Housing & The Economy: What Went Wrong

Wednesday, October 1st, 2008

UnderstandingTax has the best explanation I’ve seen so far:

The Spread: Securitization and Debt Chains

But why did Lehman Brothers and AIG go under? After all, they don’t make mortgage loans. I turn next to how the problem spread.

Assume that A borrows from B to buy a home, giving a mortgage on the home to secure her debt. B then borrows from C, using A’s mortgage as security. C in turn borrows from D, using B’s obligation as security. And so on.

Now assume that A’s mortgage goes bad. What happens to B, C, and D? Answer: all the loans up the chain go bad as well.

And this isn’t all. If the loan is secured (as mortgages and many other links in debt chains are), the lender is typically less interested in the creditworthiness of the borrower. The lender relies primarily on the collateral, not the borrower, for assurance of repayment.

As a result, each financial intermediary can be thinly capitalized. So a company with $10.1 billion in assets and $10 billion in debt may have a small amount of net equity. Indeed, the more thinly capitalized a company, the higher the return it can make on its capital.

Unfortunately, what this means is that when A’s mortgage goes bad, it’s not just the loans up the chain that go bad – financial intermediaries in the chain often go bust as well. A thinly capitalized intermediary cannot absorb many losses. And that is why teaser-rate mortgage defaults triggered and are still triggering defaults and failures across the entire financial sector. Almost everyone was in the debt-chain business and extended themselves to the max to take advantage of the extraordinary profit opportunities of that business.

There is much, much more at the link. Read it all.