It is an innovative fund raising process which came into existence in the late 1970’s and has multiplied phenomenally over the years. The crux of the concept on which this process is based is the grouping or pooling of assets with predictable and pre-defined cash flows structure or rights on future expected cash streams and the re-engineering or re-packaging of such cash flows into financial instruments or securities that are then sold to investors. Such cash flows can accrue out of loans, trade receivables, mortgages, royalties etc.
The term “securitization”, itself is derived from the fact that securities are the final mode of financial instruments which are issued to investors to obtain funds.
As any asset with an associated stream of cash flows can be securitized the securities which result from a securitization transaction are termed as Asset Backed Securities and the transaction itself is termed an Asset Backed Securitization (ABS). With more such issuances being based on underlying mortgage based loans, Mortgage Based Securitization (MBS) became widely popular.
Once mortgage backed securities started flooding the markets, the banks and financial institutions also resorted to securitization of the pool of assets to shift the risk to investors in these securities as well as to obtain funds well ahead of the scheduled tenor of these assets. This implied that originators/issuers could repeatedly re-lend a given sum, greatly increasing their fee income and providing a multiplier effect of the underlying notional. Securitization resulted in a secondary market for mortgages, and the lenders were no longer required to hold them to maturity. With increasing securitization deals being struck, and the resultant transfer of default risk, the issuers lowered their underwriting practices to increase their loan disbursements.
The flair for securitization i.e. mortgage backed securities accelerated in the 1990s and total amount of mortgage-backed securities issued tripled between 1996 and 2007, to $7.3 trillion. Alan Greenspan has commented that credit crisis cannot be blamed on sub-prime mortgages alone, but rather on the securitization of such mortgages which created a notional far exceeding the actual value of the underlying assets actually available. The credit risk in sub-prime mortgages got passed on to other investors through the securitization mechanism and with a wide arena of investors globally, the impact of the credit crisis is felt on a global level.
During 2004 to 2007, further to the drop in interest rates, many investment banks opted to leverage on the situation as they found it beneficial to raise large amounts of debt at cheaper rates and invest in mortgage backed securities on the impression that housing boom will continue.
During the boom the traders in Wall Street were eying on the bonuses available end of year and not the long term impact on the firm or the market. According to the New York State Comptroller’s office, Wall Street executives have bagged in bonuses totaling @23.9 billion in 2006.
Though profitable during boom, it had adverse impact on such institutions during drop in housing rates and increase in mortgage delinquencies and foreclosures.
After an SEC ruling in 2004 which relaxed the amount that can be raised as debt by investment banks, debt issuances multiplied. Leveraging by top five US investment banks rose phenomenally to over $4.1 trillion for fiscal year 2007, which is about 30% of US nominal GDP of 2007. These were the 5 banks which crumble under the weight of the crisis. One of them viz. Lehman Brothers went bankrupt. Two of them viz., Bear Stearns and Merrill Lynch were sold of at dead low prices.
Two more viz. Morgan Stanley and Goldman Sachs converted themselves into Commercial Banks to avail financial support from the Federal Reserve succumbing to stringent regulation.
Lowering of interest rates in the early 2000s was taken up by the Federal Reserve to negate the effect of the Information Technology bubble earlier based on the premises that the rate could be lowered as long as the inflationary pressure was being kept low.
The low interest rates contributed to the housing bubble.
US government got more inclined towards the mortgage industry to make home purchases more favorable and ended up fanning the boom by relaxing lending standards of Fannie Mae and Freddie Mac.
This has increased the ownership in residential mortgages of the government sponsored enterprises viz. Fannie Mae and Freddie Mac to a staggering $5.1 trillion.
This assumes importance when looked at in relation to net-worth of GSE’s as of 30th June 2008 which was a mere $114 million which raises serious doubts on their ability to service their guarantees.
Starting from the late 90’s, American households have been spending more than their disposable personal income on consumption or interest payments on account of low interest rates, foreign investments in a booming market and rising housing prices (approx 124% between 1997 and 2006) which added to their confidence in the economic indicators.
The sub-prime lending added on to the increase in home ownership rates and demand for housing by giving easy access to low profile borrowers to invest in a booming real estate market and thereby resulting in home ownership rate increasing from 64% in 1994 (it has been at a similar rate since 1980) to 69.2% in 2004 as per the reports by US Census Bureau on residential vacancies and homeownership.
The spurt in housing resulted in homeowners resorting to refinancing of homes at lower interest rates, or taking second mortgages on homes to enhance their spending and other needs and ended up in household debt as a percentage of annual disposable personal income @ 134% by the end of 2008 against 77% in 1990 at a staggering $14.5 trillion.
