The Sub prime mortgage crisis made easier

Unless you have been living in a remote cave for the past year or took a trip into space and have just touched down again, you will no doubt have heard of, and felt the effects of, the U.S subprime mortgage crisis. It has rippled through the global economy destroying the financial health of institutions, businesses and individuals that stand in its path. But what really happened? What really caused the sub-prime mortgage crisis?

Well I went on a mission to find out...

I spent time in numerous jargon laden trenches and only just managed to bend my head around a series of esoteric concepts.

• Firstly there was the U.S housing price conundrum - why were house prices so high?

• Then we needed to understand what Mortgage Backed Securities were and what they had to do with anything

• And finally what were Collateralized Debt Obligations

By understanding the facts, dismantling the jargon and simplifying the concepts I managed to piece together an explanation of what really happened and began to understand the subprime mortgage crisis a little better.

The U.S housing price conundrum

U.S house prices normally rise; at least according to the Case-Schiller Housing Index they have been doing so at a steady pace for most of the 20th century.

However around 2000 they started to rise rapidly. And from 2000 to 2006 they rose by a whopping 80%.

The conventional factors that economists would use to explain this phenomenon are an increase in the demand drivers, the two most obvious being an increase in the population and an increase in salaries.

However although the U.S population did increase in that period by approximately 1.5% salaries actually decreased by 3%. Therefore the net effect of the demand drivers went down by 1.5%.

So another conventional economic explanation is the supply drivers: housing must have dried up right. But is this true?

Well in 2000 there were around 115m housing units in the U.S with 1.8 million new units being built each year. So during the same period from 2000 to 2006 the number of housing units actually grew by about 6%.

What is going on? Demand was down, supply was up and yet prices did not drop, in fact they sky rocketed.

Something else must have been driving up the house prices, but what?

Well between 1980 and 2000, if you wanted to buy a house you would go to your bank manager and they would ask you to put 25% down (meaning if you wanted to buy a house worth £100,000 you gave the bank £25,000 and got a mortgage on the remaining £75,000), verify that you had a secure job and demonstrate a good credit score, say a 700 points.

In 2001 this changed to you needing to only put about 10% down, verify that you had a job and demonstrate an OK credit score, around 500 points.

By 2003 this had changed to you needing to put no money down, simply claim that you had a job and demonstrate no credit score what so ever. These people were known as NINAs : No Income, No Assets. It is the mortgages given to this class of borrowers that the real estate industry refers to as subprime mortgages.

So the bank’s lending criteria got more and more relaxed with time, which in turn meant that the number of people now able to bid on a home was significantly larger than before. And it is this that pushed up demand and caused the enormous rise in housing prices over the last few years.

But why did the banks relax their lending criteria to such an extent? To understand this we need to move into Mortgage Backed Securities.

So what are Mortgage Backed Securities?

Well, these sound rather obscure but in fact they are not so difficult to understand. Here we go.

We start with borrowers; people like you and me who need to buy a house with a mortgage. We go to the bank and we ask for say £1m to buy a house. The bank agrees and charges us 10% interest on the mortgage. Say they do this with 1000 customers; they would have £1bn in mortgage loans and receive £100m per year in interest.

Then comes along an investment bank who says to the bank, “hey we want to buy your mortgages from you and package them up so that we can sell them to investors”. Now this sounds rather strange but it’s very simple. Basically what happens is the investment bank buys the rights to the loans and the cashflows (basically the interest payments as well as any principle that is paid by the borrowers) and incorporates a new company (a Special Purpose Vehicle) and divides the share capital into say 1m shares, now each share is worth £1,100 (which is the £1bn in loans plus the £100m interest they expect to receive divided into 1m shares). The investment bank can now sell these shares to investors on the market and it is these shares that are known as Mortgage Backed securities.

So what does this have to do with the subprime mortgage crisis? Well it turns out that the investors and investment banks with their sophisticated computer models began to realise that the returns as they stood (the investment bank receiving its £100m per year in interest from all the mortgage loans) required for everyone to pay their mortgage and for no one to default or pre-pay.

“Hold on, they said, I don’t think it’s realistic to claim that everyone will pay their mortgage and if they default we won’t be able to sell the house at its market value necessarily and so we must account for this in our returns”. For example, say 20% of people default and the investment bank can only recover half the value of the house. That means that in effect 10% of all the loans are worthless, so instead of a 10% return, investors would get a 9% return.

So in response to this the investment banks began to sell different types of shares to investors. Some shares cost a bit more, and came with higher risk and higher returns. Some shares cost less, and came with lower risk and lower returns.

How did they do this?

This is where Collateralized Debt Obligations come in to play

Let’s go back to our investment bank’s special purpose vehicle. Instead of dividing up the share capital equally the investment bank separated its 1m shares into 3 classes called Equity, Mezzanine and Senior. These worked as follows. If you owned Senior shares you paid less but got less return on your investment but at significantly reduced risk, in fact you got paid first out of the money coming in from the mortgages. Then if you owned Mezzanine shares you paid a little more for your shares than Senior and got a little higher return but you were only paid from what remained from the pool of mortgage money after Senior shareholders were paid. And finally, if you owned Equity shares, the most expensive shares, you got much higher returns that the senior and Mezzanine shareholders but you were paid last from whatever was left in the pool of mortgage money after Senior and Mezzanine shareholders were paid.

These types of shares are collectively known as Collateralized Debt Obligations.

So how did all of the above contribute to the Sup-prime Mortgage Crisis?

Well it goes like this:

Because you have lots of people making money from the new types of shares (Collateralized Debt Obligations.) the investment community are hungry for more, so the banks need to sell more mortgages and they can do so now to more people than ever before because they have reduced their lending criteria in part because they are not responsible for collecting the mortgages, the investment bank is, and some investor somewhere is willing to buy from the investment bank a higher value of share for a higher return. This is perceived by the investment bank to offset the risk associated with the bank’s lending to higher risk individuals, the NINAs.

But they all got their numbers wrong and instead of something like 10% defaulting on their mortgages, which historically may have been true and was no doubt incorporated into their computer models, some 40% defaulted.

Why did so many people default?

When the housing market is booming and property prices are on the rise even those that default on paying their mortgages can sell up and even make a profit. This way the banks get their money back and no one is really hurt. But when the housing market slows down those that can’t pay their mortgage have no option to default and the bank has to foreclose on the property meaning they lose money and so do the investment banks and their investors.

And this is what happened, the housing market slowed down and house prices began to fall, due to demand tailing off, a surplus of housing stock and interest rate rises.

So lots of people, mostly the NINAs whose incomes were wholly insufficient to cover the mortgage payments they took on, could no longer afford to pay their mortgage and without any equity left in the home were forced by the banks to foreclose. This meant that the investors in the Mortgage Backed Securities and Collateralized Debt Obligations had a significantly reduced return due to the huge number of people no longer paying their mortgages. These investors included investment banks, hedge funds, private investors, institutions such as Insurance companies and pension funds and...You guessed it, banks!

A consequence of the creation of Collateralized Debt Obligations was that investors, not banks, would assume the risk for the relaxing of the bank’s lending criteria so as to be able to offer more mortgages to more people including high risk borrowers. But in the end the banks got greedy too and it’s these toxic assets that many banks are holding on their balance sheets that are expected to cost the U.S taxpayer about $8.5 trillion ($3,291 USD per person) via the U.S. government’s commitment to funding a host of economic stimulus programs.

I hope you have enjoyed this article and that I have helped make understanding the subprime mortgage crisis easier for you.