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, adiós." 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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