A Layman's Guide To The Credit Crunch, Part 4: Mortgage-Backed Securities

February 6, 2009
Estimated reading time:
2 minutes

In my last post I talked about securitization -- where a bank will effectively package loans together and sell them on to investors. These investors buy securities to try and make a return, and the bank sell them to get the loans off their books and continue making loans to people.

This is basically what happened with hundreds and thousands of subprime mortgages in the US. In the 1990s there was a housing boom in the US (and the UK), and more and more houses were built, more people were lent money than previously, and there was a growing assumption that house prices would continue to rise.

That assumption was wrong.

So now we're left with lots and lots of mortgages lent to people who couldn't afford to pay them on houses that are going down in value. Now there's a good investment.

Essentially, the foreclosure rate (the number of people who defaulted on their mortgages due to being unable to meet the repayments) increased rather dramatically, meaning that the MBSs weren't worth all that much, especially as the houses that were repossessed couldn't be sold for the value of the mortgage that was originally lent out.

This meant that mortgage-backed securities lost a huge amount of their value very quickly, and banks and investment funds that were holding them at the time had to write down the value of them (Writing down value means that, on one day a bank might have had an asset on its books called "MBS 1" that was valued at £100m, but then a week later the bank found out it wasn't worth anywhere near that, so they might have to revalue it at, say, £25m, which is an instant £75m loss for the bank).

This led to the huge losses that some banks had suffered, and this is the reason Northern Rock went under, as far as I am aware. They had a lot of these assets on their books at one point, and suddenly the music stopped, and Northern Rock were in the shit.

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