Analysis: Securitisation triggers time bombs
September 16, 2008
By Ethel Hazelhurst
Financial innovation set the scene for the recent bubble in the US housing market.
It paved the way for massive debt defaults and created a chain of financial time bombs that have been exploding around the globe since international banking group HSBC reported losses of $10.5 billion (R85 billion at yesterday’s exchange rate) on its US mortgage business in February last year.
Securitisation of mortgage debt was the innovation that started the chain reaction, allowing lenders to move credit risk off their balance sheets, freeing them to make further risky loans. Securitisation involves the packaging and sale of debt in the capital market.
Regulators tolerated the situation because it seemed that, by fragmenting the risk, securitisation prevented one institution from taking the full blast of defaulting debt, potentially triggering a domino effect in the banking system. Securitisation succeeded in spreading the risk, but it failed to protect institutions from collapse.
Central banks in the US, the UK and Europe are spending billions of dollars to stave off a powerful domino
effect raging through the banking system as the bombs go off.
To make matters worse, global banks are highly leveraged – in other words, they have high ratios of debt to equity. And relatively small losses represent a large percentage of their capital.
The problems started between 2002 and 2004, as US banks lent billions of dollars worth of mortgages to people with low incomes – the subprime market.
The US Federal funds target rate fell as low as 1 percent in June 2003, making the opportunities hard for home-hungry borrowers to refuse. In addition, borrowers were offered a low monthly repayment upfront, with higher repayments scheduled for later in the cycle. Rising house prices provided the illusion of security to both borrowers and lenders.
However, a year later, in mid-2004, the US interest rate cycle turned and the Fed funds rate rose to 5.25 percent by June 2006. Borrowers were forced to absorb the higher interest rates just as the higher payment schedule kicked in, plunging many people into bankruptcy.
As repossessed homes flooded the market, the housing bubble burst. Tumbling prices put more people at risk because their mortgage debt was worth more than the value of their homes – a situation described as negative equity. Other casualties were institutions that bought the debt.
Contagion spread from the US when three investment funds of French bank BNP Paribas were unable to trade on August 9 last year because the bank was unable to value their assets. As a result, the European interbank market went into limbo as banks refused to lend to each other. The situation was saved by huge cash injections from the European Central Bank and other central banks.
A long list of casualties followed in the UK, Europe, the US, Asia and Australia. They culminated at the weekend in the Lehman bankruptcy, which Bloomberg described as the biggest in history.
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