What I do and don't understand about the banking crisis - with links.

[cdave]

American's were offered mortgages the could only afford so long as interest rates stayed low. If they had risen, but house prices kept rising it wouldn't be a problem either as the houses could be sold to service the debt.

It was SO easy. Fill out a few online forms, make some choices, and there I was, about to close that loan. But then I did an odd thing. I carefully read the papers I was about to sign (I'm one of THOSE people). And in that residential loan application, right on line something or other, was a number that didn't make any sense to me at all. It was labeled "total household income" and was almost twice the pitiful amount I actually earn.

From where did that number come? It certainly never came from me. Since my signature would be at the bottom of this application I wanted to make sure everything was correct, so I called the mortgage broker. For the first time we spoke. She was a very nice lady, too, and explained that number was the variable required for all the ratios to be correct so I could qualify for the loan.

"But it isn't true," I said.

"Do you want the loan or not?" she asked.

Not.

Banks repackage the mortgage debts and sell them on.

Intrest rates rise. House prices fall. The repackaged mortgages are suddenly a liability, rather than an asset. The banks aren't sure who owns these bad debts, so won't lend money to each other in case it turns out that they don't have the assets to secure the loan against.

Short selling attempts to adjust the value of a bank down, but goes to far.

Here's my question. Why does no-one know who bought those repackaged mortgage debts?

The whole point of this scheme is that the mortgage lenders have been paying interest to the investment banks that own these repackaged debts. So how can banks say they don't know where the debt is?

Comments

One clarification (sort of)

[the-magician.livejournal.com]

Why does no-one know who bought those repackaged mortgage debts?

Having worked in the insurance industry, I had to do courses on reinsurance and excess of loss policies ... basically if I have car insurance and make a claim, my insurance company pays out. And they do their sums so that in an average year, they take in more than they pay out. But what happens in an unusual year, they could have to pay out vast amounts ... so they take out insurance that if they have to pay out 150% (say) of the usual annual payout, that another company will pay anything above 150% ... in exchange that other company gets, say, 10% of the premiums and most years doesn't have to pay out anything. Now that reinsurance company will be doing this sort of thing for many other insurance companies and if they all have a bad year (say a hurricane comes through and it's not excluded from their policies) then the reinsurance company could be in trouble, so it in turn reinsures with other companies to cover a really unusual year.

When the Piper Alpha oilrig caught fire, the first tier of insurance companies all hit their limits quite quickly and so went to their reinsurers, who hit their limits quite quickly and so they went to that second level (which turned out to contain a number of first level insurance companies who had bought up some "really unlikely" reinsurance bundles ... which pushed them further over their limits and back into the second tier and up to third tier insurers (who consisted of groups of first and second tier) etc. it took years for the money to go around and around, triggering excess of loss policies etc. and some companies found out they had got things wrong and went out of business, leaving some of the Lloyds names to cover those loses, which brought in more reinsurance and the numbers went around again.

It will be the same with these bundles, that a bank will have bought a bunch of different bundles thinking they couldn't all go down, and when they did, they had arrangements with other banks ... and the money goes around and no-one knows who is finally holding the baby (and in the meantime some are going out of business which means that that is being passed on to the next link in the chain, potentially putting them out of business too ... so the "bail out" is in part trying to relieve strain *now* before it ripples along and takes out the entire industry ... but you knew that!

Re: One clarification (sort of)

[cdave]

Sounds like a one of those ever decreasing infinite term sums, that add up to something like π. Except the value needed is 3.5

Re: One clarification (sort of)

[cdave]

Oh, and thanks. That was a pretty really clear example of what has probably gone wrong.