Subprime Leverage

Posted on December 8, 2008 by Ben Connard 

Subprime mortgages account for less than 7% of the mortgage market, yet are creating havoc throughout our entire financial system and causing a liquidity crisis. The idea that such a small part of the mortgage market can cause so much trouble is amazing.

The reason is that defaults on the actual mortgages trigger defaults on every other instrument tied to the mortgage.

Here’s a simple example. Bank A writes $100 million worth of mortgages to be paid off over 30 years. Bank A turns around and sells the mortgages to Client Long for $100 (plus some commission). This should be the end of the transaction. If the homeowners default, Client Long loses his investment, but losses are contained to the homeowner and Client Long.

However, Client Short comes to Bank A and says I want to short those mortgages. In other words, I think the homeowners are going to default (or at least default at a higher rate than your models assume) and want to take advantage. Bank A says fine, you give us periodic payments and we’ll give you $100 million if the homeowners default. The payments would be related to the payments due on the mortgages, based on the assumed default rate on the mortgages. This is a simple example of a credit default swap (CDS).

Now Bank A has cash flows tied to mortgages—it has essentially created a synthetic mortgage. So Bank A turns around and sells the synthetic mortgage to Client Synthetic, who is looking for an investment with a higher return than Treasuries and theoretically only slightly more risk. In addition, since Bank A’s models tell it the chances of having to pay off the CDS are small, the bank uses the revenue from the sale to Client Synthetic to make other product and keeps only a portion of the cash on the hand (creating leverage).

Why did Bank A create the synthetic mortgages? Because the demand was high with Treasuries and other more traditional debt instruments carrying such low yields. And as long as there was a client on the short end (CDS buyers), they could create the synthetic instruments. The buyers came out in droves as the CDS market grew 10 fold between 2003 and 2007. The best part being you could buy CDS without owning the underlying instrument.

This all works fine as long as the homeowners keep paying. Money is coming in from the homeowners and Client Short and being paid out to Client Long and Client Synthetic and Bank A can keep low cash levels. Problems arise when the homeowners default.

Client Synthetic loses his investment in addition to Client Long because Client Short’s payments were tied to the homeowners’ payments. Bank A also has to pay off the CDS but may not have the cash available, especially if there are more defaults then predicted. This causes massive problems for Bank A, possibly leading to bankruptcy, and definitely causing a liquidity crunch throughout the financial system.

For more information on this phenomenon:

(warning: article contains strong language)