Mortages (simple world)

HH gets 100 000 Eurosand promises paymentsover say next 20 years

A bank holds this mortgage

Mortages (more complicated)

HH gets 100 000 Eurosand promises paymentsover say next 20 years

A bank holds this mortgage

Investment bank buys mortages from many different banks and “repackages”them to “structured products”

Why “structured products” (1)

• Diversify risk -- For example: property market often only

turns down in some regions, not nationally so you can reduce risk by selling people “pieces” of many different mortgages from many different regions

-- But also diversify other type of risk. For example hold mortages from many different people

Why “structured products” (2)

• Create “speciality products”

-- For example, mortages were split into tranches

100 000 Euro mortgageo buy a 1000 Euro house

Person will stop paying mortgage ifhouse less than 50 000 Euro, approximately

Value of house

Why “structured products” (2)

• Create “speciality products”

-- For example, mortages were split into tranches

100 000 Euro mortgageo buy a 1000 Euro house

Person will stop paying mortgage ifhouse less than 50 000 Euro, approximately

Value of house

Structuredtranch SAFE

Structuredtranch RISK

What happened

• “Mortgage originators” did not care as much as in past about credit worthiness of their customers. WHY?

-- They would not “hold” the mortages but pass them on

-- They were able to pass on even bad mortages at high prices because:

- customers did not “understand the products” - the rating agencies did not do a good job

(underestimate the risk)

What happened

• Property market did turn down nationally, which the structured products assumed was unlikely to happen

Overall situation

• There was already a lot of risk due to NINJA mortgages (NoIncomeNoJob&Assets)

• At the aggregate level the bad scenario realized

Does that explain the crisis?

• In a normal year, in the US there are 150 000 million dollars in unpaid mortgages (10% of Spanish GDP)

• Now there are about 300 000 million dollars according to worst scenario

Difference is not large enough to explain crisis. Only Bear Stern, Lehman, Washington Mutual, and Wachovia have lost 260 000 million Euros.

What is the problem? (1)

• Nobody knows the composition of the structured products

• Everybody appears to assume that the worst structured products are those for sale

• Just like with the “lemons problem” of Akerlof, nobody wants to buy the worst products (think about used cars)

Consequence

• Nobody knows how to value structured products

• Nobody manages to sell any structured products

Banks cannot transform structured products into “liquidity” to cover their payment obligations. And run the risk of going bankrupt!

What is the problem? (2)

• Nobody knows how many bad structured products banks are holding

• So banks have lost trust in fellow banks.

• They don’t give them loans or only very expensively

And the “real economy”?

• Banks are unable to make new loans for two reasons

-- they cannot sell their structured assets and use the money for new loans

-- their own capital is shrinking; to make loans they have to make “provisions” with their own capital. And they have less of this

Bank runs?

• Banks are no trusting banks. What about households?

• If they lose trust, they will try and get at their savings

• But banks only hold a small share of savings deposits in liquidity

Their could be a “bank run” driving banks into bankrupcy

Solution?

• Nationalization of banks (losses covered by the tax payers in the short run; maybe there will be gains in the future)

• Government savings guarantees

• Question:

-- buy banks (and therefore the structured products they are holding)

-- buy the bad mortgages directly

And Spain?

• Provisions? For mortages and structured products? (Bank will be able to cover losses with their own capital—which means that only bank shareholders lose)

• Bad mortgages? Prices have only fallen by 5% and only for used housing

• Mortgages are personal loans, which generally reduces default risk

Still

• Spanish banks are not managing to sell mortgages internationally anymore liquidity problem

• This has reduced the credit to businesses, which could cause the recession (it could also be however that banks see the future less “rosy” than 3 years ago)