Just needed to put down my understanding of key terms that have been discussed in the current financial downturn thus far..
Securitisation : Process whereby banks issue loans(housing, car, credit card loans) that are backed up by collaterals such as the house, car, etc). Now, these banks have "securitized" this assets and issued bonds which are backed by this securities. Cash inflows from this bonds will make up for the cash outflows for the loans to ensure there is sufficient capital in the bank to provide for the depositors.
Now, the problem starts when the customers start to default on their loans. Why? First of all, they could not afford the loan based on their income but yet these homeowners applications were approved. Secondly, and this was a key reason, they could not get their loans refinanced when property prices fell. Hence, the cycle starts. Banks are not able to retrieve back their cash which they loaned out, resulting in a write down.(bad accounts). Now, these writedowns and lost in capital means that banks could not reclaim back their own capital. Selling those assets which they had collateralized was not sensible due to low market value of this share. At the same time, they had to pay the bondholders their due. Thus, banks suffer both ends.
These happened on a massive level, in terms of the kind of money that was loaned out and assets that were securitized.
Now, the current problem that needs to be addressed. Credit lending. Banks need to start lending money to businesses and consumers. Banks cant do that as they not have the capital to do so as they are still dealing with their internal illiquidity issues. Businesses need cash for their purchase of assets, be it short term or long term. Pple need loans for their college education, cars, houses? and so on. However, an important guideline that needs to be strongly enforced is the creditworthiness of this businesses and consumers. They should be able to repay the loans. Thats where the whole crux of the matter lies.
1 comments:
It is a misconception that "securitize" means to mean something "secure". This is not correct.
"Securitize" means to make something into a tradable security. For example housing loans used to be non-tradable. After a bank grants a housing loan, the bank is pretty much stuck with the loan till the loan is paid up. Securitization is to "chop" the loan into smaller and standard parts, much like share ownership, and sell it in the market. Thus investors can now buy one of these ownerships. These ownership certificates are called "securities" and hence the home loan is "securitized".
Securitization allows diversification. The bank no longer is trapped with the housing loan. It can sell a large portion of it away, and buy securities of other housing loans. Other non-bank investors can have a piece of the housing loan to diversify their portfolio as well. As risk is shared, in theory, everyone has a smaller piece of the non-systematic risk.
Furthermore in this age of financial engineering, something called the credit default swap was invented. In essence, the swap is like an insurance. The buyer of the swap receives insurance or protection, while the seller of the swap offers protection. If the debtor does not pay up, the seller of the swap will take over the loan and pay up on behalf of the debtor. In this way, the original default risk of the loan seems to be completely gone, once you buy that swap as insurance.
Hence through buying the loan security and swaps, you can craft your own exact exposure to risk. In one extreme, you can fully turn the loan into a risk-free loan. In the other extreme, you can fully bear the risk of the loan.
Since the risk can effectively be "sold" away, the banks become more careless in creating new housing loans. Hence in this period, many "toxic" risk products were created in the market, and distributed to many levels of investors. There is nothing wrong with the risk distribution and risk "slicing". The only problem is that the sellers of swaps and the buyers of loan securities are not fully knowledgeable about what they are getting into. They generated such a high demand for swaps and loan securities that the banks have to keep lowering the loan criteria to generate more loans for sale.
Of course as loan quality drops, it would be a matter of time that the bubble burst. Now all those who invested in the risk, has to bear the losses.
I think we should not blame the bank too much for generating low quality loans. It is the demand in the market to invest in such loans that draw the banks into doing it. Somewhere down the retail chain, irresponsible sales and marketing is to blame as well.
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