Recently read an article by Prof Arvind Panagariya titled " Anatomy of the Financial crisis"
There have been many articles and books written about it. I think , this piece in Economic Times provides a brief and comprehensive peek in to the whole process .
I have copied the full version and pasted down below, that is after the synopsis I have captured here.
Exttracted from the article and with some comments thrown in form my side is as follows
Borrowers are prime and sub prime, the latter being high risk due to past defaults, low income and or unsteady Income.
While bankers were forbidden from lending to such borrowers, brokers and mortgage companies affiliated to such banks lent money at 2-3% higher rates to such borrowers.
Early 2000, ARM (Adjustable rate mortgage)which are loans with a low interest to start with and jump to higher rate in the later years ,proliferated. Borrowers went for these under the assumption that they would be able to build equity ( capital appreciation of the asset) in the initial years and later would be in a position to replace the loans with low fixed rate loans .
The calculation went awry since the house prices tumbled and building of equity was not quite achieved.
ARM loans grew with the growth in housing loans. A key factor driving the expansion was the ability of the lenders to sell the mortgages to other Financial instituitions such as Goldman , Lehman etc.
Instituition buying such loans , packaged mortgages of varying risks and returns in to a mortgaged backed security ( MBS) and parcelled in to smaller denomination bonds of different seniority and returns.
Bonds were classified in to five levels of seniority with associated risk and return and bonds of smaller denominations issued. Bond with the higest seniority would attract the lowest retrun and and would also bear the lowest default risk.
There have been many articles and books written about it. I think , this piece in Economic Times provides a brief and comprehensive peek in to the whole process .
I have copied the full version and pasted down below, that is after the synopsis I have captured here.
Exttracted from the article and with some comments thrown in form my side is as follows
Borrowers are prime and sub prime, the latter being high risk due to past defaults, low income and or unsteady Income.
While bankers were forbidden from lending to such borrowers, brokers and mortgage companies affiliated to such banks lent money at 2-3% higher rates to such borrowers.
Early 2000, ARM (Adjustable rate mortgage)which are loans with a low interest to start with and jump to higher rate in the later years ,proliferated. Borrowers went for these under the assumption that they would be able to build equity ( capital appreciation of the asset) in the initial years and later would be in a position to replace the loans with low fixed rate loans .
The calculation went awry since the house prices tumbled and building of equity was not quite achieved.
ARM loans grew with the growth in housing loans. A key factor driving the expansion was the ability of the lenders to sell the mortgages to other Financial instituitions such as Goldman , Lehman etc.
Instituition buying such loans , packaged mortgages of varying risks and returns in to a mortgaged backed security ( MBS) and parcelled in to smaller denomination bonds of different seniority and returns.
Bonds were classified in to five levels of seniority with associated risk and return and bonds of smaller denominations issued. Bond with the higest seniority would attract the lowest retrun and and would also bear the lowest default risk.
Rating agencies typically rated the bonds with the highest seniority under AAA and securitisation proceeds thus produced some AAA rated assets in which even Commercial banks -otherwise forbidden from lending to sub prime borrowers -could invest.
Market took this further . Market took bonds of middle level security rated BBB belonging to different MBS and packaged them in to what is called a Collaterillised debt obligation(CDO). This was further tradable. CDO s again were rated by rating agencies.( My comment-This is nothing but trying out various permitations and combinations from the underlying asstes and creation of an illusion of better security than the individual assets suggested )
On these assets( MBS and CDO ), Investment banks like Lehman bros etc , for every USD invested , borrowed say $ 30 from the market by selling short term commercial paper.Short term interest rates being lower than long term, they all stood to make substantial money on the leveraging.Once the housing market softened, returns,on the derivatives dried up , undermining Lehman's ability to service and refinance the short term debt.
Diminution in value of the underlying assets, completely upset the apple cart.
An additional dimension was the fact that insurance was provided to gurantee safety of the underlying commercial paper of say Lehman by AIG in the form of CDS ( Credit default swaps).These rae insurance instruments against a possible premia. Once the market defaulted , the issuer of CDS ( AIG - Americal Insurance Group) had to make good on CDS worth Billions . Thsi sealed the fate of AIG.
( My comment/addition-With defaults and possible margin calls with reduced value of assets, there was need for greater cash. Investments bankets pulled out cash from various markets. Underlying assets ( houses etc ) were also possibly put up for sale at the same time , accelerating the slide in prices.
