Credit crisis: is this just the beginning? (part 2)

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[Click here to read part one of this story]. At this point, one can ask a very simple question: how is it possible that an unpaid subprime mortgage changes anything in a financial world where there are subjects indebted for billion of dollars?

The main problem is that subprime mortgages for many banks have been the fuel (if not the engine) for some sort of liquidity factory. This happened because in the last years the way banks work radically changed.

Ten or fifteen years ago, banks finacend and managed the lendings that they granted. Today is different: banks do not finance credit, they just originate it. When they grant a loan, they house it in their balance only for a short time, and then they distribute the credit to investors, by using instruments like CDO (Collateralized Debt Obligations). So today’s bank have a minimum part of their asset “locked”, and they can grant more loans.

The interesting fact is that, since modern CDO can work as some kind of guarantee (since they are built on mathematical models that should have made nearly-impossible a default), the more loans a bank grants, the more the bank can grant. Since granting a loan means profit, banks relaxed credit access criteria. Sometimes unscrupulous broker poke their nose into this process, with results you may imagine.

To this attitude of the banks, you have to sum buyers’ attitude. CDO were bought from insurance companies, pension funds and hedge funds from all over the world, often financing the buying by borrowing “low priced” money in Japan (the so-called carry trade) but also in the USA.

From this point of view, what happened is that borrowed money bought lent money, and became collateral for more lending, thanks to mathematical models of risk. But this brought also a relevant side-effect: while previously risk was inside banks, where it could be quite easily observed, managed and regulated, now risk is in places not clearly identified, and where skills and instruments to manage it are missing.

Original post (in italian): Crisi del credito: è appena l’inizio? (parte 2)

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