Thoughts on the securitization of sub-prime mortgages:
Reading a brief description of what these are, what the process really is, to see how well I can extrapolate beyond a simple description, fill in the details, consider consequences, etc. Largely in the interest of better understanding the sub-prime housing crisis.
Referring to a page from wisegeek.com, which seems to suffice for a basic encyclopedic account.
So the loan issuer, lets say a bank (not sure if other legal entities can issue mortgages), has an asset on their end of the deal, namely the principal plus whatever interest is stipulated in the loan, while the debtor, lets say a single person, has a liability on their end, as they have to pay back the principal plus the interest.
But the bank still incurs risk here, despite the mortgage being an asset from their perspective and being a liability from the perspective of the single. The risk, from the perspective of the bank, seems to boil down to the chance that the debtor doesn't pay the debt.
But this risk, again from the perspective of the bank, can be smoothed out if the mortgage, as an asset that carries some degree of risk, is sold to another financial institution that is able to pool mortgages purchased from a number of banks, and represent this mortgage pool by exchange traded funds (i.e. securities, hence the "securitization of mortgages) that are available for purchase to institutional and/or retail investors.
So the process of issuing a mortgage originally entails a risk being incurred by the mortgage-issuer, but the mortgage-issuer can defer this risk to the financial institution which is then, itself, able to securitize these mortgages and defer the risk even further to investors.
In principle, investors ought to know about what they are investing in, and should make investment decisions in light of discernible risk - risk which, in the case of securitized mortgages, still boils down to the chance that the mortgage-taker, the single individual, won't or can't pay the principal + interest.
And from what I understand, beyond this short wisegeek page about mortgage securitization, there were mortgage-rating commissions or something that would assign levels of risk (e.g. sub-prime) to different mortgages, assignments made, presumably, on the basis of what sort of screening process the bank would enforce before issuing a mortgage.
I also understand, from a Bernanke seminar, that there was a trend of banks being disturbingly indiscriminate in terms of screening potential mortgages. And I also think there may have been some foul play involved with the mortgage-rating agencies, whose word investors were trusting in their discernment of risks.
So here we can see how, if banks are liberally and indiscriminately issuing mortgages, selling those mortgages to other institutions that pool mortgages and represent them as securities which can be purchased by investors, and the investors are basing their risk-assessment on the potentially inaccurate grades given by mortgage-rating agencies, we can end up with a mess of risk deferral that is difficult to sort out, even by good actors.
