The liquidity crisis and the credit crunch

Ever wondereed how exactly the mortgage market got itself into the current situation? Robyn Hall provides a guide to residential backed securities and why the banks have stopped lending money.

What is securitisation?

Thirty years ago, if you were lucky enough to get a mortgage, it was very likely that the bank would keep the loan on its balance sheet until the loan was repaid. But getting a mortgage wasn’t easy. There was even the old joke that you would go to see the bank manager to ask how you stand for a mortgage and the answer was that you don’t – you kneel.

That is no longer true and mortgage lenders are more likely to sell the loan to a third party.

The third party often then packages your mortgage with others to investors – be they hedge funds or pension funds or the like.

It is a flexible, efficient and low-cost way of raising capital. It works by grouping together assets with predictable cash flows or rights to future income streams (such as mortgage or even music royalties – most famously David Bowie) and turning them into bond-style securities that are then sold to investors.

In the UK Halifax Bank of Scotland is the biggest securitiser of assets and that allows, or had allowed, it to fund relatively low cost mortgage deals without having to rely on savers deposits to hedge against.

Structure

What securitisation essentially does is create a subpart in what was initially a simple transaction.

Mortgage-backed securities are basically bonds secured by loans made against a property.

They comprise a collection of mortgages that lenders sell to the issuer of the securities who then uses the sums received from the borrowers in repaying their loans to fund dividends to investors.

So why do it?

Investors enjoy securities that are relatively stable – everyone should pay there mortgage as much as David Bowie will continue to sell CD’s long after he is dead.

Those income streams offer a good return on investment and are often guaranteed by a third party.

It also allows investment banks to obtain extra cash.

But the biggest benefits are that it allows the original owner of the assets, or mortgages, in the case of Northern Rock - or EMI in the case of David Bowie - are access low cost capital without bank loans, inexpensively and quickly

And it also allows them to diversify – finding new sources of both funding as well as investment, lowering the overall cost of capital. Basically, they don’t have to rely upon savers deposits to lend money.

And it carries little risk – as the majority of the risk is transferred to a third-party.

So securitisation DOES make sense. Whether a company has substantial capital needs, is seeking to improve its financial performance measures, or finds itself constrained by its credit rating.

Securitization provides a new way to unlock the income producing potential of the mortgage and to leverage the associated cash flow. This can result in greater returns to the owners of that financial institution or simply give the likes of Halifax or Northern Rock more funds so they can make more loans to other borrowers and make more money

So where did it go wrong?

The mortgage melt-down started in the US and it started in the so-called sub-prime mortgage market.

And this is where is gets complicated.

When it comes to securitising mortgages there are two main categories – prime loans which are made to people with good credit records or sub-prime loans which are made to people with not so good credit records – they might have missed a credit card payment or telephone bill or may even be in arrears.

When the pool of mortgages is sold they are given a rating – say AAA for a pool of prime residential mortgages or it could be BBB for sub-prime or indeed a mixture of both.

This rating is based upon the perceived likelihood of the mortgage being repaid.

They are then offered in the public market to investors, primarily sophisticated “institutional” investor. The better the “rating”, the more attractive the mortgage backed securities are to “institutional” investors, including those seeking a conservative investment such as state pension plans.

As a borrower repays his or her loan, the cash flow generated flows through to the investors who purchased the mortgage backed securities.

Sub-prime

Mortgage banks in America made a lot of loans on property to people who couldn’t afford the repayments after the initial discount period of the mortgage had worn off.

That meant that the loans they had sold to investors started to turn bad.

And because the loans had turned sour, that meant investors around the globe started to shy away from investing in mortgage backed securities.

And without that investment it meant the likes of Northern Rock didn’t have the ability to raise funds and ended up borrowing money off the Bank of England. Essentially the money markets shut up shop.

And so came the credit crunch

The phrase is used so often but it started off as a liquidity crisis before it turned into the "credit crunch", which is what happens when banks start hoarding cash like it is going out of fashion.

Banks are becoming very wary of whom they lend to and trying to attract fewer borrowers, not more.

And that has massive implications nationwide – both for businesses and the government.

So where do we go from here?

Repossessions will go up. Businesses will struggle to refinance. The market for first time buyers will grind to a standstill, which means the market for second time buyers and third and fourth will all dry up too. The housing market will effectively stop moving. There will even be less tax collected by the government.

Cutting interest rates will not solve the problem either – at the main issue is about access to funds.

Most agree the market hasn’t bottomed out yet. And it is still difficult to determine whether the Bank of England's decision to allow mortgage lenders to swap their residential backed securities for government bonds will help stimulate the market because the size and scale of the crisis is still difficult to determine. But it is clear that statements made by the mortgage market that things would begin to return to normal by the middle of this year are looking less and less likely.

http://www.myfinances.co.uk/news/mortgages/adverse-credit-mortgages/

Business Financial Services

The liquidity crisis and the credit crunch