Question by Adam G: Explain securitization and how it relates to the global financial crisis?

Best answer:

Answer by gorilla
When an organisation lends money it makes a legal charge on an asset ie the house for a mortgage. This is of value as the house could be sold and the bank receives interest payments relating to the debt. Over a period of time there could be thousands of such debts and the organisation may decide to sell a “parcel” of these to raise capital for other things or to improve the liquidity in its balance sheet. This is called securitization.

The global problems arose when some US companies lent money for houses to people without the ability to continue mortgage payments (it was called trailerpark lending) on the promise that the mortgage could be renewed at favourable interest rates (less than rent) and falsely inflated the values of the properties thus increasing the debt of the customer. They then securitized the lending but the value was much less than they claimed and when the property values fell, people defaulted as the debt was more than the value of their property and the banks who had purchased the parcels in good faith found that they were sat on useless paper( assets were much less than the expected value). This reduced the value of their balance sheets and also reduced their liquidity which led to distrust in the financial community as no-one knew which bank was sat on reduced value assets. The lending lines between banks were based on good faith but these were cancelled as no bank wanted to be pulled under due to the failure of another. This created a situation where credit disappeared from the system so the banks could not lend to their own customers.

It gets a bit more involved but I hope that answers your question.

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