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no correlation between loan performance and compensation

Mortgage brokers did not lend their own money. There was no correlation between loan performance and compensation. Hence there were big financial incentives for selling complex, adjustable rate mortgages for such companies since this would earn higher commissions. In 2004 Mortgage brokers originated 68% of all residential loans, with sub‐ prime loans accounting for 43% of brokerages' total loans. Securitisation Most sub‐prime lenders then invented another way of making money in a sector which was already highly risky. Many lenders wanted to ensure they didn’t lose out at possible money making opportunities in the sub‐prime market and developed a number of complex products; this was achieved by breaking down the value of the sub‐prime mortgage market and various home loans into financial sausage meat ‐ just as wholesome as the real world equivalent ‐ and selling them on to other institutions.

Debt was sold to a third party, who would then receive the loan repayments and pay a fee for this privilege. Thus debt becomes tradable just like a car. Hence the ability to securitize debt provided a way for risk to be sliced and diced and spread, thereby allowing more mortgages to be sold. Since 1994, the securitisation rate of sub‐prime loans increased from 32% to over 77% of total sub‐prime loans. This process effectively increased the number of financial institutions with a stake in the sub‐prime mortgage market. This was allowed to happen due to the manner in which the original sub‐ prime loans were securitised. Many institutions including mainstream Wall Street investment banks became owners of collateralised debt obligations (CDO’s). These are bonds created by a process of deconstructing and re‐engineering asset‐backed securities.

This essentially works by providing investors with access to the regular payments received from debt payers in return for paying to have access to the CDO as well as managements fees. Thus Wall Street investment banks made investments in the cash flows of the assets, rather than a direct investment in the underlying asset. Many institutions also became owners of mortgage‐backed securities (MBS) which were created out of the repackaging of sub‐prime loans. In simple terms this is where a bank sells a set of debts as one product. In return for a fee the new holder of this debt obligation receives the regular loan repayments. In most cases such a debt forms part of a pool of mortgage based debts lumped together into a form of asset or bond, each with different degrees of risk attached to them. Thus owners of MBS’s actually do not know the source of where the payments are coming from or even which sectors they’re being exposed to. The MBS market is worth of $6 trillion currently, even more then US treasury Bonds. The difference between CDO’s and MBS’s is in the latter the property is placed as collateral.

In any event of a downturn in the housing market it would not only be the sub‐prime providers who would lose out, but now all those who purchased collateral products would also be exposed. Credit Ratings Most debt carry ratings which indicate the amount of risk they entail, such a task is undertaken by credit rating agencies as an independent verification of credit‐worthiness. The spotlight was originally thrown on the industry after the 2001 collapse of Enron ‐ a firm built on securitisation as well as the role of credit rating agencies in the financial crash in the Asian financial crisis in 1997. Charlie McCreevy, EU internal market commissioner commented: "What's the common denominator between Enron, Parmalat, special purpose vehicles, conduits and the like? They are off­balance sheet vehicles where the risk has theoretically gone with them: tooraloo, adiĆ³s." US home loans had been pooled and packaged into tradable securities by Wall Street banks, before being sold on to financial institutions around the world. As they were bought and sold, these mortgage‐backed securities were valued according to the ratings given to them by the credit rating agencies. Credit agencies (dominated by the big three; Moody's, Standard & Poor's and Fitch) classify the risk of these repackaged securities according to their exposure to risky markets. CDO’s were classified into tranches, the highest tranche was perceived to be very low risk and was often given an AAA rating – the same rating as high grade US Treasury Bonds. This is because in the event of default the first to incur the loss would be the lower tranches and not the top tier.
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