Storm, The by Vincent Cable Read Free Book Online Page A

and of this, at the end of 2007, $1.3 trillion was sub-prime. The concept of ‘sub-prime’
     is an elastic one, but the USA, unlike the UK, has a formal definition based on the multiple of borrower’s income and loan
     value relative to house acquisition price.
    So far, so good. Lots of poor people (and others) were able to buy their homes for the first time when interest rates were
     low and house prices were rising. Lots of happy bankers and brokers werepaid bonuses for successfully closing deals. Lots of pensioners and other investors across the world were enjoying a higher
     yield on the securities that made up the assets of the institutions to which they had entrusted their money.
    What burst the bubble of US property values was rising interest rates. The US equivalent of the bank rate rose from 1 per
     cent to over 5 per cent in early 2006. Large numbers of borrowers could no longer afford to pay. Many of the sub-prime borrowers
     gave up when their ‘teaser’ loans at low interest were refinanced at the new, higher rate. Large numbers simply handed over
     their keys to their bank and disappeared, not waiting to be repossessed. The market fell sharply, with distress-selling as
     the bubble burst. Prices fell on average by 25 per cent from the peak in July 2006 to the financial crisis in the autumn of
     2008, and subsequently fell another 10 per cent before apparently stabilizing. The number of potential repossessions has been
     variously estimated at 2 million on the conservative side to as many as 6.5 million by Credit Suisse – as many as one in ten
     mortgages.
    Whilst this story has been distressing for those American families, it is not immediately obvious why their problems should
     have reverberated around the world. To understand this, I need to explain how the US mortgage market works and how its risks
     are transmitted to wider financial markets. The total US mortgage market was worth roughly $12 trillion in July 2008. This
     sum compared then with a UK mortgage market of $2.5 trillion (or £1.2 trillion) – five times smaller. US mortgage lenders,
     who are far more numerous than in the UK, raise money for new loans by selling on their debt to other institutions. Of the
     total $12 trillion, $5.2 trillion was acquired, and effectively guaranteed (or so it was assumed at the time), by two state-backed
     but privately owned agencies, the Federal Home Loan Mortgage Corporation, known as ‘Freddie Mac’, and the Federal National
     Mortgage Association, known as ‘Fannie Mae’. Fannie Mae had been created during the New Deal as a way of stimulating, while
     also stabilizing, mortgage lending and, thereby, the housing industry. In 1968 it wasprivatized, to help finance the Vietnam War, and its explicit guarantee was dropped, while Freddie Mac was set up as a competitor.
     These two agencies became the stalwarts of the Middle American mortgage market, buying and selling mortgages below a certain
     size (just over $400,000), but not the riskier sub-prime mortgages. Those were left to the (fully) private-sector banks, which
     advanced a mixture of high-grade, high-value and sub-prime mortgages. While Fannie Mae and Freddie Mac did not support sub-prime
     lending directly – though they had a lot of marginally prime loans – they did, however, hold large amounts of securities backed
     by sub-prime mortgages, so they were, indirectly, highly exposed to that market.
    Freddie Mac and Fannie Mae, and the banks, then sought to sell on the mortgage debt they had acquired in the form of mortgage-backed
     securities. This process of securitization broadened out into a slicing and dicing of the risks, through an exotic proliferation
     of new instruments, including the aforementioned CDOs and SIVs (structured investment vehicles). By repackaging the mortgage
     debt through more and more complex vehicles, securitization made it possible to dilute and spread the risk, gain access to
     a wider pool of capital, and thus