With financial jargons leaping from business pages to front page headlines, here's a guide to understanding the current US financial crisis better.
Subprime or Subprime Mortages
Simply put, they are called subprime since they are below prime status. These are loans lent to borrowers who, as some put it, are considered "NINJA" (no income, no job, no assets). In other words, high risk borrowers: they have tainted credit history or cannot prove their incomes.
These loans were used to either buy properties (called subprime mortgages) or were based on loans against the increased value of borrowers' homes, often to pay off other borrowings.
Originally, the intention was noble: to offer a consumer a way to purchase a home while they repair or build their credit history or employment status. It was meant as a good way for more people to build wealth since having a home is considered a form of savings. The assumption, however, was that banks would still be prudent in their lending.
Then a deadly element came into the picture: Banks became awash with so much cash and were competing with others in bringing in new business. They got sloppy. They started peddling loans to any takers, with little regard to the borrowers' capacity to pay them back.
Of course, subprime borrowers lined up. Who wouldn't want to buy a house even if they haven't saved any money for a downpayment, nor could afford the monthly payments down the road? The banks were more than happy to take them in, anyway house values were "always" going up so who cared about downpayments?
In a mature US financial system, banks could "sell" these mortgages to investment banks, which pooled, then "spliced, diced, and delivered" these to investors who were looking for fat margins. Financial tools based on subprime naturally offered higher interest rates since the credit (or non-repayment) risks were also higher.
Fannie Mae and Freddie Mac
No, they're not people. The names Fannie and Freddie are based on corporate acronyms; FNMA (Federal National Mortgage Association) and FHLC (Federal Home Loan Corporation). "Freddie and Fannie," however, sound much more personable and cuddly, so they inspire a false sense of confidence in home mortgage companies.
Fannie Mae was founded in 1938, during the Great Depression, when millions of families could not become homeowners or faced losing their homes. In 1968 Fannie Mae was partially privatized, and Freddie Mac was created as a wholly private company to provide competition.
They exist for two reasons: to keep the supply of money people borrow from to buy homes available and at a lower cost.
They did not lend directly to homebuyers. Instead, they created a secondary market for housing loans--or mortgages--by purchasing these mortgages and providing them fresh money to make new loans.
They repackage these loans repackages the loans as mortgage-backed securities, stamp them with government guarantees, turn these mortgages around, and sells them to investors. In effect, they were acting as the bridge between mortgage lenders (lending to those who don't have enough money to buy a house) and investors (who have spare money to park and invest in the stock market).
Since the government guarantee assures the investors that the interest and principal will be paid--whether or not the original borrower pays--investors consider mortgage-backed securities from Fannie and Freddie as "safe" investments. The low interest rates these investors pay for these means the banks and non-banks can lend housing loans at low rates too.
Almost all US mortgage lenders, from huge financial institutions like Citigroup to small, local banks, rely on Fannie Mae and Freddie Mac for low-cost and available mortgage funds. They are giants in the US housing system since they guarantee or own roughly half of all the $12 trillion US mortgage market.
They eventually collapsed when, like a row of dominoes, defaults and repossessions ripped through the housing finance system and throughout the entire economy. They have to pay out if ordinary homeowners cannot pay back their home loans, which proved a huge drain on their finances.
How a MORTGAGE is pooled, spliced, sliced and delivered
Imagine a mortgage as stream of future cash flows. In less financially sophisticated markets (like the Philippines), handling and earning from these cash flows are a simple business. Banks and other financial institutions that grant these mortgages made sure they collect these cash flows (amortization payments) on time until the entire loan is paid off. They make a decent profit along the way.
But in sophisticated markets, like the US, these cash flows are bought, sold, stripped, tranched, and securitized. In the process, various players earn fees and profits everytime the mortgage is flipped. This created some very innovative and aggressive practices since the key to earning a fee is volume--the more you flip, the more you earn--rather than quality. In the end, the banks role changed from being the loan's "quality controller" to a salesman. The more deals, the higher commissions. Who cares if the borrower stops paying the mortgage a couple of years later? That's the problem of whoever is holding the mortgage-backed instrument now.
It could be the aggregators, like FANNIE MAE and FREDDIE MAC, or large INVESTMENT BANKS that have a "structured products" group. They collect thousands of mortgages all over, then pool them together. Pooling these mortgages allows them to command a higher premium, than if they transact these mortgages individually, since it gives the buyer sense of security that he or she is diversifying his risks. He is not buying mortgages all based in, say, California, or by borrowers who are all Latin American migrants.
But when aggregators pool the mortgages, they are on their own when they price that financial product. Usually though, they have a computer model where they compute the price based on general assumptions, such as where the real estate market is headed and some historical data on default patterns. Before the subprime market exploded, most probably the assumptions are all rosy: that the real estate market will go up as much as 10 percent every year, default rates will be low, interest rates will remain low, and refinancing will never be a problem. Unrealistic--and unchecked--assumptions will naturally result in a higher aggregate price much larger than its parts.
After the pooled mortgages are stamped with bloated prices, Wall Street firms then package them up with other loans (some quality, some not), and securitize them so they could slice and dice the pool into many tranches (products), before they eventually sell them to investors. Each tranche is a customized product, describing a specific class products within an offering wherein each tranche offers varying degrees of risk to the investor. The tranches can range from alphabet soup-like products: CMO, ABS, CDO deals.
Sometimes the embedded options are stripped out. Sometimes it is derivative on top of another derivative, and given fancy names with whatever square or cube. For example, a CMO offering a partitioned MBS portfolio might have tranches that have one-year, two- year, five-year and 20-year maturities. It can also refer to segments that are offered domestically and internationally, or based on rights to the interest payments only or to the principal repayments only.The more exotic the products, the more profits the firms could squeeze from the mortgages.
In other words, investors who bought IO, PO, or other exotic and complex derivatives have little or no idea anymore about the paying behavior of the underlying mortgages. Usually, the investors merely rely on the opinions of rating agencies and bond insurance firms, which, it appears, have unbashly taken the side of the Wall Street banks and investment firms. Almost all of these bundled securities magically became 'A' rated or higher.
Investors of these exotic financial products include foreign governments, pension funds, insurance companies, banks, and hedge funds.
Asset Backed Securities
A financial security which uses any asset that has predictable and similar cash flows--such as loans, leases, credit card debt, company receivables or royalties--as collateral.
A type of asset-backed security that uses a single mortgage, or a pool of them, as collateral. Investors receive payments derived from the interest and principal of the underlying mortgages.
A situation created when banks hugely reduced their lending to each other because they were uncertain about how much money they had. This in turn resulted in more expensive loans and mortgages for ordinary people
How easily an asset is converted into cash. For example, a time deposit account is more liquid than a house. To sell a house quickly to pay urgent bills would mean having to drop the price substantially to get a buyer.
Turning something into a security, a contract that could be assigned a value, and eventually traded. It could be a stock, bond or mortgage debt. For example, taking the debt from a number of mortgages and combining them to make a financial product which can then be traded.