View source for David Bowie, Dad’s Army, and financial armageddon

{{a|g|}}As you know, it has never been my agenda to deny that [[Investment bank|investment banker]]s are mendacious, or at least silly, and they were rarely sillier, or more mendacious, than in the years leading up to the [[global financial crisis]] but ''even so'' there ''was'' method in the madness of [[residential mortgage-backed securities]] and even [[collateralised debt obligation]]s 

To help explain we turn to Captain George Mainwaring who, when not commanding Walmington-on-Sea’s home guard was a bank manager, and [[David Bowie]], chameleon-like media superstar and (at the time) living work of art. By the 1990s he’d become a sort of multi-media installation, and after decades of exploring successive personas and all kinds of new directions, and played a typically starring role in the early days of asset securitisation. 

Banks – old fashioned, proper banks – do two things: They lend, and they borrow. Their borrowings are a ''liability'', which they must eventually repay, and their loans are an ''asset'' on which they will earn income. Much of a bank’s borrowing takes the shape of [[Retail deposit|customer deposit]]s. Much of its lending is involves lending to people so they can buy houses.

A bank’s interest ''income'' on its loan portfolio should be greater than its total interest obligations on its deposits. Otherwise it will not be in business for long. A lot of people at the bank manage its “market risk” to make sure that happens.

Even though its mortgage interest rates will exceed its deposit interest rates the bank has asymmetric [[credit risk]] on its whole loan portfolio: there is no equivalent chance it will be let off some of its deposit liabilities if a customer goes bust. It has to pay those out no matter what.  For while a bank has no choice but to meet all its liabilities, whether it receives all the income due on its assets is out of its hands: Mortgage holders may go bust, after all.

This credit risk is dispersed across thousands of mortgage borrowers. Managing that credit risk is quite a job. This is where Mr. Mainwaring comes in, checking that his customers’ prospects are good enough that they’ll pay on time. Being very long term investments — up to 30 years — it’s inevitable that a portion of a given mortgage portfolio will fail. The question is how much.

Dear old George Mainwaring knows a small number of his loans will go bad but not ''which'' ones. Managing the credit risk of the mortgage portfolio involves calculating those probabilities as accurately as you can, and that in turn involves knowing as much as you can about the lenders and their financial circumstances.

A small change in the default probability can add up to a big number on a large mortgage portfolio: in a portfolio of 100,000 mortgages of £100,000 each a 0.1% change in default probability equates to a £10 million loss.

Quick sidebar: A mortgage has a long term (usually 20-30 years) and can only be repaid early in certain circumstances. As long as the customer keeps up its payments, the bank cannot ask for its money back before the term of the loan. Mortgages are, therefore, very “illiquid”. They are hard to “liquidate”. By contrast, ''on call'' deposits in a bank account are ''very'' “liquid”. A bank which finances illiquid assets with liquid liabilities has a “liquidity mismatch”: If customers withdraw their money suddenly, it is ''stuffed''.

So banks like to look for ways to make their term loans more liquid. They can’t ask the customer for their money back, they can ''sell'' — or [[Monetisation|monetise]] —their loans. Here the selling bank transfers all its rights to be repaid principal and interest to the purchasing bank, and the purchaser pays the outstanding amounts due on the loan to the seller. Instead of the customer repaying the loan, the purchasing bank does.

Banks do “trade” loans, but it is not common for little mortgage loans, because a purchasing bank doesn’t want to hold an illiquid asset like a mortgage any more than the selling bank does. And the cost and hassle of transferring mortgages is prohibitive. There’s all that monkeying round with title registration and mortgage deeds.

A few years ago a some clever bankers came up with a way of allowing banks to easily sell their mortgage portfolios called “securitisation”. A pioneering example of a securitisation was [[David Bowie]]’s– of future songwriting royalties – "Bowie Bond", under which the Thin White Duke sold his rights to future royalties to a securitisation company which financed the purchase by issuing bonds secured on his catalog of songs. Investors took the risk that his songs wouldn't yield that much money. Small risk, as it turned out, and Bowie now has his song catalogue back, and investors were repaid in full. There: some securitisation stories do have a happy ending.
Under a mortgage securitisation, a bank would sell its mortgage portfolio to a company which would finance the purchase by issuing bonds “backed” by the portfolio it was buying. A securitisation therefore is, ironically, itself rather like a mortgage loan.
And here’s the clever bit: The mortgages (illiquid, term loans, very fiddly to transfer) have now been “repackaged” into a new format: bearer bonds called “Asset-Backed Securities” (commonly abbreviated to “ABS”). ABS are freely transferable securities, like shares. You can easily buy and sell them without bothering the mortgage borrowers. In this way one of the big risks associated with mortgage lending: being stuck with the portfolio for 30 years – was largely resolved.
But - and little did anyone realise this - a much bigger problem was created.