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Securitisation
Securitisation is at the heart of the sub-prime and Credit Crunch crisis. Securitisation is the process that made it possible for banks to increase the amount of money they lent thus fuelling house prices.
Traditionally a bank would lend money to a person to buy a house. The bank would then receive interest on the loan and after a fixed period the original capital would also be paid back. However, the bank cannot lend any more money until a sufficient amount of the capital has been repaid. However, with securitisation typically a mortgage broker would lend the borrower the money. The mortgage broker would then sell on the loan to another institution, such as a bank, thus enabling the mortgage broker to lend the money again to another borrower. The mortgage broker) makes their profit from the initial mortgage setup fees as opposed to the interest payments. The bank would then makes it's profit from the interest paid on the loan. The story gets more complicated as the bank may then decide to sell the loan's on to yet another institution such as a pension fund. The pension funds would buy these loans as they were supposed to be low risk as if the borrower went bankrupt then they could always repossess the house and thus recover their money.
There are three main problem's with securitisation and these are:-
- The mortgage broker is in effect lending the banks money and thus does not care who he lends it to (typically a high risk sub-prime borrower).
- House prices can go down as well as up! Thus increasing the risk that the money may be lost.
- Nobody knows who in the world holds the bad debt and thus all the banks are afraid to lend to each other in case they go bankrupt
Example
A U.S. cowboy lends $150,000, at 2% interest, to a sub-prime house owner (unemployed drug addict) and charges him $2,000 for setting up the loan. The cowboy then sell's on the loan to a U.S. bank, and thus gets his $150,000 back, and rides off in to the sunset with his $2,000 profit. The U.S bank then decides that this unemployed drug addict might not pay the money back, so they decide to pay a Credit rating agency to rank the risk associated with the loan (conclusion AAA!), and quickly sell the loan on to a U.K. bank (now advertised as a low risk AAA mortgage backed security). The unsuspecting U.K. bank manager (these nice American's) then either decides to hold the loan himself or sell it on to a U.K. pension fund (the pension fund likes the low risk AAA mortgage backed security). Either way, when U.S. interest rates go up to 5%, and the unemployed drug addicts benefits no longer cover the mortgage repayments, the borrower defaults and the U.K. bank or pension fund is left to repossess the house which by now has dropped significantly in value. This is a mild version of the truth as in reality the cowboy returns to do even more deals and the house was never worth $150,000 in the first place! But where was the Sheriff? Well now we know he has been on vacation for the past three years!
Still the U.K. bank manager will be smiling, as he will get his bonus! Which begs the question why do bank managers get paid millions for loosing billions?!!! No wonder U.K. interest rates are going up, banking charges also up and pensions down!
Okay before the American's complain I will admit that the same lax borrowing is happening here. However, as the American wide boys invented this securitisation thing then they ought to get at least some of the blame.