How does securitization work?

Lately, I've been seeing comments on the financial crisis that mention securitization and pooling loans as a means to reduce risk, but treating it as a black box and not explaining how they were meant to do so. The documentary Inside Job is pretty egregious at this.

So, here's a very basic primer on how securitization works. Let's assume a bank makes 1,000 loans for $900 each on January 1st. There is a 90% repayment rate, and the amount due will be $1,000 on January 31st. There will be no profit in any stage of the process.

*Note that even though the bank is charging 11% annual interest, they are making 0 profit. This is one of the important functions of interest: To account for risk.*

So, the bank has $900,000 tied up in loans with a face value of $1,000,000. Enter the investment banker, on February 1 the banker offers to buy all 1,000 loans for $900,000. The bank likes this because it frees up that capital to be re-lent immediately, and it reduces the risk that more than 10% of the loans will default.

Now comes securitization. The investment bank puts those loans in a vault and creates a group of assets with a total value of $1,000,000. These are calles "tranches" rhymes with launches). The IBank creates two tranches worth $400,000 each (call them A abd B) and one tranche worth $200,000 (call it C). When the loan repayments come in at the end of the year, the money will first be payed to tranche A until it is completely paid off, then B will be paid, and anything left over will be paid to C.

The IBank then creates bonds that reflect these tranches and walk across the street to a rating agency. This is important because many of the institutions that buy large bonds are required by law to only buy bonds that have received a AAA rating from an accredited ratings agency. )In other words, the law gives institutional investors an excuse to shop their due diligence out to someone else.) The ratings agency will look at the structure and say "Over the last 5 years repayment on these types of loans has been 90% +/- 2%. So Bond A is definitely investment grade, AAA. Bond B is also AAA because the situation where it wouldn't get repaid has never happened in the past nor can we see it happening in the future. Bond C is only worth $100,000, and it's a B rating at that."

So now the investment bank has 3 bonds to sell. It sells bond A to a pension fund for $400,000, bond B to an insurance company for $400,000, and bond C to a hedge fund that is willing to gamble for $100,000. If 901 loans are paid off, the hedge fund will win, if 899 get repaid, it loses.

December 31st rolls around and the checks come in the mail. The IBank opens the first 400 envelops and sends the checks to Bond A's owners, it opens the second 400 envelops and sends those checks to Bond B's owner. It opens the rest of the envelopes and sends those checks to bond C's owners. Note that there is no relationship between any individual loan and which bond it pays off, the investment bank still has all the loans sitting in its vault.

So, how does securitization like this reduce risk? Overall risk isn't changed, only 90% of the loans will be paid off. But it allows the risk to be shunted down to investors who are more willing to take it, and that is used as a cushion to insulate more risk averse customers. That is, while only 90% of the loans will be repaid, securitization allows you to create a bond for 50% of the total value, and _that bond_ is very low risk: Repayments would have to be 5 times worse than expected in order for that bond to even think about losing value.

We went wrong by misjudging the risks. The models underestimated the effect of falling housing prices on mortgage defaults, and there was an assumption that the housing market wasn't national, so housing prices wouldn't fall everywhere at the same time. When defaults skyrocketed beyond all expectations, that meant that the lower, risky tranches were wiped out but higher level, less risky tranches also took hits or were even wiped out as well. This hurt institutional investors who weren't prepared for those kinds of losses. If ratings agencies or investors had been more pessimistic when estimating risk this recession wouldn't have been nearly as painful. We would have lost just as much money, but the people who lost it would have been better prepared to deal with it, it wouldn't have been as shocking and scary.

This is a very simple explanation, factors like profits, prepayments, heterogeneous loans and borrowers, and a million other factors combine to make securitization a complex mathematical jumble. But the main thing that went wrong (this time) is that the risk of defaults was underestimated.