Tag Archives: finance

Reading the Credit Crisis: Securitization

One of TLC’s most popular songs in the 90’s was “Waterfalls.” The chorus is:

Don’t go chasing waterfalls/ please stick to the rivers and the lakes that you’re used to. /I know that you’re gonna have if your way or nothing at all/ but I think you’re moving too fast.

I thought of this song today while reading the Senate’s report on the credit crisis. Today I finally understood something about “securitization,” and I realized that the song’s chorus is pretty wise.

At first the report’s explanation of securitization is very, very confusing:

Securitization. To make home loans sales more efficient and profitable, banks began making increasing use of a mechanism now called securitization. In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds, which are registered with the SEC, are called residential mortgage backed securities (RMBS) and are typically sold in a public offering to investors.  (p.18)

This didn’t make much sense to me. I understand that homeowners take out loans from banks to pay for houses. I understand that some banks saw a potential profit in offering loans to people who might not be able to pay off that loan. But how do you bundle a home loan? What’s the function of the offshore trust? How do bonds make payments to investors? Finally, how could any of this be sold to anyone?

Later on, in the section about credit rating agencies and “structured finance,” the report offers helpful imagery. It talks about waterfalls.

Among the oldest types of structured finance products are RMBS securities. To create these securities, issuers–often working with investment banks–bundle large number of home loans into a pool, and calculate the revenue stream coming into the loan pool from the individual mortgages. They then design a “waterfall” that delivers a stream of revenues in sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a bond, linked to that first tranche…its revenue stream is the most secure. (p.28)

This is an image I can understand. Think of a waterfall. There’s a water source at the top of it, like a lake. The lake overflows and follows the contours of a slope downward, creating a stream. In some cases there’s a cliff and the water falls over it.

The beginning of the water is the top of the cliff. Just over the edge of the cliff, on the rock’s face, is a space between it and the waterfall. The waterfall gets that part of the cliff wet–and usually every other part of it, including the very bottom of the cliff.

That space is a tranche. The tranche at the top of the cliff gets wet. It’s chances of getting really wet are pretty good since it’s at the source of the water. The tranche at the bottom gets has the least chance of getting wet since it’s farthest from the source. And all the tranches in between the top and bottom have certain likelihoods of getting wet accordingly.

This is all an analogy for securitization. Getting back to the homeowners, they pay a mortgage to their bank, which takes a profit. That movement or action–a bunch of people paying mortgages–can be “bundled” together and sold for a profit. The profit made from this sale is based on how much the people pay into their mortgages and how reliably they do so. If you want to, you could derive your own profit from these habits. This is a derivative, I think.

Back to the waterfall analogy. Imagine a bundle of homeowners and their payment habits. Their money sitting in the bank is like a lake of water. If you want to, you can go to that lake, chop a big hole in the side of it, and watch the water flow out. This is creates a derivatives market, because now people can make or lose money depending on whether or not the people living in the houses pay or don’t pay their mortgages.

But how do we know they’re going to pay? How can we be sure that we’ll make money from them?

Imagine the mortgage-payments flowing downward like a stream over a cliff. There’s a waterfall now. Since certain tranches are more likely to “get wet” (tap into the flow of profit), securitizers set up bonds. The word “bond” makes sense, I guess, since the securitizers are linking investors to the profit flow.

The word “security” makes sense, too. In a derivatives market, it’s hard to know whether you’ll make or lose money on someone else making or losing money. But if I buy a security in the form of a bond, that means I know, with a degree of certainty, that I will make money.  I feel secure that money will come in.

There are lot of different kinds of derivatives markets, I guess, all with their own securities markets. Pretty much any behavior that involves buying and selling can be securitized: corn, computers, petroleum, etc. This includes mortgages.

So what do securitizers do?

They sell a sense of certainty about making money from other people who make and lose money. Specifically, related to the credit crisis, RMBS securitizers sell a sense of certainty about making money off the mortgage paying habits of people living in houses.

Before the credit crisis, people securitized a lot and did it really fast. So TLC (whose name, ironically, also stands for Tender Love and Care) was right. One lesson in all of this is: don’t go chasing waterfalls.


I get the feeling that most structured financial products are just ways to make money when other people are making or losing money. This is why, before the 1970s, securities markets were taboo. It was too much like gambling. It’s like going to a horse race and betting on whether or not a certain horse will win.

But then two economists, Fisher Black and Myron Scholes, invented a formula called Black-Scholes that made it possible to know with greater certainty whether or not you could make or money when someone else was losing or making money.

Black and Scholes won the Nobel prize in economics for that formula in 1997. It sounds bad at first, but the report says that securities markets like RMBS were actually good business until some banks like Washington Mutual realized they could make a lot of money selling subprime loans. (Remember ‘subprime’ just means ‘bad’.) Imagine a horse that was supposed to be terrible coming from behind and winning the race. If you had a gadget that could calculate with a degree of certainty that such a horse would win, you’d probably use it to bet on the horse the gadget told you. You could make a lot of money, particularly if the horse was a bad horse.