Article by Prof Arvind Panagariya "Anatomy of the Financial crisis" reproduced down below
In the 1980s and early 1990, the United States had witnessed another crisis that saw 750 savings and loan associations (S&Ls) fail. S&Ls
had specialised in accepting savings deposits and making residential mortgage loans. Deregulation in the 1980s allowed them to lend to increasingly risky borrowers who defaulted once the housing boom ended. The crisis remained confined to the S&Ls, however, with government successfully rescuing the depositors for just $125 billion in public money. In contrast, the current crisis engulfed the entire globe largely because the proliferation of financial derivatives comprising the so-called “shadow financial economy” indirectly placed the risky mortgages on the balance sheets of financial institutions around the world. Defaults in the housing market impacted all holding these derivatives. Borrowers in the US are divided into prime and subprime with the former exhibiting low risk of default due to good credit history and the latter high risk due to past defaults or low and unsteady income. Regulations forbid commercial banks from lending to subprime borrowers. Instead, brokers and mortgage companies, often affiliated to banks and other prime lenders, lend them at rates 2 to 3 percentage points higher than in the prime market. In the 2000s, the adjustable rate mortgage (ARM) loans, which carried a lower teaser rate in the first two or three years that jumped to a much higher level subsequently proliferated. Borrowers counted on building equity and credit during the low-rate period and then replacing the ARM by a low fixed rate in the prime market. But this only worked during a boom. If house prices tumbled, no equity accumulated and the jump in the interest rate threw the borrowers into default. With the boom in the housing market, residential subprime mortgages grew from less than $100 billion in 1995 to $1.5 trillion by 2006 and came to account for 15% of all mortgages. ARM loans rose from 28% of total subprime mortgages in 1998 to 50% in 2006. A key factor driving the expansion was the ability of lenders to sell their mortgages to other financial institutions such as Goldman Sachs or Lehman Brothers. This freed them of any default risk and emboldened them to court ever riskier borrowers, often without checking their sources of income. A financial institution buying mortgages did not just hold them. Instead, it packaged mortgages of varying risks and returns into a mortgage-backed security (MBS) and parcelled it into smaller-denomination bonds of different seniority and returns. For example, think of an MBS backed by $10 million worth of mortgages. The institution would identify five levels of seniority with associated risk and return and issue 2,000 bonds of each type with face value of $1,000 each. The bonds with the highest seniority would receive the lowest return and also bear the lowest risk of default; those with next level of seniority would have the next lowest risk and return; and so on. If there were a default on some of the mortgages underlying the MBS, the lowest-seniority bonds would be the first to stop receiving returns.
Ratings agencies typically rated the bonds with the highest seniority AAA and those with the lower seniority lower. Bonds near the bottom got junk rating. The securitisation process thus produced some AAA rated assets in which even commercial banks — otherwise forbidden from lending to subprime borrowers — could invest.
The market took this process a step further. A financial institution would take bonds of middle level seniority (rated BBB) belonging to different MBSs and package them into what is called a collateralised debt obligation (CDO). It would then issue and sell secondary CDOs of varying seniority and returns along the lines of MBS-based bonds. Ratings agencies once again would give the secondary CDOs of highest seniority AAA rating! Next came the leveraging of investments. For each dollar Lehman Brothers invested in MBSs, CDOs or other derivatives, it borrowed $30 from the market principally by selling short-term commercial paper. Short-run interest rates being significantly lower than the return on mortgage-backed derivatives, it could service the debt on the commercial paper and still make a handsome profit. But as the housing market softened, returns on the derivatives began to dry up undermining Lehman’s ability to service and re-finance the short-term debt. That contributed to its eventual default. In turn, the default adversely impacted the balance sheets of Lehman’s lenders (for example, institutions holding its commercial paper) and made them vulnerable to default. An additional important dimension to the crisis was added by the so-called credit default swaps (CDS) that provide insurance against the risk of default in return for a premium. For example, holders of Lehman’s commercial paper could go to the American Insurance Group (AIG) and buy CDSs from it in case Lehman defaulted. Indeed, even those not holding the commercial paper but wishing to bet against Lehman could buy such CDSs. As uncertainty grew, the market in CDSs exploded, growing to more than $50 trillion! And with Lehman default and defaults on other derivatives, AIG had to make good on CDSs worth multi-billion dollars. A downward adjustment in its credit rating by Moody, which necessitated shoring up additional $14.5 billion in collateral, sealed the AIG’s fate. These events left all financial institutions unwilling to part with their liquid assets lest they need them to cover cash shortage caused by defaults on their assets. They also began pulling out investments elsewhere including in the emerging market economies to shore up cash. The financial markets froze entirely and even firms selling cars, furniture and other durables found themselves out of lenders. The Wall Street hurricane thus reached the Main Street. With the derivatives traded globally, financial institutions in countries with weak regulation (not Dr Reddy’s India) also became invested in them making the problem global. As governor Subbarao opens up India’s financial sector, he will have to guard against the growth of a shadow financial economy in the country! (The author is a professor at Columbia and Non-resident Senior Fellow at the Brookings Institution.)
