your question lies in the fact that these assets are accounted for using fair value accounting which stipulates that firms carry financial assets on their books at the value they could fetch in the market place currently. This is in contrast to historical cost accounting in which firms carry the asset on thier books at what they paid for it. So as these assets are now worth a lot less they have to write down the value of those assets which displays on the income statement as a loss. So you are correct that they can hold the asset and they may or may not earn a profit or smaller loss than they have taken on it (due to the fact that there is no way to know for sure how many will default) but accounting rules stipulate that they must take the loss now if it is worth less in the market than they paid. What is interesting here is that if liquidity returns to the market and things end up not being as bad as people are pricing them now then they could end up increasing earnings in another quarter as they account for that increase in value.
Here is the article that I refer to above: http://www.reuters.com/article/reutersEdge/idUSN15
I am not an accounting expert so if there are others who are reading this who can tie up any loose details here please do but I am pretty sure that this is correct from a broad standpoint.
Best Regards,Dave
Hi Dave,
Thank you so much. I understand it so much better now
Best Regards
Drake
my pleasure Drake thanks for commenting.
Best Regards,Dave
Hi Dave'
Great series of videos on this subject. Is there another party on the hook here in the form of insurance companies?? I read where some of the CDO's or SIV's had loss insurance. Is that true?? If so, are some of the insurance companies part of the financial institutions holding the instrument. Lloyds of London crashed some time ago when reinsurance contracts were spiraled within to generate a lot of commission dollars.
hi Dave
could u plz elaborate more on the traunches.......i mean what after those levels were made? were these pools on a whole sold to the purchasers or the different levels available in the pool were sold to the purchasers.....how is the procedure of selling the mortgage pools?
Thanks for the explaination. If the Fed had raised the interest rates slower than they had allowing those folks to try to find conventional mortgages, would we have averted the serious problems we are facing today?
Thank you! I bet that not one in a million people understand the current financial sitution. I certainly didn't until I read your 3 part series. I wish you would write another series of articles explaining what is happening in the stock market collapse. As an early boomer, I have 30% of my 401K (less of course on a daily basis!) tied up in equities. I see a much bleaker future, postponed retirement, etc. The equities were my "hedge" against inflation, but I doubt that the market can recover in my lifetime. Where is the money that is coming out of the market going? The US Treasury is presumably flush with cash. So why is it sitting on the sidelines instead of re-investing in the market or in someway reinvigorating the economy? If the stock market crash turns into a depression over the next 3-4 years, as it did in the 30s, many more mortgages will default, many credit card debtors will default, and it could take decades to restore trust in capitalism. I read that Roosevelt, far from being a socialist, actually saved capitalism. Now it seems that thanks to the greedy fools we elected to office since Ronald Reagan, we may again see capitalism destroyed, perhaps for good.
What was the size of the mortgage market in 2000 compared to 2006? What was the break down on market coverage by Fannie Mae, Freddie Mac, Conventional Banks, Wall Street and other. I Believe Wall Street was not a player until 2000+.
Very informative and easy to understand. Excellent
911loan 4 years ago
Great Artical, can you elaborate on these companies using issuing short term debt to buy this longer term debt essentially having to pay a lower interest rate on the short term debt that they issue to raise money than they earn on the mortgages that they are investing in. ?
Thanks
THomas
http://www.FHAmortgagePrograms.com