Expensive lessons from cheap credit
By: Melanie | Posted: 21st August 2007
The tide has turned in debt markets. We're about to find out who's been swimming naked.
The events of the past few months deserve reflection. Hank Bloggs – a citizen of the United States who never should have been lent money to start with but thought he could make his fortune in property – is no longer willing, or able, to pay back his mortgage. His default, along with that of a few of his compatriots, sends a 'hedge' fund in Sydney, Australia, to the wall. Another hedge fund, managed by Macquarie Bank and somewhat ironically named 'Fortress', is taken along for the ride, and it didn't even lend any money to Hank Bloggs or his defaulting compatriots.
Such is the nature of modern financial markets. Products are created in one country, financially engineered multiple times and flung to all corners of the world.
Not that long ago, your local bank manager was the one who decided whether the bank would provide you with a home mortgage. If you couldn't repay the loan, it was their reputation and job on the line.
Financial wizardry
Nowadays, you'd be hard pressed to find a local bank manager. Mortgage brokers sell loans on behalf of the banks, the banks collect hundreds of these loans and then chop the portfolio into different 'tranches'. Each tranche – a financial security based on the underlying portfolio – is ranked such that any defaults trickle up from the bottom (riskiest) tranche to the top (safest) tranche. If you buy the bottom tranche, you receive a higher rate of interest but, if the underlying borrowers start to default, you wear all of the pain before the tranches above wear any losses.
If you're confused, you're about to become more so, because the financial wizardry isn't over yet. Another bank will collect a portfolio of these already finely chopped securities and put them through the mincer once again.
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Tags: multiple times, reflection, financial security, fortress, borrowers, local bank, rate of interest, mortgage brokers, home mortgage, compatriots, wizardry, citizen, financial markets, sydney australia, intelligent investor, hedge fund