Last week, I wrote about how the excessiveness of the subprime lending market became a self-fulfilling prophecy that is now taking its toll on the lending industry, investors, and homeowners. In this follow-up, I will discuss why a process known as securitization was the spark that caused the explosion. While a detailed explanation of the securitization process would put most people to sleep, the following simplified discourse should cover the basics.
What is it?
Securitization is simply the structured pooling of financial assets with similar characteristics that are then repackaged, underwritten, and sold as securities, typically to large, sophisticated investors. These securities are usually backed by the cash flows of the underlying financial instruments.
The Government National Mortgage Association, or Ginnie Mae, rolled out one of the first securitizations back in 1970. Mortgages have been a very popular asset to securitize because of their long, stable cash flows. Or so we thought.
Where there's a will, there's a way
In the early days, lenders simply kept loans on their balance sheets until maturity or prepayment. Most loans were funded through deposits or bank debt, which was a direct obligation of the bank. However, as demand for loans grew, banks needed a way to unload their loans to make new ones, and securitizing them was an efficient way of growing the banks' business. It allowed them to expand without putting their business at risk in times of market decline, because prime borrowers are reliable sources of cash flow.
Unfortunately, subprime lenders apparently never got this memo. And even if they did, lenders had no reason to worry, because once loans were securitized, the transfer of risk got shifted from them to the financial organizations that bought the asset-backed securities. As long as the housing market was sizzling hot, default rates for subprime borrowers were artificially low. If a subprime borrower was facing default on a mortgage payment, he or she could sell the property at a profit very quickly, thereby paying off the mortgage and eliminating the risk. This pent-up demand for housing, coupled with greed, resulted in just about any mortgage pool being securitized, regardless of the credit quality.
How was it so easy for subprime lenders -- which, by definition, originate riskier loans -- to securitize billions of dollars' worth of loans? That's when it pays to get a few smart investment bankers involved. They'll come together, take the mortgage-backed securities, and essentially chop them up into slices, called "tranches." Each tranche is categorized according to the risk of default, with the safest tranche yielding the lowest rate and the riskier, or equity, portion of the tranche yielding the highest. These new products are given glamorous names like "collateralized debt obligations" or "collateralized mortgage obligations." And just like that, bankers have created seemingly safe securities backed by higher-risk subprime mortgages.
We're all in this together
Lenders, of course, are eager to securitize their loans. Doing so lets them clear their balance sheets of the loans, but more importantly, it gives them a new pool of cash from which to make more loans. Bankers are eager to securitize and apply their wizardry because selling investment products is what they do best. Everyone is seemingly happy and getting rich. As long the main underlying asset -- the property -- is appreciating in value and easily sold, all is good in the neighborhood.
Unfortunately, someone forgot to tell the powers that be that the clock would eventually strike midnight and the ball would come to an end. And it ended with a loud, painful bang, whose echoes can still be heard and probably will be for some time.
Indeed, the effect of the subprime mess is being felt all over. Shareholders in companies such as Accredited Home Lenders (Nasdaq: LEND), Fremont General (NYSE: FMT), and the now-bankrupt New Century Financial are hurting. Investors in the Bear Stearns (NYSE: BSC) hedge funds may also be in for a rude awakening. And that's not to mention the thousands of homeowners who are facing foreclosure or eviction.
Buffett had it right all along
Several years back, Warren Buffett remarked that financial derivatives are "financial weapons of mass destruction." A close look at what's happening in the subprime-mortgage market reveals what he meant. Some really smart people have taken one asset -- the plain old mortgage -- and singlehandedly created layers and layers of financial instruments that are predicated on it. Like dominoes, one by one, these securities are now tumbling and leaving investors and homeowners to clean up the mess.
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Fool contributor Sham Gad is running the newly launched Gad Partners Fund, a value-centric investment partnership. He owns no shares of the companies mentioned. Reach him at shammf@gmail.com. The Fool has a default-free disclosure policy.
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