How to dump risk to consumers: securitisation

February 1st, 2007

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Nowadays, in the world of business, we often hear the idea of ?risk management,? which imbue a sense of control over the unpredictability of life under the sun. While it is true to some extent, this idea had often been corrupted to the point where risks are ?managed? by simply dumping them to unsuspecting consumers. As we alluded before in Are you being ripped off by fund managers?, it is often consumers who get the worse end of the deal because of their lack of financial literacy.

Today, we will look at one of the ways of how this is done?securitisation of debt. For this, we will use the mortgage lending industry as an example. Traditionally, banks make their money through mortgage lending by borrowing money at a lower rate of interest and lending to mortgage borrowers at a higher rate. The differential between the two rates make up the profit. The only risk lenders take is the threat of default by the borrowers. When that happens, in the case of mortgage debt, the home is foreclosed and the lender sells it to the market to recoup its losses.

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product. An example of such ?investment? product is the mortgage fund. These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds). As with all financial products, these ?investment? products come with ?management? fees. In Australia, there is another twist?mortgage ‘insurance.’ For borrowers who cannot afford 20% of the home equity, they have to pay mortgage ‘insurance? on top of their regular mortgage payments. These mortgage ?insurance? protects the lenders (NOT the borrowers) against mortgage defaults.

Thus, such lending businesses are highly lucrative. There are hardly any risks by playing the role of the middle-person since they are mainly being offloaded to consumers on both sides of the deal. Since this is the case, we can expect lenders to be more tempted to offer their loans to less credit-worthy borrowers (that is, the sub-prime borrowers) were it not for the securitisation of debt.

In Australia, securitised debts are mainly confined to mortgage loans. But in the US, the level of financial ?innovation? even allow credit card debt to be securitised. Thus, retail investors beware!

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