In the 1980s and early 1990, the United States had witnessed another crisis that saw 750 savings and loan associations (S&Ls) fail. S&Ls
had specialised in accepting savings deposits and making residential mortgage loans. Deregulation in the 1980s allowed them to lend to increasingly risky borrowers who defaulted once the housing boom ended. The crisis remained confined to the S&Ls, however, with government successfully rescuing the depositors for just $125 billion in public money. In contrast, the current crisis engulfed the entire globe largely because the proliferation of financial derivatives comprising the so-called “shadow financial economy” indirectly placed the risky mortgages on the balance sheets of financial institutions around the world. Defaults in the housing market impacted all holding these derivatives. Borrowers in the US are divided into prime and subprime with the former exhibiting low risk of default due to good credit history and the latter high risk due to past defaults or low and unsteady income. Regulations forbid commercial banks from lending to subprime borrowers. Instead, brokers and mortgage companies, often affiliated to banks and other prime lenders, lend them at rates 2 to 3 percentage points higher than in the prime market. In the 2000s, the adjustable rate mortgage (ARM) loans, which carried a lower teaser rate in the first two or three years that jumped to a much higher level subsequently proliferated. Borrowers counted on building equity and credit during the low-rate period and then replacing the ARM by a low fixed rate in the prime market. But this only worked during a boom. If house prices tumbled, no equity accumulated and the jump in the interest rate threw the borrowers into default. With the boom in the housing market, residential subprime mortgages grew from less than $100 billion in 1995 to $1.5 trillion by 2006 and came to account for 15% of all mortgages. ARM loans rose from 28% of total subprime mortgages in 1998 to 50% in 2006. A key factor driving the expansion was the ability of lenders to sell their mortgages to other financial institutions such as Goldman Sachs or Lehman Brothers. This freed them of any default risk and emboldened them to court ever riskier borrowers, often without checking their sources of income. A financial institution buying mortgages did not just hold them. Instead, it packaged mortgages of varying risks and returns into a mortgage-backed security (MBS) and parcelled it into smaller-denomination bonds of different seniority and returns. For example, think of an MBS backed by $10 million worth of mortgages. The institution would identify five levels of seniority with associated risk and return and issue 2,000 bonds of each type with face value of $1,000 each. The bonds with the highest seniority would receive the lowest return and also bear the lowest risk of default; those with next level of seniority would have the next lowest risk and return; and so on. If there were a default on some of the mortgages underlying the MBS, the lowest-seniority bonds would be the first to stop receiving returns.
Ratings agencies typically rated the bonds with the highest seniority AAA and those with the lower seniority lower. Bonds near the bottom got junk rating. The securitisation process thus produced some AAA rated assets in which even commercial banks — otherwise forbidden from lending to subprime borrowers — could invest.
The market took this process a step further. A financial institution would take bonds of middle level seniority (rated BBB) belonging to different MBSs and package them into what is called a collateralised debt obligation (CDO). It would then issue and sell secondary CDOs of varying seniority and returns along the lines of MBS-based bonds. Ratings agencies once again would give the secondary CDOs of highest seniority AAA rating! Next came the leveraging of investments. For each dollar Lehman Brothers invested in MBSs, CDOs or other derivatives, it borrowed $30 from the market principally by selling short-term commercial paper. Short-run interest rates being significantly lower than the return on mortgage-backed derivatives, it could service the debt on the commercial paper and still make a handsome profit. But as the housing market softened, returns on the derivatives began to dry up undermining Lehman’s ability to service and re-finance the short-term debt. That contributed to its eventual default. In turn, the default adversely impacted the balance sheets of Lehman’s lenders (for example, institutions holding its commercial paper) and made them vulnerable to default. An additional important dimension to the crisis was added by the so-called credit default swaps (CDS) that provide insurance against the risk of default in return for a premium. For example, holders of Lehman’s commercial paper could go to the American Insurance Group (AIG) and buy CDSs from it in case Lehman defaulted. Indeed, even those not holding the commercial paper but wishing to bet against Lehman could buy such CDSs. As uncertainty grew, the market in CDSs exploded, growing to more than $50 trillion! And with Lehman default and defaults on other derivatives, AIG had to make good on CDSs worth multi-billion dollars. A downward adjustment in its credit rating by Moody, which necessitated shoring up additional $14.5 billion in collateral, sealed the AIG’s fate. These events left all financial institutions unwilling to part with their liquid assets lest they need them to cover cash shortage caused by defaults on their assets. They also began pulling out investments elsewhere including in the emerging market economies to shore up cash. The financial markets froze entirely and even firms selling cars, furniture and other durables found themselves out of lenders. The Wall Street hurricane thus reached the Main Street. With the derivatives traded globally, financial institutions in countries with weak regulation (not Dr Reddy’s India) also became invested in them making the problem global. As governor Subbarao opens up India’s financial sector, he will have to guard against the growth of a shadow financial economy in the country! (The author is a professor at Columbia and Non-resident Senior Fellow at the Brookings Institution.)
