Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis

Abstract

The credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. These instruments—RMBSs, CDOs, SIVs, and CDSs—shifted the risk of mortgage lending, especially the default risk, from one party to another, until many lost sight of the real risks of the underlying loans. But when housing-price appreciation reversed, many subprime borrowers, having made only negligible down payments, owed more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders, and losses, magnified by vast leverage, spread up the tower of structured instruments to CDO investors and CDS sellers. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.

The current credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. Structured finance products such as residential mortgage-backed securities (RMBSs), collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and credit default swaps (CDSs) enabled the expansion of lending to subprime mortgage borrowers while disguising the real risk of such lending. Structured securitization transformed subprime loans into products offering relatively high returns while carrying AAA ratings from the credit-rating agencies. These products seemed to reduce risk by shifting it from the lenders that made the mortgage loans to the banks that bought the loans to pool and package them into RMBSs and CDOs and to the investors that held CDOs, SIV commercial paper, and CDSs. Demand for structured finance products helped fuel mortgage lending, which facilitated more purchases of homes and, in turn, put upward pressure on prices. As lenders exhausted the pool of possible homebuyers, however, housing prices began to decline. Many subprime borrowers who had made little or no down payments found themselves owing more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders and, magnified by vast amounts of leverage, spread up the tower of structured instruments to investors in CDOs and sellers of CDSs. The solvency of some participating institutions became questionable, lenders were reluctant to extend credit, and liquidity began to dry up, all of which caused further declines in housing prices, more defaults, and more losses. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.