Prepare for the next Lehman, know the “dark face of loan securitization”

Hello, this is Koyama.



“The current situation is strikingly similar to the pre-Leman Shock era.”

Such whispers are circulating among market participants, though,



In the previous newsletter,

“Is the situation now really similar to the pre-Lehman shock period?”

To verify that, we discussed the historical background of Lehman Brothers’ collapse.

A quick recap: Around 2003,





In the United States, subprime loans aimed at borrowers with low credit began to expand,

and many people relied on rising housing prices,

to take out risky home loans, which was the start of the事.



“I have no money, but the house price will rise anyway, so it’s fine!

If it comes to it, I can just sell the house.”

With such optimism, low-income people also

began taking out loans without a secure repayment plan.



Meanwhile, in 2006 housing prices stopped rising,

defaults on loans surged,

leading to Lehman Shock, as was described.



However, the market was distorted not only by

the people who took on reckless loans, but also by the lenders who pushed them.



Financial institutions that relentlessly sought profits

and urged many people to take on reckless loans were,

the real culprits behind Lehman Shock.





When you hear “lending company,”

you may not picture them clearly, but

think of consumer finance in Japan— lending to low-credit borrowers at high interest.

That might help you visualize it.





So, what did those consumer-finance-like lenders do

before Lehman Shock?



Today, before the Lehman Shock occurred,

lenders urged low-income individuals to borrow

to take out loans, and what were they doing behind the scenes?

We will explain that today.



We won’t go into every detail, but

we’ll outline the overall flow in a concise way so you can understand it.





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Lenders who avoid risk

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Subprime loans are loans aimed at people with low credit,

so lenders are well aware that

the risk of default is high.





Therefore lenders do not just sit back and wait

for repayments to come in.



Lenders transfer the money they will eventually recover

the right to receive, that is, the loan claims,

to securities firms and other financial institutions.



They divested the risk of default.



By the way,

when you hear that “lenders sold loan claims,”

you might wonder…

it may be hard to picture, but…



Lenders

hold the right to receive future payments on

the money lent as subprime loans,right?



This can be seen as an asset, and simply selling that asset

helps visualize it.



So, what did investment firms or others who bought loan claims do?



Of course, investment firms did not hold loan claims as is.





They securitize the loan claims.



The meaning of securitization may be hard to grasp.



The investment company that bought the loan claims

backed their future cash flows’ credit strength

by issuing “Residential Mortgage-Backed Securities (RMBS).”





Also, you might find more difficult terms…

“Residential Mortgage-Backed Securities” are, as the name indicates,

securities issued backed by residential mortgages.





The investment firm issues

the “Residential Mortgage-Backed Securities,”

and sells them to investors, which is the sequence.


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Subprime loan: a cash cow

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For lenders, this is a very tasty situation, isn’t it?





They are freed from default risk,

and even more, money lent can come back to them again

without waiting for repayments.



And lenders use that money to

make more subprime loans.



The greed is evident, isn’t it? (laugh)



Lenders sold loan claims

and, having been freed from default risk,

used the funds to extend more lending.





The more loans they issued,

the lower the risk, and the more profitable the business.



From the lenders’ perspective,

since they bear no default risk,

the loan screening becomes increasingly lax.



Thus,

people who would not normally pass loan screening

began to obtain loans, and the market’s bomb

grew larger and larger.



Lenders too, must have suspected that market risk

was expanding.



But they hoped to “make as much money as possible,” and

subprime loans continued to expand without limit.



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Summary

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To summarize the story:



Lenders, after inducing high-interest subprime loans to low-credit individuals,

sold those loan claims to investment companies,





Investment companies securitized those loan claims andsold them to investors.



Lenders then used the funds again to

induce more subprime loans for low-credit borrowers.



For low-credit individuals,

even high interest made it possible to obtain a mortgage,

which was a relief in a way.



Here, the interests of lenders and those with low credit aligned,

and explosivelysubprime loans expanded,

which eventually led to the Lehman Shock.





But don’t you find it strange?



Why would investors want securities whose underlying assets are loans to low-credit individuals?







For example, if someone says,

“There are securities backed by consumer-finance loans, would you be interested?”



Would you buy them?



It is natural to feel“scary.”



So, why did investors buy the securities?



The answer will be explained in the next installment.



And with that, thank you very much for watching until the end today.





Keizo Shimoyama