Though these mortgages attracted borrowers with a sub-prime rate for some fixed period initially, when borrowers were unable make the higher payments once the initial grace period ended, they tried to refinance their mortgages. Once house prices started to crash (by over 20% from their peak in 2006), refinancing became more and more difficult and borrowers burdened by high monthly payments began to default. Borrowers can resort to just walk away from their mortgages and abandon their homes in-spite of the consequence of damaging credit rating. Moreover, US residential mortgages are non-recourse loans i.e. if creditor repossesses the property purchased with a mortgage in default he has no further claim against defaulting borrower’s income/assets. With more defaults and foreclosures, supply of homes for sale rises moving prices downward, and along with it the homeowners’ equity. This also reduces the value of mortgage-backed securities, which erodes the capital of banks dealing with such securities. This has formed a vicious cycle which is at the heart of the crisis.
Another contributing factor is speculation in residential real estates. During housing boom, homes were increasingly bought with an intention of investment instead of primary residences.
This resulted in homes being purchased while under construction, and then sold for a profit without the seller having resided in them. Many investors also assumed highly leveraged positions in multiple properties relying on a bullish real estate boom.
These are loans provided at sub-prime rates against mortgage of property. Apart from the availability of sub-prime rates in-spite of not having eligible credit ratings, another incentive that drove these mortgages was that the US Tax Code had provisions to allow 100% tax deductibility of all interest payments and part of principal payments on housing loans. This would result in a tax break of 30% to 50%, on both real interest and inflation part of nominal interest rates which induced people to go for second and third mortgages, and use the proceeds to enhance consumer spending and car purchases. Sub-prime mortgage loans come with a higher rate of default than prime mortgage loans and are priced adjusted for the risk carried by the lender.
Sub-prime mortgages saw huge attraction in the early part of 21st Century and comprised about 21 percent of overall mortgage originations during the period 2004 to 2006 as against only 9 percent of overall originations during the period 1996 to 2004. Sub-prime mortgages became almost 20% of overall US home loan market in 2006 and amounted to approx $600 billion.
These mortgages also carry the following special features:
- Option to pay only interest for an initial period of about 5 to 10 years.
- “Pay option” loans, usually with adjustable rates, where borrowers can choose their form of monthly payment being either full payment or only interest or a minimum payment which could be lower than payment required to reduce the balance of the loan;
- “Hybrid” mortgages starting with fixed rates later converted to adjustable rates.
Hybrid class of mortgages have become popular since 1990s and commonly called the “2-28 loan”, 2 representing initial two years when interest rate is fixed and 28 representing remaining life of loan i.e. 28 years when loan gets reset to a variable adjustable rate typically a spread over a benchmark index like LIBOR. Other variations of hybrid mortgages are “3-27” and the “5-25”.
In order to tap the increasing sub-prime market, lenders took on a lot of risk accompanied with poor credit ratings. To offset the risks, lenders demanded a higher interest rate or other credit enhancements to compensate the increased costs associated with collection from such borrowers, as well as the probable default rate.
Sub-prime loans can offer an opportunity for borrowers with a less-than-ideal credit record to become a home owner. Borrowers may use this credit to purchase homes, purchasing a car, meeting living expenses, or even closing overdue on a high interest credit card. But due to low profile credit of borrower, it is only available at higher interest rates. But there is an avenue provided by sub-prime lending which is a method of repairing credit; in case of good track record, the borrower would be able to refinance again onto normal rates after a certain period of time.
Normally, the kind of credit profile that disqualifies a borrower for a prime loan may be one or more of the following:
- Two or more loan payments paid after they were overdue for 30 days in last 1 year, or one or more loan payments paid after they were overdue for 90 days in the last 3 years;
- Foreclosure, repossession, or non-payment of a loan in the past;
- Bankruptcy within the previous 7 years;
- High default probability
FNMA prime loans go to borrowers with
- a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723),
- a debt-to-income ratio no greater than 45% (meaning that no more than 45% of gross income pays for housing and other debt), and
- a combined loan-to-value ratio of 90% (meaning that the borrower is paying a 10% down payment).
Sub-prime lending was a result of the increasing demand in the marketplace for loans to less-than-ideal customers, meaning, those with imperfect credit and who are therefore unable to avail funding through normal sources. This induced many companies to enter the market taking advantage of low prime interest rates and the resultant negative real interest rates thereby resulting in the sub-prime markets to flourish. With such modest rates, the leverage arising out of borrowing in sub-prime enhanced their returns on investments.
Further, in 1999, Fannie Mae, largest home mortgage underwriter in US, because of pressure from the Clinton administration, relaxed credit requirements on loans it buys from other lenders, hoping it would result in more loans to minority and low-income buyers and also targeted maintaining 50% portion of their portfolios in loans to minority and low -income borrowers.
These loans intended to serve the purpose of those who would otherwise find it difficult to raise funding and for those who avail such loans understanding that they are higher risk, and that they must take all diligent efforts to service the loan payments, interest and principal.