All Economis Global: Securitization and the subprime crisisThe subprim...

All Economis Global: Securitization and the subprime crisisThe subprim...: "Securitization and the subprime crisis The subprime crisis came about in large part because of financial instruments such as securitizatio..."

Securitization and the subprime crisis

The subprime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)
As BBC’s former economic editor and presenter, Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up.
Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example,

• Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities.
• Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on.
• Some banks loaned even more to have an excuse to securitize those loans.
• Running out of who to loan to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Subprime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US.
• Some banks evens started to buy securities from others.
• Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news. Side Note»

High street banks got into a form of investment banking, buying, selling and trading risk. Investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management.
Many banks were taking on huge risks increasing their exposure to problems. Perhaps it was ironic, as Evan Davies observed, that a financial instrument to reduce risk and help lend more—securities—would backfire so much.
When people did eventually start to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while and even now, there is a crisis of confidence. Some investment banks were sitting on the riskiest loans that other investors did not want. Assets were plummeting in value so lenders wanted to take their money back. But some investment banks had little in deposits; no secure retail funding, so some collapsed quickly and dramatically.
The problem was so large, banks even with large capital reserves ran out, so they had to turn to governments for bail out. New capital was injected into banks to, in effect, allow them to lose more money without going bust. That still wasn’t enough and confidence was not restored. (Some think it may take years for confidence to return.)
Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. Meanwhile businesses and individuals that rely on credit find it harder to get. A spiral of problems result.
As Evan Davies described it, banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves.