PART II: Securitization, CDOs and Sub-Prime Mortgages

The Global Financial Crisis: How Did We Get Into This Mess?

PART I: The Back Story
PART II: Securitization, CDOs and Sub-Prime Mortgages
PART III: Money Market Actions Fail to Stem the Tide
PART IV: Corporate Casualties Pile Up

PART II: Securitization, CDOs and Sub-Prime Mortgages

Between 2004 and 2006, the Fed hiked interest rates from 1% to 5.35%, but people kept buying property unabated as prices continued to increase. The first wave of loan defaults and delinquencies was seen in 2006, but mortgage lending just kept on growing. As default rates, particularly among sub-prime borrowers, started to balloon, the whole finance industry came to feel the pain. When mortgages that had been repackaged and sold off in bulk to investment banks, insurance companies and other financial heavyweights – in an attempt to minimize risks – were no longer being serviced by homeowners, the shock waves spread across the entire financial system.

The practice of bundling up various loans (including mortgages) into portfolios for sale to a third party is known as securitization, and has been common among banks for a long time. The party buying the so-called asset-backed securities (ABS) receives regular interest income from all the debtors paying off their loans, and the issuing bank gets a lump-sum payment and passes on its risk to the purchaser.

A new and rather complex type of ABS, Collateralized Debt Obligations (CDOs), consists of mortgages, other loans such as credit card debt, bonds, real estate and other asset types. A CDO can be split into securities with different risk profiles – and different prices and returns – from the same asset pool. That means that if a number of debtors stop making their monthly repayments, the risk is not shared equally among CDO buyers; rather, holders of lower interest-bearing, lower-risk senior tranches get paid before those who bought high-interest junior CDOs.

In 2006, house prices started to come down and sub-prime defaults to mount up. Banks and other financial institutions with exposure to CDOs – many of them not mortgage lenders at all – mostly didn’t start reporting losses on their holdings until the following year, when the situation was becoming too plain to ignore. Investors stopped purchasing CDOs and the credit market seized up as intra-bank lending ground to a virtual halt amid growing worries that we were seeing only the tip of the bad loans iceberg.

The credit crunch affected practically the entire financial industry since so many financial institutions had bought CDOs on the back of recommendations from the ratings agencies (Standard & Poor’s, Moody’s and Fitch). These agencies have since been slammed for their lack of critical judgment. The sudden shortage of buyers also forced many corporations to cancel bond sales, which had financial consequences for investors, employees and the wider economy. In other words, the CDOs and other complex financial instruments (derivatives) that had been designed to reduce risks ended up creating more risks that caused serious damage to the economy.

And it’s not just the U.S. that has been hit by the sub-prime mortgage crisis. From the UK and the Eurozone to Australia and China, sub-prime home loans have gone bad all over the world, and have come to be termed “toxic assets”. The malaise in the mortgage market has now also spread globally to “safe” mortgages held by borrowers with good credit histories. These mortgage-holders have been hit by rising unemployment, higher fuel and food prices, and falling house prices as the credit crisis has turned into a full-blown recession in many countries. 

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