How has so much money been lost in the credit crunch? In essence, it is simple. In the US, over one trillion dollars were lent by financial institutions to house buyers whose income and job prospects were relatively poor. These sub-prime mortgages were then bundled together and sold in the form of mortgage-backed securities. The purchaser of bundles of such securities gained a high rate of return because sub-prime borrowers, being riskier prospects for lending, are charged high rates of interest.
So how risky are these bundles of sub-prime mortgages? This is hard to tell but, luckily (or perhaps not), there are specialist institutions, such as rating agencies, whose job it is to estimate the probability of major losses on these bundles. The key factor here is not so much the chances that any individual loan will default as the chances that large numbers of loans will default simultaneously. And this depends on the extent to which defaults occur because of idiosyncratic events—like the borrower falling sick—or because of events which affect everyone, like falls in property prices or rises in unemployment.
So the rating agencies crunched the data from the recent past to arrive at predictions, and concluded that most of the relevant events were idiosyncratic, because the recent past was devoid of any major downward shocks in the housing market. As a consequence, these clever number crunchers then announced to their managers that these bundles of sub-prime mortgages were pretty safe.
What followed was inevitable. The treasury departments of many British banks (and lots of other institutions across the world) saw assets on the market that paid high returns and were deemed to be as safe as government bonds. Without pausing to ask whether this was too good to be true, they invested large quantities of their core reserves in sub-prime mortgage backed securities. When US housing and other markets turned down, there were lots of simultaneous defaults, with over a million mortgage foreclosures in the US in less than a year. So the market value of these securities collapsed—and a good part of the core capital of British banks disappeared down the drain.
