Tuesday, March 18, 2008

Credit Crunch Characters (3) - Securitisation

In the good old days, you got your mortgage with a bank. They paid their depositors about 3% interest and charged about 5% interest on house mortgages. The margin between 3% and 5% covered the risk and provided the traditional bankers with a reasonable income. However, this margin is not sufficient to sustain the lifestyles of the whiskey-drinking graduates of Harvard and Princeton who moved into investment banking in recent years. They had to find a way to squeeze more out of the margin between lending and borrowing. Competition prevented them from pushing up the interest rate paid on mortgages, as home buyers were shopping around for the best deal. The only way to increase the bankers margin was to reduce the cost of the money they were lending.

Securitisation was the answer. The bank take all the mortgages on a their loan book and wraps them up in one security, commonly called a Mortgage Backed Security (MBS). An MBS uses hundreds of mortgages as collateral and the interest payments from the mortgagors provide a steady stream of income. Securitisation has two benefits for the bank. Risk is reduced, because even if one mortgage turns sour, the others will cover it. Managing one security is cheaper than managing thousands of small depositors, so the cost of funding is reduced. This allowed the bank to squeeze a bit more out of the 3% to 5% margin. The other benefit was that these securities could be sold to a Pension Fund or Hedge Fund and moved off the banks balance sheet (more on that in a couple of days).

The problem with securitisation is that the owner of the MBS bears the risk of defaulting mortgages, but is too far removed from the process to understand the risk they carry. By separating those who scrutinise borrowers from those who carry the risk of default, securitisation reduced accountability.

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