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Mortages (simple world)
HH gets 100 000 Euros
and promises payments
over say next 20 years
A bank holds
this mortgage
Mortages (more complicated)
HH gets 100 000 Euros
and promises payments
over say next 20 years
A bank holds
this mortgage
Investment bank buys mortages from
many different banks and “repackages”
them to “structured products”
Why “structured products” (1)
• Diversify risk
-- For example: property market often only
turns down in some regions, not nationally
so you can reduce risk by selling people
“pieces” of many different mortgages from
many different regions
-- But also diversify other type of risk. For
example hold mortages from many
different people
Why “structured products” (2)
• Create “speciality products”
-- For example, mortages were split into
tranches
Value of house
100 000 Euro mortgage
o buy a 1000 Euro house
Person will stop paying mortgage if
house less than 50 000 Euro, approximatel
Why “structured products” (2)
• Create “speciality products”
-- For example, mortages were split into
tranches
Structured
tranch RISK
Value of house
Structured
tranch SAFE
100 000 Euro mortgage
o buy a 1000 Euro house
Person will stop paying mortgage if
house less than 50 000 Euro, approximatel
What happened
• “Mortgage originators” did not care as much as
in past about credit worthiness of their
customers. WHY?
-- They would not “hold” the mortages but pass
them on
-- They were able to pass on even bad mortages
at high prices because:
- customers did not “understand the products”
- the rating agencies did not do a good job
(underestimate the risk)
What happened
• Property market did turn down nationally,
which the structured products assumed
was unlikely to happen
Overall situation
• There was already a lot of risk due to
NINJA mortgages
(NoIncomeNoJob&Assets)
• At the aggregate level the bad scenario
realized
Does that explain the crisis?
• In a normal year, in the US there are 150 000
million dollars in unpaid mortgages (10% of
Spanish GDP)
• Now there are about 300 000 million dollars
according to worst scenario
 Difference is not large enough to explain crisis.
Only Bear Stern, Lehman, Washington Mutual,
and Wachovia have lost 260 000 million Euros.
What is the problem? (1)
• Nobody knows the composition of the
structured products
• Everybody appears to assume that the
worst structured products are those for
sale
• Just like with the “lemons problem” of
Akerlof, nobody wants to buy the worst
products (think about used cars)
Consequence
• Nobody knows how to value structured
products
• Nobody manages to sell any structured
products
Banks cannot transform structured
products into “liquidity” to cover their
payment obligations. And run the risk of
going bankrupt!
What is the problem? (2)
• Nobody knows how many bad structured
products banks are holding
• So banks have lost trust in fellow banks.
• They don’t give them loans or only very
expensively
And the “real economy”?
• Banks are unable to make new loans for
two reasons
-- they cannot sell their structured assets
and use the money for new loans
-- their own capital is shrinking; to make
loans they have to make “provisions” with
their own capital. And they have less of
this
Bank runs?
• Banks are no trusting banks. What about
households?
• If they lose trust, they will try and get at
their savings
• But banks only hold a small share of
savings deposits in liquidity
 Their could be a “bank run” driving banks
into bankrupcy
Solution?
• Nationalization of banks (losses covered
by the tax payers in the short run; maybe
there will be gains in the future)
• Government savings guarantees
• Question:
-- buy banks (and therefore the structured
products they are holding)
-- buy the bad mortgages directly
And Spain?
• Provisions? For mortages and structured
products? (Bank will be able to cover
losses with their own capital—which
means that only bank shareholders lose)
• Bad mortgages? Prices have only fallen by
5% and only for used housing
• Mortgages are personal loans, which
generally reduces default risk
Still
• Spanish banks are not managing to sell
mortgages internationally anymore
liquidity problem
• This has reduced the credit to businesses,
which could cause the recession (it could
also be however that banks see the future
less “rosy” than 3 years ago)