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Published on October 8, 2007

Last week, we continued reading about how some major global financial institutions had begun writing off billions of dollars from their third-quarter earnings because of plummeting sub-prime loans.

These institutions, including Citigroup and UBS, were not neophyte investors. They employed some of the most sophisticated and highly paid financial wizards and yet they are losing billions of dollars on these "safe" high-grade bond investments. How could this happen?

Russell Toy, Deloitte's Global Financial Industry country leader, said many of the sub-prime problems had arisen because of the sudden untrammelled growth of the real-estate mortgage-backed securitisation industry. "Since 2000, the industry has experienced exponential growth - probably at about 75 per cent per year until 2006," he said.

During the past year, many sub-prime loans were pooled with regular real-estate loans and securitised in such a way that credit agencies were able to give the bonds investment-quality ratings. "Many of the sub-prime loans were to home-buyers with tainted credit histories."

These home mortgage-loan real-estate securities were then sliced and diced into different tranches and sold to investors all over the world. "Tranche is a French word meaning 'slice' or 'portion' and in the investment world it describes a security that can be split up into smaller pieces and sold to investors," Toy said.

These securities were sliced up

to create investments for investors

with different risk appetites. "The top-rated tranche in most cases would

have the highest chance of being paid off and would carry the lower interest rate."

Toy said most securities would have at least three tranches available for sale. At the bottom would be a first-loss piece that would bear the brunt any defaults and in most cases would pay no interest but would yield a high return if and when all the loans were repaid. "This is usually an equity piece and in some cases would yield a double-digit return when repaid. No interest is paid during the bond's lifetime."

The other two tranches could be specifically tailored for different types of bond investors. These tranches may feature mortgages with different expected repayment lives. "For instance, insurance companies may want to buy bonds that match their own expected cash needs that may

in some cases be more than 10 years out."

Consequently, securitisation of real-estate mortgages created a completely new investor base for home mortgages, which had for most of the 20th century been financed locally by nearby financial institutions. Now, how did these seemingly innocuous investment-grade bonds suddenly become toxic?

As the US real-estate market climbed higher and the thirst for securitisation paper grew, investment bankers became much more aggressive and many of these home-loan securities were further sliced and diced into riskier financial instruments. For instance, some the later collateralised debt obligations (CDOs) included securities that were heavily weighted with the highest-risk equity tranches of previously issued real-estate mortgage securities.

When the US real-estate market started heading downward earlier this year and the higher interest-rate environment began making it difficult for borrowers with "teaser-rate" adjustable rate mortgages to make payments on mortgages that had reverted to higher interest rates, many sub-prime loans began defaulting.

As property prices dropped, many sub-prime borrowers that may have made down payments of 5 per cent or less suddenly had mortgages that were under water. "Their mortgages were now more than the market value of their homes," Toy said.

Consequently, any CDOs packed with sub-prime loans could have equity tranches that are virtually worthless. "Many of these tranches are not readily traded and in a liquidity crunch no one really knows their value."

Local media reports have indicated that Thai financial institutions may be holding about US$700 million (Bt24.15 billion) of CDOs. Toy said bankers should not assume all CDOs are bad. "You have to look at their underlying assets. There may be no US assets."

However, if the CDO consists primarily of sub-prime loans, Toy added, bankers would then have serious issues to consider. "The problem is that many CDOs are bundled up and people real don't know what's in them."