sub-prime crisis - a short overview
Well, this will not be my most analytical post, but let's see how all this got berserk:- A poor guy wants to buy a house and tells his mortgage broker that, well, he is not sure he can ever pay it back and is not even sure he will have a job in the future because his boss is not giving him good signs. The mortgage broker does not see the problem since the house value, in a bullish house market, is climbing so the collateral to the debt will always be worst something -> no risk. He even gives some fresh air to the poor guy by giving him a preferential rate for the next 2 years. The mortgage broker gets the money from a bank and pockets the corresponding commission.
- After some months the bank working with our mortgage broker above starts to have a lot of these uncertain mortgages and decides to go to a big investment bank to see if they can solve the problem. The investment bank takes the mortgages, issues new securities (CDOs for instance) with the logic that the mortgages are indeed smelling badly but there are so many of them that if we package them in a pool, cut it into tranches where the lower tranches protect the higher ones against bankruptcy and get higher interest for that, add a subtle touch of Credit Derivatives (instruments protecting against defaults) then we can issue very good papers that will be rated AAA by Moody's. Even the second tranch will be BBB because there are so many underlying mortgages that there is no chance all of them go bankrupt at the same time.
- Is this transparent? No! The guys who issue the accounting rules allow to have SPVs (Special Purpose Vehicles) somewhere in a non-transparent country that hold the underlying mortgages which disappear from the issuer's balance sheet. Wow. Cool.
- The CDOs are then sold to insurrance companies, banks and other insitutions looking for safe investments. There is no way to analyze the real underlying mortgage pool when buying a CDO. Moody's gave it a AAA so who care? Note: some CDOs are CDOs of CDOs up to 8 levels of CDOs. Pfff... transparency at it's best!
- Meantime the interest rates go up, the teaser rate period arrives at its end, the mortgage owner cannot pay back anymore, loses his house, more and more houses are for sales, the house prices go down, AAA tranches start defaulting, the embedded credit derivative protections cannot hold for so many defaults, the market loses confidence in CDOs and all CDO prices go down, banks who thought they had CDOs ready for selling when needing liquidity suddenly have a bunch of stuff worst less than before or nothing and start facing difficulties in liquidity management..... and here comes the global financial crisis.
Walter
Labels: CDOs and other SPVs, sub-prime
posted by Walti @ 9:23 AM
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