The same thing happened for subprime loans.  These were high-risk and had the potential to make more money if the homeowners beat the odds set against them and paid off their mortgages.

The credit agencies saw that they could make money by giving the subprime loans good credit ratings, and the investment bankers saw they could charge high prices for securitizing large bundles of these loans for investors. The riskiness made it all very profitable.

In my attempt to understand why the financial crisis happened–why some people hurt other people to make money–this helps a lot. Black-Scholes and the securitization process makes it clearer to me.

Losing money hurts most people. We work and work and save and save so we can make a better life for ourselves and our families. This is particularly true with houses. We want nice places to live and raise children. When we lose money, it’s harder to make a better life for ourselves and our families because we can’t afford a nice place to live. Since making a good life for ourselves and the people we love one purpose of livinge, it can be really hurtful when that doesn’t happen.

Securitization, particularly in the last few years, became a business where people know–with certainty–how to make money when other people lose it. Another way of saying this is: sometimes when you securitize you’re profiting from other people’s hurt.



Reading The Senate Report On The Financial Crisis

I’ve been reading Senator Carl Levin et al.’s report on the financial crisis recently in an attempt to figure out what happened and what’s happening in financial capitalism. These reports are becoming more and more important, so I thought I’d share a few general ideas I’ve learned so far if anyone else is interested.

The general ideas are: (1) There isn’t one person we can blame. Many different kinds of people are involved; (2) Policymakers made it okay for banks to become big businesses; (3) Some companies treat their clients like enemies; (4)  Some banks take advantage of people who want to live in houses; (5) “Subprime” just means “bad,” and some companies sold bad stuff on purpose.

1) There isn’t one person we can blame. Many different kinds of people are involved. These include investment banks like Goldman Sachs, lending banks like Washington Mutual, borrowers like you and me, federal economic policymakers, and credit rating agencies like Standard & Poor’s.

Robert Reich recently badmouthed the report in the New York Times Book Review for not blaming one person or entity. I’ve wanted to place blame on a single entity also, but the report is clear: many kinds of people are at fault. The reasons they’re all at fault may be similar in some profound way (greed, short-term thinking, lack of education and communication, etc) but the mechanics behind each entity’s role in the crisis is unique. It’s too complex to blame one person or company.

2) Policymakers made it okay for banks to become big businesses. Before the 1990s there were mostly small, local banks. Large national banks and lenders are new things. The government allowed banks to grow in size and cross state boundaries.

“Until relatively recently, federal and state laws limited federally-chartered banks from branching across state lines. Instead, as late as the 1990s, U.S. banking consisted primarily of thousands of modest sized banks tied to local communities…In 1994, for the first time, Congress explicitly authorized interstate banking, which allowed federally-chartered banks to open branches more easily than before…These and other steps paved the way, over the course of little more than the last decade, for a relatively small number of U.S. banks and broker-dealers to become giant financial conglomerates.” (p.15-16)

The financial crisis didn’t stop this trend, either:

“By the end of 2008, Bank of America had purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JP Morgan had purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each controlled more than 10% of all U.S. deposits.” (p.16-17)

3) Some companies treat their clients like enemies. In the last twenty years, large financial institutions like investment banks and lenders did more “proprietary trading.” This is where a company thinks about it’s own profit independently from the profit of the people it serves (its clients).

“Over the last ten years…some firms began referring to their clients, not as customers, but as counterparties.” (p.17)

Institutions involved in the financial crisis set up situations where they wanted  their clients to do poorly. If their clients lost money according to these situations, they made more.

4) Some banks take advantage of people who want to live in houses. As banks got larger and were allowed to make more money, they found ways to keep getting bigger and keep making more money. One way was to let people who want to live in houses take out big loans even though it was unlikely that they could pay those loans back.

“When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profits from a larger revenue stream to support bigger pools of mortgage backed securities.” (20)

A lot of people want to live in houses. A lot of these people don’t save a lot and don’t know much about finance. Borrowers, brokers, and banks let these people take out huge, high-risk loans to make more money. “Higher risk loans grew from about 19% to about 55%” and “lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender’s credit requirements.” (p.25)

5) “Subprime” just means “bad,” and a lot of companies sold bad stuff on purpose. If a loan is high-risk then that means it’s likely you’re going to get in trouble if you take it.  It means you won’t be able to pay it off and you’ll go into a lot of debt. It’s bad. Everyone involved in the credit crisis encouraged borrowers to take these kinds of loans, which are called “subprime.” Then other people manipulated the high-riskiness of the loans to make more money.  It was profitable to sell bad stuff. In fact, what made the stuff profitable was that it was bad.

I’m trying to be as fair as possible here. I don’t want to make any generalizations that are violent, sarcastic, ironic, or unjust.  I just want to understand why there are some people that choose to hurt other people to make more money for themselves. It seems like this report is a good case study.