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Most people have by now read about the sub-prime mortgage crisis, but it's a fair bet than many of them were unable to understand what the fuss is about. Why should this problem pose a potential threat to the entire US or even global financial system?
The essentials of the "crisis" seem straightforward enough. For several years, mortgage banks and other lenders in America dished out lotsa money to people who couldn't afford to take on so much (or even any) debt, to buy houses they really couldn't afford. The whole business was driven by greed, of course, which explains why all normal banking rules and lending standards were trampled underfoot. The basic assumption was that the value of the property underlying the debt (the house or apartment being purchased) would keep rising, so that the buyer would be able to sell at a profit or, in the worst case, the bank would foreclose on the property, sell it and repay the mortgage and give the borrower/ex-owner the change, if any.
However, once the housing price boom turned sour, the rotten foundations of this scheme were exposed. As time goes on, prices keep falling, the number of foreclosures keeps rising and the number of mortgages that go sour has exploded. On top of this is the issue of the kind of mortgages that were offered, notably adjustable-rate mortgages on which interest rates are artificially low for the first year or two, but then jump up and sharply increase the repayment burden on the borrower.
This part is fairly straightforward, since most people have direct experience in mortgages, repayments and house prices. However, even if many borrowers now default and lenders suffer heavy losses, the worst-case scenario would "only" be a recession in the US and some fall-out in the rest of the world. There are no obvious grounds for the global financial system to collapse, or even be in danger.
Enter financial engineering. In today's super-sophisticated financial markets, mortgage loans are bundled up by the thousands and packaged into bonds, which are sold to investors. Since a large bundle of mortgages diffuses the risk of borrowers defaulting, the bonds built from these mortgage bundles are pretty safe. Normally, only a tiny fraction would go sour and even in today's climate, losses should be contained to relatively low levels. No one wants to lose 10 or 15 cents on the dollar, but as a worst-case scenario that is tolerable.
However, financial engineering doesn't stop at the bundling stage, it merely starts there. In each bundle, 90% of the total can be considered very safe, so this is hived off and given the best rating available. The next "tranche" is less safe, but if you take that bit from lots of bundles and repackage them all together, the risk is much more diluted, so these bits too end up with "AAA" ratings. And so on.
The last one or two percent is the really dangerous stuff - so much so that it is termed "toxic waste" in the industry. But with sufficient massaging and mixing, even this can be repackaged into a bond that gets an investment-grade rating, "A" or "BBB." That certification makes the investment kosher for pension funds and such in most countries.
In other words, this financial engineering-plus-repackaging succeeds in turning a) impure gold into gold b) silver and copper into gold; and eventually turns pure dross and total muck into solid steel. This "steel," in the form of investment-grade bonds, are then bought by pension funds and even central banks around the world - so that these worthy institutions are now the lenders to the bankrupt and defaulting borrowers of mortgages-they-couldn't-afford in houses-they-are-about-to-lose, back in the US of A.
The current estimates of losses from the accumulating piles of sub-prime mortgages that have gone or are going sour is $150- 250 billion - and keeps rising. But even these seemingly massive sums would not represent a big deal to the global economy if they were evenly spread around. Like manure, a little everywhere is good, but a large pile in one place is bad news. The big problem about securitization (the process of turning bundles of loans into bonds) is that nobody can keep track of where the risk is and who is holding how much of it.
That's a critical factor in the market response, which is characterized by fear - fuelled by ignorance. Everyone knows the toxic waste is out there somewhere and that a large dosage could be fatal, even for a major institution. The fact that most people are fine and will survive is no comfort, if the bank, pension fund or insurance company that you save with, or lend to or do other business with, is holding what Warren Buffet has rightly termed "financial weapons of mass destruction."